Four suggestions for the Budget are first on policy continuity while responding to current trends. Second, on enhancing fiscal-monetary coordination; third, on facilitating effective partnership with the States and fourth, some issues on enhancing the diversity, stability and efficacy of the financial sector. The latter points contribute to necessary institutional strengthening.
Continuity with responsiveness
Indian macroeconomic policy has done well in difficult times. Reforms have also begun to pay off after initial costs. An example is the revenue buoyancy in GST. Other reforms will also do so and should be continued. Another example is the admirable transparency in the Budget. Better accounting norms improve the credibility and accuracy of the Budget figures. This is an opportunity to clearly show the different ways in which government spending supports the economy, since there is a demand for such support.
Reviving tax revenues make it possible to finance essential expenditure consistent with medium-term consolidation on the announced path. This would give a strong signal of control and continuity. The stimulus built in can, however, be increased in view of the third wave and some signs of slowdown in recent data. Stimulus can also be given through the financial sector as before and through continuing efforts to improve the quality of expenditure. The latter implies a shift towards high multiplier and high job creation items (investment in human capacity creation, infrastructure greening the economy, employment subsidy) and supporting vulnerable sections. High government cash balances indicate spending lags, so tax cuts may be given to stimulate consumption. Temporary cuts would be more effective without upsetting reform.
Better than expected growth recoveries despite relatively conservative aggregate government spending indicates a better composition of government spending supported by appropriate monetary-financial conditions delivers and should continue.
Good coordination between fiscal and monetary policy has been a major contributor to revival. Along with moderate deficits, if investment and other supply-side reforms raise productivity and lower inflation, policy rates can remain steady so as to reduce volatility and ensure real interest rates stay below growth rates. This has many benefits such as enabling faster fiscal consolidation, reducing potential spikes in risk-premium and the heavy burden of interest payments in the Budget.
If inflation is persistently above the tolerance band policy rates have to rise in inflation targeting regimes.
An excellent example of coordination is the Centre’s cut in fuel taxes on November 4 that was followed by many States. It had a large impact on household inflation expectations. These had shot up in early November but fell by end November. While household expectations are backward looking, firms are more forward-looking and their inflation expectations also moderated. All this made it feasible for the MPC to continue its accommodative growth supporting stance. Temporary tax cuts could lower inflation and raise consumption.
As private investment will only slowly gain momentum, public investment has to sustain its pace. States have to pitch in for this to reach a critical mass. But they seem to have difficulty in spending.
The GST Council experience could be used to set up an Inter-State Fiscal Council. The formal responsibilities of the Council could be to improve data, accounting systems and incentive mechanisms. Better technology, transparency and predictability could enable timely payments. Introducing norms such as ensuring funding before announcing schemes, and pre- announced expenditure totals from finance ministries would reduce competitive bidding-up of expenditures. As CSS rationalisation gets under way, discussion with and rationalisation of State-level schemes could be a game-changer. States’ multiple schemes create duplication and waste but are rarely shut since each gives rise to some interest groups that want continuity.
Such a council would help put peer pressure on the laggards, raise awareness and convergence to best practices. States do want to be part of and contribute to the Indian growth story. Leadership from the Centre can help get them on board. Crucial reforms that encounter resistance at the Central level may be feasible if one State starts and others follow as evidence of better outcomes accumulates.
Furthering financial diversity
A key objective should be to build up the diversity of the financial sector so that it can meet public and private funding needs and serve India’s diverse population. Diversity also makes for resilience since exposures vary. Therefore current initiatives towards building a DFI and setting up a bad bank are in the right direction. Features such as take out financing could also be developed.
The problems in PSBs were not due to ownership as much as the inability of the Indian financial sector to fund infrastructure. Since private banks evaded infrastructure finance they stayed healthier. Diverse types of finance are the answer.
Warranties on loans to MSMEs have worked well and should be continued. They reduce financial sector risk aversion and help vulnerable firms, without impairing financial stability since the government picks up the tab. This is the correct way to use banks to meet essential social objectives — private banks are using the scheme more. Since warranties do not add to current government borrowing they do not crowd out the private sector.
India is approaching index inclusion that is expected to raise fixed income inflows. Increasing diversity of participants in G-secs markets will aid price discovery. Short rates fell with policy rates but long rates remained irrationally high, raising spreads, perhaps because of the dominance of a few large lenders.
At present active funds account for about 95 per cent of inflows. Index inclusion would increase the share of passive funds. But there is no research establishing that pension funds or passive index linked funds are better than active funds for financial stability. There are some positive and some negative effects, depending on the objectives and strategies of the funds. The one thing the literature agrees on is that the size of the domestic market matters to contain stress from foreign fund volatility.
India’s carefully sequenced capital account convertibility, including capping and sequencing of different types of inflows has served it well, protecting somewhat from recurrent global crises. The current cap on fixed income inflow is at 6 per cent of the domestic market although actual inflows are only at about 2 per cent, partly because of global stress led outflows.
It would be useful to also cap fixed income stocks as a percentage of India’s international investment position, preventing interest sensitive flows from becoming a large share of India’s liabilities. If caps bite they would constrain active funds. Caps protect domestic policy autonomy, so that policy rates can be appropriate for the domestic cycle rather than blindly following Fed rates. Else index inclusion at a time of rising global rates may lead to more volatility.
Foreign inflows that are not absorbed through a rise in physical investment add to reserves and the monetary base, reducing space available for the RBI to support government borrowing. For example, the share of G-secs in the RBI balance sheet fell from 73 per cent in 2001 as inflows peaked. It was 2 per cent in 2006 and was even negative for a few years. It follows inflows that are excessive in relation to absorptive capacity and size of the domestic financial sector can raise G-secs yields instead of lowering them.
The writer is Emeritus Professor, IGIDR. Views expressed are personal