Mihir S Sharma: Another clean-up job

Arun Jaitley's fourth Budget must show Indian economic policy decision-making can still be trusted

Over the past month, it has become increasingly clear that there is a divide in how demonetisation is discussed inside India and outside. In India, by and large, it is seen as a fait accompli; a political masterstroke; a painful and extreme, even unnecessary step, but one that is essentially comprehensible and understandable. Outside, no such excuses are being made. Not only has it underlined India’s inability to execute policy and left Narendra Modi’s reputation for competence in tatters, but it has been met with complete bewilderment. It looks eccentric, even absurd, causing people to question whether India’s decision-makers have the slightest idea of how to run an economy; and it plays neatly into the existing stereotype of the Indian state as intrusive to an unusual degree, and uncaring about the economic consequences of its decisions. 

This is the context in which Arun Jaitley’s fourth Budget will be presented. Much has already been written about how it will need to incorporate measures that restore confidence after the vast demand destruction that demonetisation has caused. But equally important will be the degree to which the Budget restores confidence worldwide that grown-up policy decisions are being made in India. We may not like to hear it, but our reputation as a destination for investment has taken a terrible hit. We may feel the need to give a respectful hearing to messianic speeches from various government functionaries about black money and the digital future; the rest of the world feels no such obligation. 

For Mr Jaitley, this will no doubt be a familiar position. By this time last year, expectations from the Narendra Modi government were at the lowest they had been. Its economic policy seemed incoherent, slow and confused. But the last Budget quite effectively took the wind out of that narrative. Faced with a prime minister turning hard to the populist left, the finance minister in 2016 nevertheless produced a forward-looking Budget that attempted genuine movement on such matters as tax reform and welfare delivery mechanisms. It appeared coherent and thought through, and helped to restore a certain optimism about the government’s policy choices.

Unfortunately, the year since then has not been kind. The departure of Raghuram Rajan was a blow to the notion that India was home to well-functioning, independent institutions. The troubled banking sector remains essentially untouched — indeed, there has been significant backsliding on cleaning up bad lending since Mr Rajan’s departure. The goods and services tax (GST) may become a reality, but little was done over the year to suggest the government is really prepared for its challenges of implementation. A sequence of inexplicable anti-foreign capital acts — the refusal to allow NTT DoCoMo to take money out of India, the cancellation of bilateral investment treaties, and so on — effectively undermined the PM’s ‘Make in India’ rhetoric. And then, to cap it all, there was the tragedy that was demonetisation. 

Clearly, Mr Jaitley and his team have another repair job to do. And this year, their constraints will be even tighter. Not only has the PM maintained his populist line — as was clear from his New Year’s Eve address — but we are closer to the crucial UP assembly election and also to the start of the central government’s re-election campaign. The fiscal consolidation path will really begin to bite this coming year, when the deficit-to-GDP ratio is supposed to go down to three per cent. The long bonanza caused by the decline in crude oil prices — and commodity prices in general — is tapering off, with severe implications for government resources and for real growth in India that has increasingly been driven by cost-cutting rather than productivity increases. 

Meanwhile, the Budget exercise will take place amid little or no clarity about several key ingredients. First of all, actual growth is uncertain, since the Central Statistics Office’s Advance Estimates of GDP are based largely on numbers from the months before demonetisation. Secondly, actual revenue next year is a bit of a mystery because of the effects of the introduction of GST. Even tax revenue this year has been a bit of a puzzle, and it is not clear what may have caused some of the large increases over last year, and whether they are sustainable. Thirdly, the government’s numbers themselves will be the object of much confusion thanks to the long-overdue phasing out of the Plan/non-Plan distinction for expenditure. 

Thus Mr Jaitley will have to resist many pressures from various quarters. His boss may want larger and more spectacular populist packages in the Budget, and Mr Jaitley will have to find the money for it. Various large industries hit by demonetisation, particularly I suspect construction and real estate, will have been demanding the Budget address their needs — in the national interest, of course. He already has committed to tax rationalisation of various kinds, and a reduction in personal income tax rates is apparently his own dearest desire. 

Illustration by Ajay Mohanty

So, you might ask, as is usual, why he should have time to spare for what a bunch of arrogant and under-informed investors think. Why not dump fiscal consolidation and focus on what makes domestic political sense? After all, India’s government knows best what India needs. And, sure, that argument can be made. However, the facts are sobering. The year 2017 might well see global capital turn further away from emerging markets, even “bright spots” like India, to look again at how it could take advantage of developments in mature markets such as the Trump phenomenon. But such capital is essential to India’s development. The Indian private sector is still unwilling to invest; many large companies have not been able to deal with their debt overhang; banks which have their own well-known troubles are now being used, Indira Gandhi-style, mainly as instruments for building a New India rather than as the arteries of the financial system. Investment is still stalled, although “policy paralysis” headlines have vanished. So, like it or not, foreign capital is still important. 

And to keep that flowing in — correctly, to actually get it to start flowing into the sectors and projects that we need it to, since the nature of foreign capital flows so far has not been helpful — the Budget will have to take its expectations into account. India is clinging on to an investment-grade credit rating, and its fiscal discipline has been a large part of that. Keeping that rating going is essential; the impact across the board of a downgrade, or even a change in outlook, would be quite disastrous at this point in time. Mr Jaitley must hold the fiscal line. That’s the one number everyone will look to see. 

But the biggest task is to restore the narrative once again. The Budget will have to be credible, reformist and forward-looking. Its numbers will have to add up, and its policy choices mature. If not, the damage to India’s reputation from demonetisation cannot even begin to be repaired.


m.s.sharma@gmail.com

Twitter: @mihirssharma