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COMING UP: LAST CHANCE BUDGET

For UPA-II government, Budget 2012-13 is the final opportunity to renew economic reforms

Will the Reserve Bank of India’s (RBI) rate cuts which are around the corner help the Indian economy move back to its 8% to 9% growth trajectory? Is India’s sustainable level of growth 7%, and were the last few years really an aberration on the upside, or is the current growth rate a cyclical downturn from a structural level of 9%? And what will happen to the rupee this year — was the slide to . 54 temporary, or has the rupee found a lower level?

Answers to these fundamental questions will shape how the next financial year pans out economically, and impact the assumptions the government makes in next year’s budget. In the past, our economic policy mandarins have usually got these answers wrong, and in doing so have ended up making budget assumptions that have been far too optimistic. As a result, most budgets end up doomed to underachieving their targets right from the outset.

Consider that in last year’s budget, the finance minister assumed a 9% growth rate and inflation of 7%. Q2 delivered 6.9% and we are on track for just over 7% for the full year. Average inflation for the year is likely to be higher than 9%. The fiscal deficit will overshoot from 4.5% to perhaps close to 6% and the borrowing target will be almost . 1,00,000 crore higher than initially assumed. On an earnings base of $170 billion and expenditure base of $250 billion, we will have overshot our targeted fiscal deficit of $80 billion by almost 25%! Fortunately this extra borrowing will perhaps not lead to a crowding out of private sector investments simply because corporates are not in a position to invest in this climate. As far as our natural growth rate is concerned, it is clear that we have moved up from the 5% to 6% growth level to safely 7% and above, courtesy the earlier reforms, the higher savings rate and incremental capital output ratio (ICOR). However, the “above” is a dynamic number and depends on the continuing process of reforms (on a lagged basis), or the absence thereof. Unfortunately, over the last few years we have not had the structural reforms at a pace needed to drive this growth. If we had actively debottlenecked supply side constraints and created more manufacturing elasticity in the economy, then automatically extra demand could have been met without a corresponding increase in inflation.

The entire economy would have been at a higher plateau of growth today. On the other hand, if we choke off investments either through crowding out or lack of business opportunities, then capacity creation suffers and the room to grow becomes limited. In this scenario the structural growth rate of the economy drifts downwards, and any growth over this new lower level is both temporary, and leads to higher inflation, leading to the central bank stepping in with rate increases that constrain both the demand side and the investment cycle to cool the economy down.

So the first answer is that due to the absence of continuing reforms economic growth is moving down a gear. Within this medium term structural move down, we have in addition, a cyclical downturn which has been accentuated by our structurally lower ceiling. What this means is that even if the cycle reverses through RBI rate cuts, it will likely not lead to a reversal in growth rates up to 9% plus, but rather oscillate around the 7% to 7.5% mark in the medium term. 
And therein lies the tragedy of the last few years of India’s economic management. Yes, we can congratulate ourselves on being at 6 to 7% when the rest of the world is struggling with zero growth. But then we do not have the luxury of per capita incomes of $30,000 to begin with. 
The average Indian earns less than a 20th of what most of those in the developed world enjoy. Any chest thumping therefore is best left to the monkeys. Meanwhile, we need every single ounce of growth we can wring out of the economy, and any government that does not do its utmost in this regard is selling the country and its people short.

What of the rupee? While our foreign currency reserves are at approximately $300 billion, net of volatile foreign institutional investment(FII) flows and short term debt (up from 12.9% of FX reserves in 2006 to 21.2% in 2011), we still have about 4 months of imports cover, which appears adequate. However, given that the RBI has always prided itself on managing rupee volatility rather than targeting a specific level, it is quite surprising that we have witnessed such a whiplash movement in. But all things considered, I think we should see a move in the rupee back to around 50 or below as capital flows, both foreign direct investment (FDI) and FII, regain some balance, and barring unforeseen events in Europe or in the price of oil.

So what should be the finance minister’s priorities for the budget? Reviving growth and controlling the fiscal deficit are the two most important tasks he can lead with. Specific steps should include real divestment of government assets, a fundamental reform of the power sector, the government credibly curtailing its borrowing program, and allowing FDI in more sectors. Any action along any of these would greatly boost the current gloomy sentiment, and that would be half the battle won. 

But the government needs to convince business that it is alive to their concerns, and not just enamoured of entitlement programs which mean wasteful expenditure of the tax payers’ hard earned money. With parliamentary elections looming in early 2014, this is the Last Chance Budget the government has to showcase its economic credentials. Let’s see what’s in store.

It’s hard to discern where this government is taking the Indian economy or indeed, where it intends to take it. Is the purpose of the economic managers to simply keep things going in the hope that at some point miraculously the economy will revert back to an 8 to 9% growth rate, and the increasing macro stresses will automatically get redressed? Or is it that they truly believe that this economic course is best for an India that needs redistributive justice as a bigger end goal than growing the pie – that long standing economic question. Or does it believe that subsidy spending, and spending on rural schemes is what is required to kickstart the Indian economy, and out of rural India will come the driver for more long term sustainable growth?

Let’s examine the facts. UPA I was driven by significant tailwinds – whether out of the structural reforms carried out by the (also minority) NDA government, or otherwise. From FY 2003-4 to FY 2007-8, both inclusive, a period of 5 years when growth averaged more than 8%, the actual fiscal deficit achieved was consistently less than the target. In other words, policy makers consistently under estimated the growth rate of the Indian economy during this period. This also resulted in lower borrowings than target. In fact, during this period, average borrowings were about Rs 1,30,000 cr annually, or about $30 billion. Interest rates remained benign and tax collections were ahead of budget estimates in 3 of the 5 years.

While the macro numbers looked great, what they hid was that very little was being done on structural reforms to further drive the Indian economy. Nothing significant was done on various issues that drive growth in the medium term, such as infra build, clearing large projects, driving market based tariffs, privatization, and generally improving the supply side capacity of the economy. There was policy drift in sector after sector. In some sectors such as telecom and power there was outright mismanagement. So during UPA I, while the macro picture remained healthy, the structural reform story came to a halt, while in certain sectors it actually caused significant problems down the line.

In FY 2008-9, the year leading up to the elections, the UPA lost the plot even on the macro discipline. Clearly the global economy was extremely fragile during this time and so a fiscal stimulus was definitely required. However, the huge increase in subsidies as a result of entitlement programs, while in synch with the government’s socialist tendencies, was beyond what the economy could support. In the 4 year period from FY 2008-9 to 2011-12, the fiscal deficit has averaged 5.8%, up from 3.6% in the UPA I period. This has also resulted in average government borrowings during this period increasing to Rs 4,10,000 cr, or about $90 billion – a threefold increase from the earlier period. Unfortunately, once the government succumbed to the temptation of subsidies and higher spending, it became a victim of its own policies and now shows little tendency of weaning itself off this drug.

In general, one could argue that higher fiscal deficits by themselves are not the problem. As long as the economy grows in real terms or is accompanied by significant structural reforms which can ensure this growth continues, or alternatively if the spending goes into productive sectors of the economy and creates roads, ports, bridges, power, etc., or even goes into building the country’s long term security, it is alright. But if as has happened over the last few years, the spending is simply putting money in people’s pockets, then we are not helping them finding sustainable solutions to their problems and doing a disservice to them in the long term.
One last datapoint. Our subsidy bill has increased from Rs 70,000 cr ($15 billion) in FY 2007-8, to Rs 2,16,000 cr ($45 billion) in FY 2011-12 – again a three-fold increase. And where is this money going – it is going roughly equally into oil and diesel, fertilizer and food. The first two are linked to increasing prices of oil and gas. Sadly we have no real long term plan to tackle this – there are only 2 choices – either we increase domestic prices for these products, or we hope like hell that international prices decline. However this is totally outside our control and our track record on hoping has not been particularly good!

It is understandable that this government is following its socialist tendencies on spending – though masked in the guise of “coalition politics”. By not passing on actual prices into the economy – whether in power, oil and gas, coal (all energy), fertilizers, railways, etc., it is increasing the disequilibriums of this economy, and this will be harder to redress the longer it continues. But the puzzling question is why the government continues to be silent on the reform front. Is it that its experience in policy making in UPA I resulted in such headaches in the telecom and power tangles, that it believes that drift is a better answer – that things will somehow muddle along, that this muddle is more harmless, and therefore better infinitely than the kind of scandals we have seen.

While domestic investors are continuing to look overseas for growth, both domestic and foreign investors are getting increasingly worried about the policy and tax environment in India. If the government can roll back fifty years to clarify its legislative intent, if government awarded licenses can be cancelled by the Supreme Court, investors and corporates will legitimately question the sanctity of the investment environment in India, and we will lose much needed investments into the country.

In all this, one simple fact cannot have escaped the government. That growth delivers higher tax revenues, particularly corporate taxes, and that it is this incremental revenue that allows the government to play Robin Hood. If this spigot is turned off or turned away, then all the spending plans of the government will remain just that – plans.

Source: Economic Times