The Reserve Bank of India’s (RBI’s) review of the monetary policy clearly
signals an end to the expansionary policy stance.This comes in the background of improved global outlook, more optimistic growth prospects for the economy and more importantly, the fear of inflationary expectations. An increase in the cash reserve ratio (CRR) by 75 basis points (bps) was widely expected due to the uneasy price situation. In particular, the sharp surge in food prices has been a cause for worry. It was widely expected that RBI would harden the monetary policy stance and the increase in the CRR by 75 bps in two stages is supposed to give a clear message about the RBI’s readiness to take harsh measures to control inflation. Of course, the measure is more in the nature of a signal, for it is unclear how the hardening of monetary policy stance will control increase in food prices. Furthermore, increase in the CRR, in the short term, is not likely to significantly impact the structure of interest rates in view of the low non-food demand for credit and the prevailing excess liquidity with banks. Nevertheless, the measure signals an end to the accommodating monetary policy. The RBI’s review also passes on the baton to the finance ministry to rein in fiscal deficits.
With a clear message regarding the monetary policy given, the focus has shifted to the North Block and it is widely hoped that the forthcoming Budget will reverse the expansionary fiscal policy and rein in fiscal deficits. There could be some shortfall in the tax revenue, particularly from indirect taxes. There are concerns that the revenue from the third-generation spectrum auction will not accrue this year and that is budgeted at about Rs 35,000 crore. In addition, fertiliser subsidy amounting to almost Rs 20,000 crore has accrued but has not been paid yet. There are also large payments amounting to almost Rs 30,000 crore to be made to oil marketing companies and probably this will be paid out in the form of oil bonds. The food subsidy bill is also likely to show a significant increase in view of the surge in prices of food items. The Supplementary Demand for Grants, placed in Parliament in December, involving Rs 25,725 crore of cash expenditures is supposed to be met with savings from other departments and, therefore, this year there is no additional expenditure liability on that account. On the positive side, it is estimated that direct tax collections are likely to meet the target and there would be substantial additional revenues from disinvestment.
Even with additional deficits on account of fertiliser, food and oil subsidy, and lower non-tax revenue realisation, the fiscal deficit as a ratio of GDP is expected to remain at the same level due to an entirely unexpected phenomenon of revision in GDP! The new series of GDP with 2004-05 as the base year shows the GDP to be higher by 5.3 per cent in 2007-08 and 2.4 per cent in 2008-09. Assuming a 7 per cent real growth and adding 7 per cent increase in prices, the GDP estimate for 2009-10 would work out to be 7.8 per cent higher than what was assumed in the Budget, which implies that the budgeted fiscal deficit would be 6.3 per cent, according to the new GDP estimates. Thus, even if the fiscal deficit in absolute terms goes up by Rs 30,000 crore, it would remain at 6.8 per cent as a ratio of GDP!
After two years of runaway deficits, surely, the time is ripe for the finance minister to initiate the fiscal consolidation process in the forthcoming Budget. It is important to start the process of unwinding the expansionary fiscal policy to enable greater monetary policy flexibility, besides avoiding crowding out. The Industrial Outlook Survey of RBI and various business confidence indices show significant improvements in industrial and business outlook during the last quarter and continued indulgence in high levels of fiscal deficit will financially crowd out private investments. The policy flexibility will be even more constrained if there is return of surge in capital flows. Therefore, the finance minister doesn’t have much freedom and will have to return to austerity.
We still do not know the fiscal restructuring plan recommended by the Thirteenth Finance Commission, but the Medium Term Fiscal Framework presented with the Budget last year set the fiscal deficit target for 2010-11 at 5.5 per cent of GDP. Unlike during the period from 2003-04 to 2007-08, when the Centre’s fiscal deficit as a ratio of GDP was compressed from 4.5 per cent to 2.7 per cent mainly due to increase in revenues, particularly from income and service taxes, the fiscal adjustment in the coming years will have to focus on compressing unproductive public expenditures. There has not been much progress in working out a feasible plan to reduce subsidies on fertilisers and continued buoyancy in oil prices and unwillingness to revise the prices of kerosene and gas will continue to pose problems in reducing oil subsidies. The difficulty is compounded by the fact that capital expenditure of the Central government has shown a steady decline in the process of fiscal correction and increasing expenditures for infrastructure sectors and providing adequate viability gap funding would require additional allocation to capital expenditures. The Centre’s capital expenditure relative to GDP declined from 2.5 per cent in 2007-08 to 1.8 per cent in 2008-09 before marginally recovering to 2.1 per cent in 2009-10.
Reducing the fiscal deficit to 5.5 per cent of GDP may not pose a serious problem in 2010-11 as spending on pay arrears and loan waiver, which constituted over half a percent of GDP, will be saved. In addition, the revenue from the third-generation spectrum auction and disinvestment will be realised in 2010-11. These two measures together can reduce the fiscal deficit by about 1 per cent of GDP. In addition, the Central government should unwind the stimulus by partially restoring the excise duty and service tax cuts. Extending the service tax to all services and having a common threshold would be in the direction of evolving the goods and services tax (GST). In this Budget, in addition, the tax cuts can be partially restored by unifying the rate at 12 per cent. The additional revenue generated from this can be used to increase capital expenditures.
The author is Director, NIPFP. The views are personal. Comments at: firstname.lastname@example.org