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Monday, December 06, 2021

First manage the recovery

The government should focus on a durable plan instead of going into immediate overdrive

Written by Jahangir Aziz |
May 18, 2009 12:33:06 am

The UPA has returned to power and with significantly higher votes. In these days of fractured Parliament,this is as good as a mandate. The market will heave a big sigh of relief and even jump with joy at the prospects of a full-term stable government. Monday’s gap-up at opening of the stock market could be big. The mandate,however,will also raise expectations of a roll out of reforms. The refrain already making the rounds is no more excuses. But a reform overdrive is unlikely. Not because political constraints have not lessened,but because the financial turmoil has raised concerns globally — unfounded or otherwise — about financial liberalisation. Unlike the 1991-92 downturn,which was seen as a crisis and thus was responded to with fundamental reforms,the current slowdown is seen as collateral damage from a global shock and the need for big reforms viewed as less urgent. So in the near-term,policies will likely be focused on securing a durable economic recovery and reforms that are seen as needed to achieve this will be hastened.

Needless to say,an early presentation of the full-year FY10 budget will clearly be highest on the new government’s agenda. In June when the government most likely will be presenting the budget,there will be rumours of a recovery but not hard evidence. Not that a recovery will not be forming in the economy — indeed a recovery in the second half of 2009 is very likely — just that it is unlikely to show up in the data. Instead the data flow will still be telling the adjustment story of the earlier months. So additional fiscal support will be demanded and provided. But fiscal space is limited. If oil and naphtha prices remain soft,lower subsidies should allow about 2 per cent of GDP in additional fiscal space. This will likely be used up to accommodate both lower taxes and higher spending. So the overall central deficit could reach 8 per cent of GDP and with the state deficit around 11 per cent of GDP,the same as in FY09.

Much is expected from the government on increased infrastructure spending. And the economy truly needs it even if the global shock had not occurred. The financial crunch has made it that much more difficult for the private sector to finance their participation in such projects. This calls for increased government equity in infrastructure projects. But direct spending of such size from the budget looks difficult. Instead,the government will have to depend on expanded refinancing facilities and government guarantees to make it cheaper to raise long-term funds. In this regard,also eliminating the limit on FII holding of domestic corporate bonds would clearly be useful.

But consecutive years of 11 per cent of GDP will raise two main concerns. The first is that this will imply an even larger government borrowing than in the first half. And the borrowing would be occurring at a time when private credit is also likely to revive with the economic recovery. This would likely exert significant pressure on interest rates. Given that a revival of the investment cycle is critical for the durability of the recovery,higher interest rates could be the spoiler. The government has several relatively easy options to manage liquidity and limit the rise in rates. Among these are continued open market purchases of government securities by the RBI,a shift in the government’s borrowing to the shorter tenor,increase FII holding of government bonds,and issue NRI bonds. These measures should be able to keep the rise in rates to modest levels.

A bigger problem is that the high deficit will raise serious concerns about debt sustainability and this could spike rates even if liquidity is managed. The market empathises with the need to provide short-term fiscal support,but the June budget will need to be framed within a medium-term consolidation programme to assure sustainability. This balancing makes the formulation of the budget harder but not impossible,given the electoral mandate. Four elements need to be part of any medium-term consolidation programme. Enacting the successor to the FRBM Act with credible targets and a broadened definition of the deficit that includes outlays such as oil and fertiliser bonds should be relatively easy.

The 13th Finance Commission should have a draft act ready soon. As promised in the Congress party manifesto implementing a nationwide goods and services tax (GST) should also be relatively painless given widespread agreement and technical preparation.

 More difficult,but under the current political configuration very doable,is a return to privatisation. Unless the asset side of the government is brought into play it will be very difficult to bring down public debt. However unfortunate the present cash-crunch,maybe it opens the political space to garner agreement if not willingness to divest.  Equities have recovered significantly from its lows of last year,but concerns remain that the market may not be strong enough or global liquidity sufficiently normalised to absorb a large increase in supply. This concern can be allayed by making the listed public sector undertakings issue 2-3 year convertible bonds,which would ensure commitment to the divestment and let the market choose its timing.

Beyond the budget,the UPA brings with it an unfinished agenda of reforms in the pension and banking sectors,changes in how the FDI cap is calculated and raising it for insurance and retail businesses. More fundamental changes,especially in the financial sector,as laid out in the Mistry and Rajan committee reports will probably be undertaken in the FY11 budget and beyond. It would of course help if the June budget laid out a roadmap for these reforms.

These reforms are needed to return growth to the 8-9 per cent trajectory. That said,rather than overload the immediate agenda,focusing on managing the recovery to ensure its durability should be the government’s first-order of business.

The writer is chief economist India,JP Morgan Chase. He was principal econo mic advisor in the previous UPA government.

These are his personal views.

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