The forthcoming Union budget would be presented at a time when there are strong headwinds from the global financial markets and weak global growth. This is reflected in the continued deceleration in India’s exports growth. There are other factors — such as low international oil prices, which declined by about two-thirds since the last budget, the very low current account deficit, 7.6 per cent GDP growth in the current financial year (FY15) and domestic inflation below the target — that should provide some headroom for prudent fiscal policy in the budget. In addition, recently, the stock markets have declined sharply, which is partially attributed to bulging NPAs in the banking sector. Following these mixed developments, there are expectations that the forthcoming budget would ensure balance between growth and fiscal prudence.
On growth, two issues need to be understood. Despite India being the fastest growing economy in the world today, do we still need growth-revival policies? For this, one has to understand what is the potential growth of India and what is the level of growth India wants to achieve. In the past, the Planning Commission used to address both these issues, under the five-year plans, by providing medium-term perspective on growth aspirations and the drivers through which one could achieve such growth targets. In the absence of the commission’s guidance, there appears to be some institutional vacuum in this regard. So is 7.6 per cent GDP growth below potential, more so when the external demand has been subdued for a long time? This is an empirical issue that needs to be addressed through long-term GDP and investment data. The adoption of a new GDP methodology and the lack of its back series make such estimates quite difficult. As far as the data is concerned, despite the investment rate decelerating from 33.4 per cent to 29.4 per cent over the last four financial years (FY13 to FY16), the real GDP growth rate has accelerated from 5.6 per cent to 7.6 per cent. While this trend may be misunderstood for declining ICORs (Incremental Capital Output Ratio — a declining ratio indicates efficiency gains and vice versa), it could also pose a question on the way the new GDP is estimated.
Be that as it may, the issue is this: What can be done in the budget to push growth closer to the 9-10 per cent, which India achieved before the 2008 financial crisis? In this regard, there was an interesting discussion among economists and analysts (even RBI Governor Raghuram Rajan jumped in) on whether to relax the fiscal deficit target or not, as prescribed in the revised Fiscal Responsibility and Budget Management (FRBM) Act, 2003, announced during the last budget as part of the Medium Term Fiscal Policy (MTFP) statement. Under the act, the Central government fiscal deficit, as a percentage of GDP, was fixed at 3.9 per cent for FY16, and 3.5 per cent (FY17) and 3.0 per cent (FY18) as rolling targets. But this is only half the story. Within the MTFP there are other sub-targets; the effective revenue deficit needs to be brought down to zero by FY18, with revenue deficit at 2 per cent. In other words, the capital expenditure (which is the difference between fiscal deficit and effective revenue deficit) should be increased from 1.9 per cent of GDP in FY16 to 3 per cent by FY18. Our own analysis in the past suggests that these targets are internally consistent with high growth, provided all the targets are achieved and not just the headline target of fiscal deficits. Deviation in any of these targets could not only result in contraction of economic activity but also put pressure on public debt and its servicing.
So can the government relax the MTFP targets in the budget to revive growth? There are three issues here. One, while it appears to be confident of achieving the fiscal deficit target, it is not clear whether
it will achieve the revenue deficit target of 2.8 per cent and effective revenue deficit target of 2 per cent. In fact, it is not clear whether the concept of effective revenue deficit still exists. If not, the pressure to sharply reduce the revenue deficit to zero by FY18 could be huge.
Second, fiscal consolidation would be expansionary only when there is expenditure switching from consumption to investment activities. What is happening currently is a reverse mechanism that is leading to lower growth. Data (between FY13 and FY16) shows that consumption expenditure (both private and government, as a ratio of GDP) is increasing while investment rate (both public and private) is decelerating. Hence, to revive growth, there is a need to shift the demand from consumption to investment. Any relaxation in revenue deficit should also show up in fiscal deficit, thus ensuring no compression in capital expenditure targets.
Third, it is very important to review midway the downside risks in achieving the fiscal deficit targets. For example, in
the current year, apart from nominal GDP growth assumption, all other assumptions, such as oil prices, inflation, exchange rate, etc, have been off the mark. As such, the FRBM targets need a relook.
To sum up, there is no doubt Finance Minister Arun Jaitley faces a dilemma with regard to the fiscal roadmap. However, in the context of the presumed output gap, and with deviation in revenue deficit target, sticking to the fiscal deficit target is riskier than relaxing it a little in order to prop-up growth. Further, the crowding-out impact of a slightly higher fiscal deficit (especially due to higher capital expenditures) on private investments, in the context of stressed banks, is expected to be weaker than anticipated.