The Reserve Bank of India on Tuesday said it would be constrained in cutting interest rates in response to declining growth unless the government takes steps to significantly reduce its fiscal deficit.
D Subbarao,governor of the central bank,said the government needed to cut fuel subsidies if it wished to increase subsidies on food. He admitted,however,that deregulating fuel prices would risk a temporary rise in inflation.
The widening deficit,Subbarao said,threatens the countrys macroeconomic stability. He felt the next budget in mid-March must embark on a credible path of fiscal consolidation.
In the absence of credible fiscal consolidation,the Reserve Bank will be constrained from lowering the policy rate in response to decelerating private consumption and investment spending, Subbarao said.
He said: The forthcoming Union Budget must exploit the opportunity to begin this process in a credible and sustainable way.
The governments fiscal deficit,the difference between its spending and receipts,is expected to increase as a percentage of GDP in the twelve months to March 31 compared with its level in 2010-11 even after adjusting for windfall revenues of nearly Rs 1.06 lakh crore from the auctions of 3G spectrum and BWA spectrum.
The fiscal slippage contributed to the government borrowing an additional 22.3 per cent of its budgeted estimate of nearly Rs 4.17 lakh crore,reaching nearly 83 per cent of its net-borrowing target by January 16.
The central government will also issue an additional Rs 1.025 lakh crore in bonds over the budgeted amount of Rs 15,000 crore in the present financial year.
The overshooting has affected the cost at which the government borrows,Subbarao said. The yield on ten-year government bonds rose to 8.89 per cent by the end of October before easing to 8.22 per cent by mid-January.
Subbarao said: If the increase in government borrowing already announced is an indication,the gross fiscal deficit for 2011-12 will overshoot the budget estimate substantially. At the current juncture when there is a need to boost private investment,the increase in fiscal deficit could potentially crowd out credit to the private sector.
The budget estimated the fiscal deficit at 4.6 per cent of GDP this year. But analysts say the deficit will be nearly 100 basis points higher at 5.5 per cent of the GDP.
Subbarao said: The anticipated fiscal slippage,which is caused largely by high levels of consumption spending by the government,poses a significant threat to both inflation management and,more broadly,to macroeconomic stability.
The prices of coal and petroleum also contain suppressed inflation since they do not reflect market forces,Subbarao said. However,he felt the government needed to reduce its subsidy to the commodities to control demand and the oil-import bill.
Revision in domestic administered prices will add to inflationary pressures,although such revisions are necessary to maintain the balance between supply and demand. Particularly,as the food subsidy bill is expected to rise,it will be prudent to fully deregulate diesel prices to contain both aggregate demand and trade deficit.
The RBI concluded that strong signs of fiscal consolidation were necessary to reduce the crowding-out of private investment and prevent a spiral in inflationary expectations,which feed into borrowing costs.
Strong signs of fiscal consolidation,which will shift the balance of aggregate demand from public to private and from consumption to capital formation,are critical to create the space for lowering the policy rate without the imminent risk of resurgent inflation, Subbarao said.