Sunday, May 13, 2012

Budget Points to Lack of Fiscal Discipline - My article in Hindu Business Line

Date March 20, 2012 

With the budget and the RBI economic policy out of the way, the critical policy week for the Indian economy has proved to be a damp squib as the neither any credible action on tightening of the fiscal policy came through in the budget nor did the RBI relented on reducing the interest rates.
To be fair unlike the last year this time around the projected numbers on the revenue side are more realistic and the budget does attempt to talk about controlling the expenditure. The revenues estimates through direct tax collection assume a private sector credit growth of around 21% (the average of last 8 years) from the existing 16% which is certainly achievable if the government keeps its expenditure under control and consequently the RBI cuts the interest rates.
As a matter of fact the government has projected its credit requirements to increase by just about 13% (the lowest in the last 5 years) which if proven correct would make all the pieces of the budget fall into the right places perfectly. However the expenditure that it has projected to put across this number is a bit baffling.
The bloated government expenditure is primarily on account of two factors: The ever bulging food, fuel and fertiliser subsidy bill and it’s excessive re-distributionist policies that are squandering away precious economic resources and causing serious misallocations of capital without having much of an effect in increasing the real supply and economic productivity. It was critical for this budget to address the government expenditure issue as this has resulted into the country falling into an inflation and slowdown quagmire.
The budget does propose to cap the subsidies to 2% of GDP but the implementation is left in the hands of the executive. The fiscal deficit has been proposed to be brought down to 5.1% but the money reserved for subsidies provide some food for thought over the credibility of the forecast. While the fertilizer subsidy is proposed to be brought down by 6000 crores, the oil subsidy is planned to be cut by 25000 crores over the previous year i.e. a cut of about 36%! This can only happen if the oil prices collapse (unlikely unless we have a global recession) or the government actually raises the prices especially 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, this price rise is unlikely to fall through.
The Brent crude prices are already averaging over 120 dollars/barrel which is about 7% 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 percent, the oil subsidy bill could actually grow to 75000 crores.
Inability to the pass the increased subsidy bill would add around 40000 crores to the government borrowing. This increase would negatively impact the private sector credit growth and in turn the government revenue estimates and may add in excess of 50000 crores to the government borrowing program. Suffice it to say that if the government is unable to pass part of this bill onto the consumers as indicated in the budget, it would end up increasing the government’s fiscal deficit to 5.5% and its expected credit growth by over 20% from last year. This may again restrict the hands of RBI in slashing the interest rates aggressively thus hampering the private sector credit creation and 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 more and more economic resources were being driven into stimulating the already high consumption levels, capital investment took a backseat. As a matter of fact the gross capital formation is actually estimated to be negative for this year. This has happened only 2 times in the last 2 decades (1996-97 and 2000-01). This is a serious problem for a fast growing economy like India as this would mean severe supply constraints going forward.

If the government is able to come out good on its promises in this budget things would look better the next year, otherwise the only hope would be that global liquidity conditions remain benign abroad thus enabling the private sector to cater to its capital requirements and avoiding the country’s growth rate from slipping down further.

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