The International Monetary Fund (IMF) has sounded the alarm on India's fiscal situation, criticised the strategy of pump-priming the economy and instead called for bolder policy initiatives to revive the investment and growth momentum.
Cautioning against relying on administrative measures to limit foreign exchange demand and curb forex speculation, the IMF has urged the government to use interest rate policy to resist "overshooting" of the exchange rate.
The report notes that foreign exchange reserves, which were equivalent to six months of imports and more than double the maturing debt obligations in 1998-99, are now at a comfortable level.
In its annual Article IV consultations review of the economy, the IMF observes that despite the increased strains due to an economic slowdown and the south-east Asian financial crisis, real GDP growth remained positive, the balance of payments position satisfactory and foreign exchange reserves relatively comfortable.
"Directors (of the IMF) expressed concern that the public sector deficit cannot be sustained at its current level without heavy costs to the country's long-term economic prospects.
They also expressed doubts whether the modest reduction in the fiscal deficit targeted for this year will be achieved, pointing to possible slippages in both the revenue and expenditure estimates," the report states.
The IMF has pulled up the government for rolling back some budgetary measures, saying, "the reversal of certain budgetary initiatives runs the risk of further undermining the credibility of the fiscal policy stance".
The IMF has urged the government to launch an ambitious and front-loaded medium-term fiscal adjustment programme, involving policy actions from both the Centre and the states.
"This would help lower real interest rates, improve debt dynamics, create room for meeting essential social and infrastructure spending and reduce the drag on growth," the report says.
The IMF endorsed the government's move to lower tax rates, but said the reduction was not matched by an expansion of the tax base. It said this could be achieved by eliminating costly tax exemptions, mainly in the agricultural and export sectors.
According to the IMF, the persistently high level of fiscal deficit had led to a situation wherein the monetary policy had come to be the only means of ensuring macroeconomic stability.
"Monetary policy should be firmly focussed on a low inflation objective and from this perspective, they cautioned against a premature easing of the recently tightened monetary stance and further monetisation of the deficit," states the report.
The IMF has welcomed the BJP-led coalition government's intention of accelerating reforms related to privatisation, foreign direct investment and the infrastructure and insurance sectors. But the report notes that "room still exists for simplifying the regulatory framework, enhancing transparency and thereby facilitating investment decisions."
According to the IMF, India still maintains a high level of protection. The Fund has recommended that India should press for tariff cuts and faster elimination of the remaining quantitative restrictions on imports.
It has also made a case for dereservation, restructuring of labour laws and putting in place an effective exit policy.
The IMF has also urged the government to accelerate financial sector reforms and implement the Narasimham Panel recommendations for the banking sector. "The experience of Asian countries shows that the costs of delaying such reforms could be extremely high," says the report.
The country review comes on the heels of the release of the IMF's annual report on international capital markets.
In its annual capital markets report, the IMF has said that controls on inward movement of capital could be a useful tool for some countries, admitting that opening economies prematurely to free flows of capital constituted "an accident waiting to happen".
The IMF has also suggested that a significant increase in capital flight from the countries in Asia worst affected took place long before the crisis hit.
The report is the most explicit admission to date that the IMF's views on the efficacy of capital controls has shifted.
