The Hindu Business Line : Fiscal management — A victim of political cycles

Post-1996, efforts at bringing down the Centre's fiscal deficit have been barely credible. But advocates of fiscal activism put forward several arguments to support their view that nothing untoward has happened to the economy since then. Most of these defences, however, are flawed, says A. Vasudevan, pointing out that only definitive fiscal policy rules for the medium term will obviate the dangers of political cycles.

A LOT has been written on fiscal policy issues in recent weeks. No one says there should be fiscal balance or fiscal surplus in the medium term. No one also specifies the exact limits to fiscal deficit relevant for the short term. However, one figure — 4 per cent of fiscal deficit as a percentage of GDP — was mentioned in the early 1990s as the Lakshman rekha for India's sound macroeconomic adjustment.

This figure represented the combined Central and States' deficit without clarifying what exactly should be the Centre's deficit. And it was felt that the combined States' deficit, net of transfers, could be limited at around 1 per cent, closer to the average achieved till the early 1990s.

There were serious attempts to bring down the Centre's deficit from 1991-92, but after 1996 the efforts were hardly credible. Advocates of fiscal activism, however, point out that nothing untoward has happened to the economy since then.

They see the recent policy announcements for leaving more money in the pockets of consumers and the relaxing of decisions on the use of foreign exchange reserves as spurring the dormant growth impulses. On the other hand, the majority of observers describe these announcements as political giveaways just before the general elections.

Since elections take place every five years, the present moves are typically like political cycles when deficits go up. This has been rendered possible because there are no fiscal policy rules and fiscal transparency has not yet been codified.

Interestingly, one of the strong dissenting voices was that of Martin Feldstein, the well-known fiscal expert of Harvard University. In his L. K. Jha Memorial Lecture, sponsored by the Reserve Bank of India on January 12, he observed: "One of the major problems facing the Indian economy is your large budget deficit and the resulting high level of national debt."

He added: "Large fiscal deficits have a variety of adverse consequences: reducing economic growth, lowering real incomes, and increasing the risk of financial and economic crises of the type that we recently witnessed in several countries of Asia and Latin America. Since I am here in a central bank, I should add that, under some circumstances, fiscal deficits can also lead to inflation."

By often quoting data relating to the Indian fiscal situation, he has sent a message to New Delhi. The papers read at the NIPFP-IMF Conference on Fiscal Policy in India at New Delhi on January 16-17 also carried similar messages and expressed concern at the apparent ease with which fiscal deficits were tolerated in India.

The defenders of the faith have, however, marshalled many an argument to show that the current fiscal position is not going to be harmful in the foreseeable future.

First, they point out that the gross fiscal deficit relative to GDP would not go beyond what was budgeted for 2003-04 as GDP is expected to grow at over 8 per cent this year and the average inflation rate could be stable or even lower than in 2002-03. This argument is facetious, because one has to normalise the ratio to get at the severity of the problem and take into account the high revenue deficit as well.

The second defence is that the domestic debt increase on account of large cumulative fiscal deficits would not be burdensome since it is owed to domestic residents. This argument is fallacious because it still entails servicing of interest on debt through collection of additional taxes, impairing loss of real incomes.

Third, it is said that fiscal deficits have not caused depreciation of the rupee. But this was because of the large capital inflows. No doubt, large capital inflows did not cause large appreciation. The rate, in fact, has been more or less stabilised with deft interventions, which means that the exchange rate vis-à-vis the weak US dollar has been export-inducing. But the fiscal deficit per se in this case has not been at the heart of the favourable prospect for exports.

Fourth, fiscal deficit is said not to have led to short-term external borrowings but it would have, had not India followed a conscious policy of avoiding short-term debt accumulation.

Finally, fiscal deficit, it is pointed out, has not led to financial instability. Fortunately, the financial reforms have been based on fairly good prudential norms but this does not mean that the soundness of financial institutions has been assured, given the scope for improving loan recoveries and reducing non-performing assets.

Thus, considering that several holes may be picked in the defences, why is there no strong opposition to the present fiscal position? This may be because the average voter is not interested in the fiscal deficit and he perceives some benefits from higher public expenditure.

Expenditure cannot be easily curtailed, surely not in the election year. And new taxes and tax rate increases would also be ruled out in the election year. In any case, where is the tax buoyancy? One must be dreaming about it when it is known that agriculture and the service sector together account for over three-fourths of GDP and are not only under-taxed but also less tax-compliant.

At present, the overall public sector deficit is placed at nearly 11 per cent of GDP. The public sector absorbs almost the entire savings of the household sector in the form of holding of financial assets. There is apparently a crowding out. The private sector's domestic saving available for investment thus consists of only the organised corporate sector's measly saving rate of about 4 per cent!

The household sector's saving in the form of physical assets is already accounted for as investment. But the estimation of physical savings leaves much to be desired, particularly as the physical savings rate has exhibited inexplicable variability.

If the estimation is not robust, then raising the private investment rate would depend on augmenting the corporate savings rate, or/and eliminating public sector dis-saving, or/and inducing households to save more in the form of financial assets rather than in the form of physical assets.

The last mentioned point is important because there is reason to believe that the financial savings and physical savings of households are substitutable in favour of the former since the capital values of some of the physical assets move in either direction and affect the risk-return profile of the overall investment portfolio of households.

If none of the above alternatives operate, the only way by which the private sector can improve its investment rate would be by garnering inflows from abroad, particularly in the form of foreign direct investment.

Large capital inflows could carry an implicit cost, against which the authorities have to maintain guard.

Fiscal activism surely is not a way of ensuring sustained financial stability. The priority is to make fiscal transparency credible by having definitive fiscal policy rules for the medium term as part of India's political economy. It is only then that the dangers of political cycles would be eliminated.

One expects, for the sake of posterity, that the authorities will move quickly to reverse the present fiscal position once the general elections are over.

(The author, a former Executive Director of the Reserve Bank of India, can be reached by e-mail at asurivasudevan@hotmail.com)