The critical policy week for the Indian economy — which included the Budget and RBI monetary review — proved to be a damp squib.

The Budget did not take any credible steps on fiscal tightening, nor did the RBI reduce interest rates. However, RBI did effect a cut in the cash reserve ratio the week before.

To be fair, unlike last year, this time around, the projected numbers on the revenue side are more realistic, and the Budget does talk about controlling expenditure.

RUNAWAY SUBSIDIES

The revenue estimates through direct tax collection assume a private sector credit growth of around 21 per cent (the average of last eight years) from the existing 16 per cent. This is certainly achievable, provided the government keeps its expenditure under control, and the RBI cuts interest rates. The government has, in fact, projected its credit requirements to increase by just about 13 per cent, the lowest in the last five years. (This is the difference between the budgeted estimate of market borrowings for 2012-13 and the revised estimates of market borrowings for 2011-12.)

If this does indeed happen, it would make all the pieces of the Budget fall into place. However, the expenditure projections are rather puzzling.

Bloated government expenditure is primarily on account of two factors — the ever-bulging food, fuel and fertiliser subsidy bill and the government's excessive re-distributionist policies. These policies are squandering away precious economic resources and causing serious misallocation of capital, without increasing real supply and economic productivity.

It was critical for this Budget to address government expenditure, which has pushed the country into an inflation and slowdown quagmire.

The Budget proposes to cap subsidies to 2 per cent of GDP, but the implementation is left in the hands of the Executive. The fiscal deficit is to be brought down to 5.1 per cent, but the money reserved for subsidies does evoke some food for thought over the credibility of the forecast.

While the fertiliser subsidy is proposed to be brought down by Rs 6,225 crore over the revised estimates for 2011-12, the oil subsidy is planned to be cut by nearly Rs 24,901 crore , i.e. a cut of about 36 per cent!

This can happen only if oil prices collapse (unlikely, unless we have a global recession) or the government actually raises prices of diesel, kerosene and other petroleum products.

If the previous year is any indication, where the government missed its fiscal deficit target by 130 basis points, it may be unable to take strong steps on the petroleum subsidy front. Brent crude prices are already averaging over $120/barrel which is about 7 per cent more than last year's average. Even assuming these prices hold through the year and the growth in crude oil demand stays at around 3 per cent, the oil subsidy bill could actually grow to Rs 75,000 crore.

IMPACT ON INVESTMENT

Inability to the pass the increased subsidy bill could add around Rs 40,000 crore to government borrowing. This could raise the government's fiscal deficit to 5.5 per cent and its expected credit growth by over 20 per cent.

The increase would negatively impact private sector credit growth. Government credit as a proportion of private credit would then rise to 52 per cent in 2012-13 (see graph).

This may again restrict the hands of the RBI in slashing the interest rates aggressively, thus hampering private sector credit creation. As a result, the country may see a prolonged period of high inflation and lower growth.

This year has been a difficult one for the Indian economy. As economic resources were being driven into stimulating already high consumption levels, capital investment took a backseat.

Gross fixed capital formation has been fallen as a proportion of GDP over the last three years.. This is a serious problem for a fast growing economy, and could mean severe supply constraints going forward.

If the government is able to come good on its promises in this Budget, things would look better the next year.

Otherwise, the only hope would lie in liquidity conditions being benign abroad, thereby enabling the private sector to meet its capital requirements.

(The author is an independent financial consultant at Random Chalice Financial Research, Delhi. The views are personal.)

(This article was published on March 19, 2012)
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