Why fiscal rules should be revisited

The Union government has once again deviated from the stated fiscal consolidation road map. It will now aim to contain the fiscal deficit at 3.8 per cent of gross domestic product (GDP), compared with the current year’s budget estimate of 3.3 per cent. The government aims to bring down the fiscal deficit to 3.5 per cent of GDP in the next financial year. Presenting the Union Budget for 2020-21, Finance Minister Nirmala Sitharaman used the escape clause under the Fiscal Responsibility and Budget Management (FRBM) Act on account of structural reforms in the economy, with unanticipated fiscal implications for both the current and the next fiscal year.

According to the revised FRBM rules, as amended by the Finance Act, 2018, the central government debt stock should not exceed 40 per cent of GDP by the end of financial year 2024-25. The fiscal deficit was also expected to be reduced to 3 per cent of GDP by 2020-21. The law provides for deviation from the fiscal deficit target by up to 0.5 per cent of GDP under various circumstances. In accordance with the latest revision, the central government’s debt is expected to decline from 50.3 per cent of GDP in the current year to 45.5 per cent by 2022-23. Clearly, the government will take more time to reach the earlier target because of slower than desired consolidation. While a higher level of debt has risks, especially in the environment of slow growth, deviations from annual fiscal target also has costs.

The 15th Finance Commission is expected to constitute a committee to examine the fiscal and debt situation and present a road map. This would be a good opportunity to revisit the fiscal management framework. The committee would do well to reassess the fiscal deficit target of 3 per cent of GDP. As also highlighted by the FRBM review committee, the 3 per cent target for both the Centre and states in the FRBM Act, 2003, was set after considering the available pool of financial savings. It was also deemed sufficient to attain government debt-to-GDP ratio of 50 per cent over 10 years. Household financial savings were projected at 10 per cent of GDP. Another 2 per cent of GDP was added as external borrowing (current account deficit). The available pool of financial savings at 12 per cent of GDP was equally allocated to the government and the private sector. The FRBM review committee also broadly followed this path. Net household financial savings in 2014-15 was at 7.6 per cent of GDP. The sustainable medium-term current account deficit was estimated to be about 2.3 per cent of GDP. Therefore, the available savings of about 10 per cent of GDP was allocated equally between the public and the private sector. But this needs to be reviewed again, as the net household financial savings have dropped to 6.5 per cent of GDP. 

This essentially means that even at the stated level of deficit, the government is preempting the entire pool of financial savings and investment activity largely depends on imported savings. Things will not change much even if the general government deficit is brought down to 6 per cent of GDP. So, the basis for allocating 50 per cent of financial savings to the public sector also needs to be debated. The size of the government, even with the current level of deficit, is far less than 50 per cent of GDP.

The current level of savings and the requirement of the public sector means a revival of private investment will mostly  depend on imported savings. The strain on financial resources is visible in the bond market. To reduce the pressure, the government is looking to issue special securities to non-resident investors. The idea is to get Indian government bonds included in global bond indices, which would result in a stable flow of foreign savings. Large passive investors, such as pension and insurance funds, invest in funds tracking such indices. The government is also increasing the foreign investment limit in the corporate debt market. The Reserve Bank of India (RBI), on its part, is flooding the system with liquidity to improve the transmission of policy rates.

Higher dependence on foreign savings, aside from  increasing financial stability risks by adding to external debt, will create distortions in the system. Higher flow of foreign capital will put upward pressure on the rupee, which will affect India’s external competitiveness. Overvaluation of the rupee is said be affecting India’s exports, which have practically stagnated in recent years. Continued intervention by the RBI in the currency market can affect its monetary policy objectives. In fact, the need for continued flow of foreign funds could incentivise the system to keep the rupee strong.

Therefore, the challenge for the Finance Commission would be to suggest a road map to bring down the general government deficit to a more sustainable level, which leaves adequate means for the private sector. Since it is not easy to augment revenues at the scale required, large adjustments in expenditure would be necessary. A delay in adjustment would not only affect the potential growth but also increase longer-term financial stability risks.