The Hindu Business Line : IMF cautions India on the fiscal front

JUST ahead of the Union Budget 2006-07, the International Monetary Fund (IMF) today cautioned India that its macro-economic policies should remain vigilant, while maintaining that the current favourable economic conditions provide "a good opportunity to speed up structural reforms".

This is the nub of the Article IV Agreement, the Fund staff team report made after discussing the issues with the Indian authorities which was discussed on February 4 in Washington at the Fund's Executive Board.The report was released in Washington today and communicated to New Delhi by the Managing Director of the IMF as Chairman of the Board.

Staff projects GDP growth of over 7.5 per cent this year, led by strong domestic demand. But for 2006-07, growth is expected to decline slightly as the economy further re-adjusts to higher oil prices and domestic and world interest rates rise. While export growth continues to be strong, a large increase in both oil and non-oil imports caused the trade deficit to widen further this year and contribute to a sharp deterioration in the current account deficit. Staff projects it to reach 3 per cent of GDP in 2005-06.

Following three years of declining fiscal deficits, a "pause" in deficit reduction was announced this fiscal, it said adding that the 2005-06 Budget deficit target of 4.3 per cent of GDP falls short of the minimum reduction required by the Fiscal Responsibility and Budget Management (FRBM) Act. "This reflected significant spending increases for key social and infrastructure needs and higher transfers to the States. The general Government deficit is projected by staff to rise, for the first time in four years, to 7.75 per cent of GDP," they said.

Though inflation has remained contained, underlying pressures point to upside risks. In particular, domestic demand remains strong, as demonstrated by a widening current account deficit and rapid credit growth. Hence, fiscal policy should counter demand pressure, the Directors of the Executive Board said adding the importance of overperforming on the Budget and meeting the minimum adjustment required under the FRBM Act. They also cautioned that markets might construe the pause in deficit reduction in the current fiscal year as "a weakening of the commitment to reform".

Underlining the need for the Indian economy to adapt to permanently higher international oil prices, they favoured moving gradually to the full pass-through on oil prices — with targeted support for the poor — which would help limit fiscal and quasi-fiscal losses and provide spurs for more efficient energy use, thus adding competitiveness in the medium term.

Expressing concern over India's large public debt which is a key constraint to growth, they warned that without further enhancing tax revenues and reducing low-priority spending, it would be difficult to create fiscal space for the planned large and crucial increases in infrastructure and social spending. "Fiscal consolidation is a prerequisite for more complete financial sector development and further opening up of the capital account," the Fund noted.

While acceleration of tax reform is critical to achieve the Government's deficit reduction targets, the directors emphasised the need to further broaden the tax base by trimming extant exemptions and eventually introducing a goods and services tax with few exemptions. Plumping for bringing general tariff to ASEAN levels, they said broad-based tariff reductions would help minimise the trade diversion potentially associated with preferential trade arrangements. Continued loosening of sectoral limits on foreign direct investment together with bids to improve business climate and liberalise labour laws could foster growth and job creation, while reducing India's reliance on shorter-term capital flows, they said.

While expressing that greater spending efficiency, in particular improved targeting of subsidies, would be required to generate the needed fiscal adjustment, they said the new rural employment guarantee programmes signifies " a potentially large expenditure commitment" and advised "the Government to proceed cautiously with it".

In hailing recent reforms made by the States in the wake of the Twelfth Finance Commission to further strengthen their finances, they stressed that State finances could be beefed up further by increasing conditionality and hardening budget constraints, including via tighter global borrowing ceilings. There is a need for consolidating the recent gains through tax base broadening and further reforms in the pension, subsidy and State electric utility areas.

The current sound position of the financial system provides a good basis for its further deepening through increasing private and foreign participation in the banking sector, including by expediting implementation of the RBI's banking reform roadmap, they noted.

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