A case against aggressive fiscal consolidation: Sonal Varma

The key debate going into this year's budget is between fiscal consolidation and growth. Should the government deviate from its pre-set fiscal consolidation path of 3.5 per cent of gross domestic product (GDP) in FY17 and three per cent in FY18, given the increased pay and pension burden due to the seventh pay commission, or should it stick to the road map as deviation could raise credibility concerns?

The economic survey broadly appears to support a modest deviation. The keyword is 'modest'.


Even as GDP growth is expected at seven to 7.75 per cent in FY17, the survey sees downside risks from various quarters. Weaker global demand, lower positive terms-of-trade gains and the twin balance sheet challenge - of public sector banks and select large corporate houses - are expected to act as dampers.

Inflation risks are also seen as contained. The survey expects CPI inflation at around 4.5 to five per cent in FY17, undershooting the RBI's five per cent target, due to a less sanguine growth outlook, lower oil prices and deflationary pressures from China. We believe that the survey maybe over-optimistic in its inflation projections, as much of the fiscal expansion will be consumption-oriented in 2016 and inflation expectations have not yet meaningfully receded.

Not surprisingly, the survey sees room for more easing by the Reserve Bank of India. In fact, it calls the RBI's policy stance neutral, rather than accommodative as stated by the RBI, and argues that the RBI itself may be responsible for the lack of policy transmission (into lower lending rates), as it has kept liquidity conditions very tight, a point that will resonate with banks.

Against the backdrop of less-than-ideal growth, low inflation and balance sheet challenges, the survey argues that the benefits from aggressive fiscal consolidation - such as reinforcement of credibility, and the declining path of debt and deficits - are much smaller than the costs (to growth). A better strategy would be to consolidate gradually by 0.2 to 0.3 percentage points every year so as to support growth, yet lower the debt ratio, eventually.

The cost-benefit analysis in the survey suggests that the government may again deviate from the fiscal consolidation path set out last year. While the survey believes this is a reasonable strategy, rating agencies may not share this view. This is because state governments are also expected to deviate from their fiscal path over the next two years owing to the UDAY scheme and the pay hikes, which suggests that on a general government level, the fiscal deficit is unlikely to consolidate materially.

On the urgent issue of stressed assets of the banking system, the survey prescribes recognition (which is underway), recapitalisation (expected in the budget), resolution (of stressed assets) and reforms (to avoid a repeat). This is a logical sequence. Interestingly, it prescribes that public sector banks could also be recapitalised by the RBI because its total equity (as a percentage of its balance sheet) at 32 per cent is much higher than the global median (16 per cent). Of course, whether this idea is accepted by the RBI remains to be seen!

Sonal Varma
Executive Director and India Economist, Nomura