In the run-up to the budget, there was enormous pressure on the finance minister to launch a fiscal stimulus so as to pump-prime the economy. That she did not succumb to the temptation is a big relief as any attempt to spend our way out of the growth slump would have been a futile endeavour; worse, it would have triggered deeper problems down the line.
Fiscal stimulus enthusiasts should note that there is already considerable stimulus in the system. It has long been known that the true fiscal deficit is higher than what the government’s books show. To her credit, the finance minister took a step towards transparency by admitting to off-balance sheet borrowings of 0.8 per cent of GDP for both the current and next fiscal year — acknowledging that the fiscal deficit would actually be higher at 4.6 per cent and 4.3 per cent of GDP respectively. This is already excessive. Add to this the unrealistic projections of revenue growth and disinvestment proceeds for next year and we have a potentially unsustainable fiscal situation. Any stimulus on top of this would have been clearly unwarranted, and for many reasons.
Fiscal pressures will undermine the Reserve Bank of India’s struggle to revive investment by bringing down long-term interest rates. It could result in a sovereign ratings downgrade and jeopardise efforts to attract foreign capital. It can stoke inflationary pressures, something we cannot afford when inflation is above the RBI’s target rate. And most importantly, it can lead to pressures on the external sector. The balance of payments crisis of 1991 and the near crisis of 2013 in the wake of taper tantrums were, at their heart, a consequence of extended fiscal profligacy.
The supporters of a fiscal stimulus will raise several counter-arguments. They will argue that our debt-to-GDP ratio is low in international terms. The data don’t bear this out. In any case, our experience as well as research shows that international comparisons of debt-to-GDP ratios, without reference to other parameters, are misleading. The supporters will argue that we do not need to worry because our debt is mostly in domestic currency unlike that of many emerging economies. That didn’t protect us from previous crises, and there is no reason to believe that it will protect us from the next one, especially as our foreign debt is proportionally higher than before. They will also argue that our foreign exchange reserves are robust and a balance of payments crisis is improbable. Such complacence is misplaced. We should not forget the lesson that in good times any amount of forex reserves looks like it is too large, but in bad times no amount of reserves is large enough.
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As much as the headline fiscal deficit numbers are a cause for concern, the underlying quality of fiscal consolidation is a bigger concern. Conveniently off the radar, the revenue deficit, far from coming down, is actually going up. This year, more than two-thirds of what the government is borrowing is going to finance current expenditures like salaries, pensions, interest payments and subsidies. That ratio will rise to three-quarters next year. This is simply unsustainable as it will increasingly crowd out capital expenditure.
Another dimension of the quality of fiscal consolidation is the combined fiscal position of states which is in fact the big elephant in the room. Together, states spend one-and-a-half times more than the Centre. Studies show that how efficiently states spend their money has a much greater development impact as compared to the Centre. And states are not doing a good job. In its latest annual report on state finances, the RBI raised several red flags on state finances — states’ increasing weakness in their own revenue generation, their unsustainable debt burdens and their tendency to retrench capital expenditures in order to accommodate fiscal shocks such as farm loan waivers, power sector loans under UDAY and a host of income transfer schemes. The market will penalise mismanagement of public finances; it does not care who is responsible — the Centre or states — for an unsustainable fiscal stance.
On top of all these concerns, by far the biggest fear about a fiscal stimulus, especially in a vigorous democracy like ours, is that it is tempting to plunge into a spending programme saying it is a one-off and will be withdrawn when the pressure eases. Experience shows that it is very difficult to bail out. As Milton Friedman famously said, there is nothing more permanent than a temporary government programme.
What the economy needs for a sustained turnaround is kickstarting private
investment. And a necessary condition for inspiring investor confidence is implementation of structural and governance reforms. This will be a long-haul. But, as Mao Zedong said, even a thousand-mile journey has to start with a first step. That the budget did not launch the journey is a big disappointment. But, at least, the budget did not make a bad situation worse by embarking on fiscal adventurism. It’s better, as Keynes said, to be roughly right than precisely wrong.
This article first appeared in the print edition on February 12, 2020 under the title ‘Shun fiscal adventurism’. The writer, a former governor of the Reserve Bank of India, is currently visiting fellow at the University of Pennsylvania.
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