India - Continuing fiscal concerns

M.Govinda Rao

Fiscal imbalance in India continues to be a cause for concern. Despite impressive increases in the revenue productivity from direct taxes, there is a real fear that fiscal imbalance would accentuate to harden the interest rates and crowd out private investment. The savings-investment imbalance thus created could intensify the recessionary climate in the economy. The excess demand created by large deficits could spill over to imports and create a balance-of-payments difficulty as well. The problem is not merely with the imbalances. What is even more worrisome is that the prevailing regime does not vest the finance ministry with powers to exercise control over the overall fiscal situation and, not surprisingly, it does not have the control.
The fact that fiscal outlook which looked reasonably good last year should change so drastically shows inherent weaknesses in the system. The Union Budget 2008-09 projects the Centre’s fiscal deficit at 2.5 per cent of GDP, much lower than the target set in the Fiscal Responsibility and Budget Management Act (FRBMA). However, it was obvious at the time of the budget presentation itself that the actual deficit would be substantially higher. Unfunded liabilities on account of pay revision and the loan waiver have now become clearer. The burden of pay and pension revision is now estimated at about Rs 30,000 crore for the current year, and of the total liability of Rs 66,000 crore from the loan waiver, a third will have to be met this year. These two items will add an additional one per cent of GDP to revenue deficit as well as fiscal deficit. Indeed, there will be additional pressures to increase subsidies and transfers in an election year and as the interest rates harden, the debt servicing expenditure too could increase. Indeed, it is still possible to show lower deficits through creative accounting and by postponing expenditures, but that would only reduce the effectiveness of expenditure policy.
More worrisome are off-budget liabilities. The subsidies on food, fertilisers and oil were significantly underfunded last year and the budget estimates did not fully reflect the liabilities. The actual subsidy will depend on the purchase and sales prices of these items this year. Indeed, when the oil prices increased to over $140/barrel, the situation looked totally beyond control. Even after the price cooled off to about $100/barrel, under-recoveries continue to be large, for, over the last five years, while the prices of crude oil increased by over 200 per cent, the prices of distillates, on an average, increased by only about 50 per cent. The Economic Advisory Council, in its Economic Outlook, has placed off-budget liabilities at 5 per cent of GDP, and it would be a challenge to limit them even at that level. This implies that the aggregate fiscal deficit including off-budget liabilities of the central and state governments for 2008-09 will be over 10 per cent. This is likely to substantially dry up liquidity.
Thus, surging capital flows will continue to create inflexibility in calibrating monetary policy if the Reserve Bank continues to sterilise them. At the same time, large and increasing fiscal liabilities claim significant part of household savings. This will dry up liquidity and enhance the cost of borrowing to the Indian corporate sector. The large open and hidden deficit has made credit rating agencies to downgrade the rating for India. Fitch has revised India’s long-term currency issuer default rating (IDR) outlook to “negative” from “stable”. This means that the agency has put India on watch and if conditions do not improve in 12 to 18 months, its rating could be downgraded. Others too are watching the fiscal situation. This will seriously constrain Indian corporates to access funds from international financial markets.
A worrisome feature of the Indian fiscal scenario is that the finance ministry cannot exercise much control over it, for it is the various central ministries that take decisions on subsidies. The budget is not comprehensive and this makes the fiscal scenario opaque. The inter-linkage between government accounts and the accounts of public enterprises makes it easy to hide deficits. In this situation, the finance ministry can hardly be held responsible for the proliferation of liabilities.
At a conceptual level, there is a bigger problem of diluting the effectiveness of budgetary policy itself, for, the finance ministry can neither control deficits nor determine final allocations to various activities. If it makes a serious attempt to contain deficits, it has to cut down budgeted allocations, and invariably, it is the more productive expenditures that get the axe. A significant outcome of the FRBMA is that it has pushed a large proportion of the liabilities outside the budget.
A lack of control over deficits arises from the fact that a large proportion of the liabilities arise from the government’s decision to subsidise the consumption of certain commodities by fixing the sale price, replacing the market. Even if the decision to subsidise is taken, it is preferable to provide direct cash transfers rather than subsidise commodities to avoid unintended distortions and to make the subsidy element transparent. Furthermore, since the subsidy element is determined by the difference between the global prices of these commodities and the prices at which these are sold, it is impossible to exercise control over the volume of subsidy in a coalition regime when the government’s willingness to revise prices upwards is low.
The point simply is that in such a regime, the finance ministry, which is entrusted with the task of allocating resources to various public services and controlling deficits, simply cannot undertake this function. The finance ministry has no control over pricing decisions and, therefore, cannot control subsidies. It has to either cut productive expenditures allocated in the budget to control deficits, or allow the deficits to proliferate when the international commodity prices of subsidised commodities escalate.
The problem is compounded by the uncertainty surrounding deficits. No one can predict with any degree of accuracy the global commodity prices and hence the volume of deficits. It is futile to blame the finance minister for the irrational policies pursued by the ministries of agriculture, fertilisers and petroleum! It is worrisome that fiscal policy in India has considerably lost its effectiveness as a macroeconomic policy instrument.
The author is Director, National Institute of Public Finance and Policy. Comments at mgr@nipfp.org.in