The Hindu Business Line : Growth versus fiscal prudence

Fiscal deficit reduction and maintenance of non-inflationary growth momentum constitute the key to India's economic advancement, even as there has been a raging controversy on both counts in recent days.

On fiscal deficit reduction, the United Progressive Alliance Government has been considering the "inclusive" growth strategy, which would entail substantial subvention to keep the various welfare programmes going.

While the Plan panel favours relaxing strict adherence to the Fiscal Responsibility and Budget Management Act (FRBM), 2003, by plumping for shifting the goalposts so that the public investment on the scale desired could be made, the Finance Minister, Mr P. Chidambaram, has refused any such accommodation, as such a move could negate investor confidence in policy stability in India.

On the inflation front, when on July 25 the RBI unveiled its first quarterly review of the Annual Statement on Monetary Policy for 2006-07 and raised both the reverse repo and the repo rates by 25 basis points, over and above the surprise hike of the same magnitude on June 9, there was some controversy over the alleged letter from North Block asking commercial banks not to hike lending rates that would affect growth impulses in the economy.

So on two different issues linked to macroeconomic fundamentals, the Finance Minister wore two hats, even though in the 2005-06 Budget he had pressed the "pause" button on the FRBM Act.

In this context, the central bank, in its monastic adherence to monetarist stance, expatiated on both the issues with clarity, setting at rest the doubts and likely policy distortions by administrators, acting under political compulsions.

The RBI did this in its 2005-06 Annual Report, though not many commentators have dealt with these two issues that hold considerable significance for all stakeholders of the economy, particularly when the trade-off between growth and inflation is glaringly deleterious.

Growing deficits

The report said the revenue and fiscal deficits in 2006-07 of the Central Government are budgeted to be reduced by the minimum annual thresholds, as stipulated under the FRBM Rules. But the progress in the Central Government finances during the first quarter of 2006-07 (April-June) shows that the key deficit indicators "departed from the past trend, both in terms of proportion to Budget Estimates as well as growth rates."

Thus, the revenue deficit during April-June 2006 grew 49.4 per cent and constituted 83.4 per cent of the Budget Estimates for 2006-07. The fiscal deficit increased by 42.6 per cent during the first three months of the current fiscal compared with 30.8 per cent a year ago.

Though the Government has reiterated that the deficit targets set under the FRBM Act would be met with an evening-out of revenues and expenditures over the year, the RBI rightly called for "determined measures for fiscal consolidation" to achieve the declared FRBM targets so that the current growth momentum of the economy can be maintained.

It said that despite the fiscal consolidation in recent years, the combined fiscal deficit of the Centre and States continues to be high by global standards.

The persistence of large deficits over the past decades has resulted in elevated public debt — currently around 80 per cent of GDP — while revenue deficits continue to remain high.

Cost of growth

In another context, the RBI said in the report that since the late 1990s, the fiscal consolidation process has been primarily led by revenue augmentation, which implies greater role to be played by economic growth in containment of fiscal gaps. The experience of the recent years suggests that prudent fiscal policy and high economic growth comprise a virtuous circle.

The "pause" in the FRBM path in 2005-06 has resulted in a slowdown in the progress towards fiscal consolidation. Both revenue and gross fiscal deficits, relative to GDP, slipped last year over their levels in 2004-05.

With the resumption of progress in approaching FRBM targets in 2006-07, reductions in key deficits have been budgeted to fulfil only the minimum annual stipulations. Consequently, larger deficit reductions in 2007-08 and 2008-09 would be required to meet the FRBM targets. It this pressure to maintain fiscal prudence in the next two years or the beginning of the Eleventh Plan (2007-12) that prompted Mr Chidambaram to resist suggestions to relax the FRBM goals.

Improve tax revenue

Given that revenue expenditure has remained broadly stable in the last decade and a half, and non-tax receipts continue to be sluggish, the scope for deepening fiscal empowerment lies in improving tax revenues. This would require concerted efforts in substantially improving the tax-GDP ratio by further widening of the tax base and severely curtailing tax exemptions.

No wonder, the central bank frowns upon the tax largesse lavished on the Special Economic Zones (SEZs) that could put paid to Centre's tax calculations when the general tariff level is being brought down under WTO dispensation.

In fact, while suggesting that government's strategy of augmenting tax collection through liquidation of tax arrears and improvement in tax administration in the wake of likely sluggishness in non-debt receipts (such as disinvestment), the RBI said the tax regime could be revisited comprehensively "to minimise transaction costs and remove regressive elements, thus contributing to both growth and fairness in public policy."

It lays emphasis on adhering to the FRBM targets in respect of fiscal deficit and revenue deficit as being critical for macroeconomic, financial, external sector and Budgetary sustainability.

Besides, as use of borrowed resources for meeting the current expenditure requirements has widened the asset-liability mismatch over the years, it is essential to eliminate revenue deficit and generate sufficient revenue surplus, which can be used for asset creation without generating liabilities.

"Any slippage in achieving the FRBM targets could erode the gains achieved in the initial year of the FRBM. It could also generate a chain effect at the State levels to relax targets set out in their fiscal responsibility legislations."

What worries the apex bank is that any deviation from the FRBM targets will have both "national and international repercussions in terms of credibility."

Tracking inflation

On the important issue of inflation, the RBI has adverted to the question of proper measurement of inflation and inflationary pressures, in the wake of the recent firming up of headline inflation across the globe due to higher oil and other commodity prices. Use of core measures is debatable in the wake of record high crude oil prices.

Whereas a core measure is useful if a shock is temporary, it said that in the current scenario a large part of increase in the oil price is widely believed to have a big permanent component.

Hence, the use of core inflation excluding the oil prices could be misleading.

Besides, the current high oil prices reflect to a large extent the increase in global demand for oil from countries such as China.

At the same time, these emerging economies have added to global supply of manufacture that kept prices of tradables low.

Thus exclusion of high oil prices while including the benefits from low prices of tradables — both of which are the result of the phenomenon of increased globalisation — is conceptually debatable.

In India, core inflation is not deemed relevant for several reasons, because the two major sources of supply shock — food and fuel — account for a large share of the index. Besides, pass through of higher oil prices has been halting and the headline inflation in a way understates the problem.

Hence, such an explanatory approach to headline and underlying inflation pressure in Monetary Policy has added credibility to the Policy; no wonder that when the Mint Street hoists red signal by effecting adjustment in repo rates or reverse repo rates, the mandarins in the administrative machinery try other ways to determine interest rates when they are effectively deregulated and market-determined.

So when the RBI says that there are continuing signs of demand pressures, especially high credit growth that could exert upward pressure on prices when associated with supply shock such as from oil, the message is unequivocal and the authorities should not do anything to undermine it if they really swear by the central bank's autonomous status.

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