Dealing with deficits

In the rosy glow surrounding India's rise as one of the fastest-growing economies of the world, one aspect that is glossed over is its not-so-comfortable fiscal position. The media and the electorate may get quite worked up about poor governance, scams, corruption and other issues, but fiscal profligacy is seen as a necessary indulgence to keep the economy going.

It is the dangers of such neglect that are flagged by the authors Mr Willem H Buiter and Mr Urjit R Patel in their April 2010 research paper titled “ Fiscal Rules in India: Are they effective? ” ( NBER Working Paper: >http://www.nber.org/papers/w15934 ).

Despite the question posed in the title, the events detailed in the paper clearly show that successive Indian governments have simply not paid heed to their self-imposed rules on spending or living beyond their means, in recent years.

India's fiscal position has been allowed to steadily deteriorate by governments that have postponed deficit targets, put them in ‘pause mode' to attend to more pressing matters or even tried their hand at window dressing by resorting to “off balance sheet” items.

Mr Buiter and Mr Patel point out that India's fiscal position, measured by indicators such as general government budget deficit and gross debt-to-GDP ratio, “put it in the same camp as fiscally stretched States such as Greece, Portugal, Spain, Ireland and UK”. And this is a persisting problem. “Over the last three decades, India has found it impossible to sustain for an appreciable time, an overall public sector financial deficit of less than 8 per cent of GDP….it has been extremely rare for the general government fiscal deficit to be less than 6 per cent”.

The fiscal deficit, at a precarious 7.8 per cent in 2008-09 has since moderated to 5.1 per cent, but well above the target of 3 per cent set by Fiscal Responsibility and Budget Management (FRBM) Act, for a deadline two years ago !

It is growth at risk

But what's wrong with running big deficits, as long as the economy is growing and the government remains solvent? In answer, the authors point out that persistently high public debt and deficits can actually derail economic growth.

One, if a country's debt position is already precarious, it could make it more vulnerable to sovereign default during a downturn or external shock. High debt usually induces the government to raise tax rates or cut essential spending, neither of which may be great for growth.

Two, big government borrowings can crowd out the private sector and push it to borrow overseas, creating problems of its own. This is particularly relevant to India, where the low external liabilities of the exchequer are often cited as a comfort factor to dismiss default risk.

With more liberal ceilings for foreign borrowings, Indian companies have taken to this route in a big way in recent years. And during the liquidity crisis if 2008, quite a few Indian companies were at the brink of default, unable to service foreign currency convertible bonds.

Populist, spending

Isn't India's high deficit a fall-out of stimulus spending to prime up the economy in 2008-09? Not really, say the authors. They point out that if one includes “off budget items” such as oil and fertiliser bonds, fiscal indicators for India have been slipping since 2004-05. Indeed, India's stubbornly high deficit is not so much a story of its income stagnating as one of unbridled spending.

As the paper notes “The recent profligacy of the central government has its primary driver in populist spending policies by the ruling coalition leading up to the national elections in May 2009; the three stimulus packages …only helped matters along in the same direction”Still, the country has not abandoned its attempts at reining in its fiscal excesses. The 13{+t}{+h} Finance Commission Report recently laid down a five-year roadmap to trim the deficit and public debt.

The 2011 Budget also chimed in, reiterating that the fiscal deficit would be reduced to 4.6 per cent of GDP in 2011-12 and further to 3.5 per cent by 2013-14. While the stock markets seemed quite happy with this “roadmap”, it is quite difficult to take such intentions at face value, given that our track record in sticking to targets, even when it was legislated by Parliament, has been quite poor. As this paper observes, India's attempts at fiscal discipline have fallen flat mainly because running high deficits has not entailed any political cost to the party at the helm.

Set a thief!

If the electorate is not bothered about the deficit and even laws have failed to rein in liberal spenders, what is the solution to India's problem of debt and deficits?

The authors suggest that we set a thief to catch a thief. In this case, use the State governments to police the Centre's performance on deficits. While the Central government has taken quite a lackadaisical attitude to deficits in recent years, the State governments have done much better at reining in wasteful expenditure and generally sticking to the rules.

Now Mr Buiter and Mr Patel suggest that we set down clear annual deficit targets for both Central and State governments. If the Centre slips up in meeting its target, it must then pay penalty by making up this shortfall in the next year and also allowing the States to run a higher deficit of the same quantum.

As States do tend to be politically powerful, the Centre may be more wary of violating its limits if it affects them. Remember that coalition politics has endowed State governments with a lot of “informal” clout too at the Centre, so this carrot and stick approach may well work!

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