Stress points

The fiscal situation and the balance of payments scenario deserve particular attention from policymakers

Even as the Reserve Bank of India (RBI) chose to hold off on cutting interest rates last Tuesday, it painted a rather gloomy picture of the economy. The statement by RBI Governor D Subbarao, made while announcing the status quo policy, clearly indicated that global conditions had deteriorated markedly since the previous announcement in October and that the Indian economy was certainly not immune to the overall problem. In fact, India is bearing the combined brunt of a domestic business cycle and the global turbulence, which is taking its toll in a number of ways. While several issues relating to the future course of the economy arise from this analysis, two potential stress points deserve particular attention from policymakers as they visualise life beyond the crisis.

The first is the fiscal situation, which, over the course of the past one year, has gone from reasonably healthy to severely degraded. The Prime Minister’s Economic Advisory Council recently estimated that the effective combined fiscal deficit (including fuel and fertiliser subsidies) of the centre and states would be around 8 per cent of GDP in the current year. Many private forecasters put the number significantly higher, pointing to not just a sharp but a potentially irretrievable deviation from the fiscal responsibility mandate of 6 per cent. The current state of global capital markets does not raise hopes of large capital inflows for some time to come. This will put pressure on the government to provide resources for many investments, e.g. in infrastructure, which were earlier expected to be financed by foreign investors. At the same time, if the growth rate does not return to the heady levels of the past couple of years, revenue growth will be subdued. We just may have the makings of a painful trade-off between sustaining growth and fiscal discipline. The Governor’s statement refers to the need for the centre and states to “re-anchor to a revised FRBM (Fiscal Responsibility and Budget Management) mandate”, once the crisis has abated. What that revised mandate will be is anybody’s guess, but it is quite clear that the issue of fiscal management will regain centre stage in the policy drama.

The second is the balance of payments (BoP) scenario. While the statement is quite reassuring about the stability of the situation, based on a favourable maturity profile of external debt, some thought needs to be given to threats to various components of inflows and outflows. Invisibles, both remittances and service exports, face diminished prospects, which, together with falling or stagnant merchandise exports, raise concerns about a widening current account deficit. Of course, subdued energy and commodity prices will help contain the pressure, but at the same time, capital flows are not going to provide anywhere near the cushion they have been for the past few years. Even optimistic observers of the global financial system do not believe that the flow of funds into emerging markets will return anywhere close to pre-crisis levels. Though the foreign exchange reserves position remains reasonably healthy, the overall situation is a far cry from the “problem of plenty” until 2007. Overall, both the fiscal and BoP situations, while evolving in predictable ways during the downturn, do pose significant risks to even a moderately recovering economy. Their potential to inflict damage even as the economy begins to turn around should not be ignored.