In fact: How India learnt to tighten belt, be fiscally responsible

In 1999, a year into Atal Bihari Vajpayee’s NDA government, as India’s mounting debt burden started to reflect in worsening indicators such as the fiscal deficit and the financial health of states, the Finance Ministry under Finance Minister Yashwant Sinha braced for the return of an economic crisis like the one of the late 80s. […]

Written by Shaji Vikraman | Updated: April 5, 2017 6:08:00 pm

In 1999, a year into Atal Bihari Vajpayee’s NDA government, as India’s mounting debt burden started to reflect in worsening indicators such as the fiscal deficit and the financial health of states, the Finance Ministry under Finance Minister Yashwant Sinha braced for the return of an economic crisis like the one of the late 80s. After a period of revenue surpluses in the states in the early 80s, an expansionary policy by Rajiv Gandhi’s government had created conditions that led to the balance of payments crisis of 1990-91. The P V Narasimha Rao government managed to restore the balance before the impact of the Fifth Pay Commission and a slowing economy hit the finances of both the central government and the states.

During discussions in the Ministry, it was pointed out that most countries, including some in sub-Saharan Africa, had laws to curb borrowings and budgets. India had been an outlier for the good part of over six decades, with a record of spending and borrowing with inadequate revenues to meet current expenditure. After Finance Secretary Vijay Kelkar discussed this matter based on a paper on fiscal management and global practices written by Urjit Patel, then an economic advisor in the Ministry (and now RBI Deputy Governor), Sinha and his officials decided to form a committee. RBI Governor Bimal Jalan asked his deputy, Y V Reddy, whether he would head the committee, but Reddy declined, given the role of the central bank and the perceived need to maintain a distance from legislating for the state.

With Kelkar moving to Washington to represent India on the International Monetary Fund board, Sinha appointed, in early 2000, EAS Sarma, the new Economic Affairs Secretary, to head the committee. The panel had the active participation of the National Institute of Public Finance and Policy and its head Ashok Lahiri, later Chief Economic Advisor in the same government. As the committee began work on a medium-term plan aimed at fiscal discipline and binding legislation, it received behind-the-scenes support from RBI Deputy Governor Reddy.

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The concern wasn’t just fiscal prudence — it was also to make the budgetmaking process more transparent, and ensure more discussion and debate — in Parliament and outside. Anchoring this exercise was a key Ministry official involved in the Budget process, who had been overseas, and had prepared a paper on fiscal legislation.

The committee debated targets to ensure fiscal discipline, and whether they needed to be built into the new law. The norm then was to cap fiscal deficit — the government’s borrowings from the market — at 3% of GDP or national income as incorporated in the Maastricht Treaty of 1992. Some economists felt the government would be better off without physical targets for indicators such as fiscal and revenue deficits. But given India’s economic track record, many in the committee leaned towards physical targets to achieve the broader goal.

Sinha initially backed a lower deficit target of 2%, and got Vajpayee on board on the legislation that was proposed in his 2000-01 budget. In July 2000, the Sarma committee recommended an oversight body — headed by the Prime Minister and including the Leader of Opposition, RBI Governor and others — to ensure fiscal responsibility, but one member, the CAG, dissented on the ground that such a fiscal management committee went against the basic structure of the Constitution, and would be an encroachment on the prerogative of the Finance Minister. But the target of an annual reduction, starting 2004-05, of the revenue deficit by 0.5% and the fiscal deficit by 0.3%, and the elimination of the revenue deficit by 2007-08, was written into the new law — as was a target for lowering liabilities in the form of guarantees provided by the government on borrowings by companies it owned, and an end to easy money or borrowings from the RBI. That was how, for the first time in India, legislation seeking to impose prudent limits for borrowings and on government debt was conceived.

The Fiscal Responsibility and Budget Management (FRBM) Bill found the going tough in Parliament. The government worked hard to convince the Standing Committee on Finance and the Public Accounts Committtee of benefits of the Bill. On his visits from Washington, Kelkar told Vajpayee and others such as Shivraj Patil, who headed the Standing Committee on Finance, that in the event of another economic crisis, access to funding from multilateral lenders such as the IMF would be tough, especially after the 1998 nuclear tests. The Bill was ultimately piloted through Parliament by Sinha’s successor Jaswant Singh. But it was a diluted version of the original, as the NDA, at the end of its term, had to make several compromises. A committee headed by Kelkar then provided a roadmap for implementing the Act.

The new law, however, was notified only in July 2004, after the UPA government took over. Finance Minister P Chidambaram, who presented the first Budget, announced that in keeping with the Common Minimum Programme of the coalition government, the revenue deficit would be eliminated a year later than planned — in 2008-09 — and brought an amendment to the Finance Bill. In his second budget in 2005, Chidambaram announced that he was pressing the pause button because of the additional burden of implementing the recommendations of the 12th Finance Commission. The economic rebound between 2004-05 and 2007-08 helped the government reduce deficits below the budgeted targets subsequently. More importantly, state governments that had adopted a similar law lowered their debt burdens considerably, leading to impressive consolidated macroeconomic indicators.

The setback came in 2008-09, after the global financial crisis. New Finance Minister Pranab Mukherjee favoured counter-cyclical measures that fiscal year to support industry, cutting excise duty by 4% and service tax by 2%. By the end of the next fiscal — 2009-10 — fiscal deficit had risen to 6.5% of GDP from just 2.5% in 2007-08. Fiscal discipline had taken a blow, and many reckon that the troubles of the government subsequently may have been rooted in that period of economic management.

With a crisis in the offing and a currency battle under way, Chidambaram, after returning to the Finance Ministry, spoke to Kelkar, and asked him for a quick fiscal consolidation roadmap. This was done in four weeks. By the time the Narendra Modi government took over, with two consecutive years of sub-par 5% economic growth, the debate had shifted to the possible need for a policy that would provide for higher spending in years of slowdown, and an aggressive lowering of debt during periods of rapid economic growth.

In the 2016 Budget, Finance Minister Arun Jaitley announced the government’s plan to review the FRBM Act to consider whether the target for fiscal deficit could be in a range. But not many have noticed how, over the last few years, the record of fiscal consolidation by states has been far superior. In other words, the central government has occupied the fiscal space vacated by states after fiscal consolidation.

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