The Indian economy is presently poised on the edge of a fiscal precipice, making corrective measures aimed at speedy fiscal consolidation an imperative necessity if serious adverse consequences stemming from this situation are to be averted in an efficient and timely manner. A careful analysis of the trends in the current year, 2012-13, suggests a likely fiscal deficit of around 6.1 percent which is far higher than the budget estimate of 5.1 percent of GDP, if immediate mid-year corrective actions are not taken. Runaway fiscal deficits, leading to unsustainable levels of public debt, can cause diverse forms of macroeconomic imbalances varying with the means through which the deficit is financed. High fiscal deficits tend to heighten inflation, reduce room for monetary policy stimulus, increase the risk of external sector imbalances and dampen private investment, growth and employment. The current account deficit was already high at 4.2 percent of GDP in 2011-12 and could deteriorate further. Apart from this, the consequences of not quickly taking credible effective measures for correcting the current fiscal deficit is likely to be a sovereign credit downgrade and flight of foreign capital. This will invariably further weaken the rupee and negatively impact the capital markets and the banking sector. In addition, the situation leaves little head room for counter-cyclical policy measures in the event of another global crisis. The growing fiscal deficit also leaves limited monetary space for lowering interest rates to stimulate private investment and growth. In a country where millions of young, both skilled and unskilled, enter the labour force each year, a growth slowdown is inefficient, inequitable, and potentially politically destabilizing. It is the poor and the unemployed who will suffer the most in the event of sluggish growth and consequent political instability.
Fiscal Consolidation in India
After three years of deliberations, the Fiscal Responsibility and Budget Management Act (FRBMA) was enacted in 2003. The fiscal improvement from FY 2002-03 to 2007-08 saw a rise in foreign reserves providing unprecedented import cover and global confidence (Annex 1, Figure 1). This fiscal discipline fed into other economic variables in a positive manner. The aggregate disbursements of the central and state governments showed an increase in capital outlays from 11.87 percent in 2002-03 to 18.59 percent 2007-08 (as percentage of aggregate disbursements). The lowering of the government’s fiscal deficit (GFD) was accompanied by a benign inflationary environment, lower real interest rates and significant increase in private sector investment. It must be mentioned of course, that global economic conditions were also favourable during this period (Annex 1, Figure 2).
The twin deficits hypothesis implies that, given a certain level of private savings, an increase in the government deficit will have to be balanced by either a reduction in private investment or an increase in the Current Account Deficit (CAD.) The CAD then needs to be financed through external capital inflows, government external debt or drawdown of foreign exchange reserves. Government’s funding of the deficit through domestic sources tends to be inflationary. Even when the government does not explicitly use seigniorage, if the central bank has to auction government bonds and have adequate takers it needs to create enough liquidity. The RBI indicates that it has been doing so in recent years1. This increase in liquidity can be inflationary.
Given this background, the recent increase in government deficits, the investment decline, the rigidity of inflation, the pronounced IIP decline and the widening of the CAD are all pointers to a deepening fiscal crisis.
The Do-Nothing Scenario
The rationale for a credible and effective fiscal consolidation in the current context is built on three main grounds: (a) we are in state of high fiscal stress, with a “do-nothing” approach likely to result in a Central Government fiscal deficit of 6.1 per cent of GDP in the current year 2012-13; this could result from a likely shortfall in gross tax revenues by around Rupees 60,000 crore and higher than budgeted expenditures on subsidies, by about Rupees 70,000 crore ; (b) this fiscal stress is also compounding the problem of twin deficits, with the current account deficit at 4.2 per cent of GDP last year, and possibly at 4.3 per cent of GDP this year, at a time when the world market and capitals flows are exceedingly fragile and where financing of this magnitude is creating huge risks for macroeconomic and external stability; and (c) the gross borrowing requirement, already high, is likely to exceed last year’s level by a large margin (5.8 per cent of GDP versus 5.4 per cent of GDP last year), leading to crowding-out of private sector financing for investment. Foreign exchange reserves are falling, and the currency is especially vulnerable. The combination is reminiscent of the situation last seen in 1990-91.
The Financial Health of OMC’s
A worrying aspect related to the need for fiscal consolidation is the financial health of the Oil Marketing Companies (OMCs). While there appears to have been some correction in 2009-2010, possibly due to petrol price deregulation the situation remains grim. It could worsen with a rise in crude prices and a ballooning of the oil subsidy burden. If the OMCs are not adequately funded against their under recoveries there is a genuine risk that is analogous to the case of the state electricity boards, the high debt of the OMCs could lead them into financial crisis. This in turn, could not only cause an oil supply breakdown resulting in immense public hardship but also adversely impact the banking system from where such debt is sourced.
A clearer perspective emerges when the present domestic fiscal situation is viewed against the backdrop of comparative emerging economy parameters. Cross-country benchmarking suggests that India is clearly an outlier in terms of major fiscal indicators and currently has the least room for counter-cyclical fiscal policy response if conditions take a turn for the worse in global markets, second only to Egypt among 27 major emerging markets, measured in terms of inflation, real interest rates, exchange rates, current account deficits, cyclically adjusted budget balances and general government debt levels2. The situation is all the more dangerous now, much more so than in the past, because we have a surge in young people looking for jobs. If the elasticity of employment to GDP growth is 0.4 then growth of about 7 per cent per annum would give us 2.8 per cent employment growth. With a labour force growth of 2.5 per cent, this would provide adequate employment opportunities. However, if growth slips to say six percent or below, and employment growth slows below 2.4 per cent, unemployment would rise.
We cannot overemphasize the need and urgency of fiscal consolidation. Growth is faltering and inflation seems to be embedded. The external payment situation is flashing red lights. The global economy is likely to be more turbulent, making financing of the large external payment deficits very challenging. Potentially, if no action is taken, we are likely to be in a worse situation than in 1991 for several reasons. Energy prices are at much more elevated levels while our import dependence is now even greater. The Indian economy now is much more open and global developments have greater impact than before. India’s “demographic bulge” demands higher growth to meet the rising aspirations of our young generation. In order words, our economy may be encountering a “perfect storm.”
There is yet another strategic consideration for us now. It is imperative that as a responsible nuclear power, India pursues a responsible fiscal policy. This will enable us to retain our strategic autonomy.
The process of fiscal consolidation will no doubt cause some short term pain which should be equitably shared. With determined policy action and astute political statesmanship, the pain of voluntary fiscal correction now will forestall the pain of externally enforced involuntary fiscal correction later.