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December 21, 2012

How India can step back from a fiscal precipice

Take credible measures to make India’s public finances sustainable

The first sentence of the September 2012 Report of the Committee on Roadmap for Fiscal Consolidation, set up by the Ministry of Finance, India (known as Vijay Kelkar Committee Report) begins with the following sentence. “The Indian economy is presently poised on the edge of a fiscal precipice…” In a statement to the Parliament on December 14, 2012, the Union Finance Minister stated, “if we do not succeed in fiscal consolidation, there is a risk of rating downgrade to junk status. We cannot afford that”.

The Reserve Bank of India, RBI, in its July 2012 monetary policy review reiterated its concern about lax fiscal policy, poor public financial management and non-monetary policy induced slowdown in investments.

The above statements underline the gravity and urgency of undertaking credible and substantive measures towards making India’s public finances sustainable within the next two to three years. The current global economic environment has substantially increased the risk of inaction when public finances are perceived to be unsustainable, as evidenced by the experiences of Greece, Spain and other countries. It has reduced the distinction between domestic policies and their outcomes and external policies. Each is interlinked and affects the other. For India this aspect is even more relevant as its current account deficit in the balance of payments (which reflects the difference between receipts from exports of goods and services and certain transfers, such as net remittances, and net tourism receipts on the one hand, and expenditure on imports of goods and services, including import of gold on the other). India’s current account deficit exceeded 4 percent of GDP during the January-June 2012 period, a level considered well above manageable level of less than 3 percent of GDP.

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India thus needs to address both, the high fiscal deficits and the current account deficits simultaneously, severely constraining policy space and options, while sharply raising the economic, social, and geo-strategic costs of incompetent or inappropriate policy response. Managing domestic and international perceptions concerning macroeconomic policy credibility and competence is now an essential task not just of relevant policymakers, but also other private and public stakeholders.

Traditionally fiscal consolidation is analysed in terms of trends in fiscal deficits, and the trends in public debt to GDP ratios. Globally, three percent fiscal deficit (broadly defined as tax and non tax revenues excluding borrowing, less current and capital expenditures) and public debt stock of 60 percent of GDP are considered manageable. India’s combined deficit including both the Union and the state governments has consistently been high, and has been around eight percent in recent years. This is in spite of the increasing use of off- budget agencies controlled by the government such as the public sector banks, oil and fertiliser companies, LIC, (Life Insurance corporation of India), and EPFO, (Employees Provident Fund Organisation) to undertake quasi-fiscal operations.

The Fiscal Discipline Index computed by the 13th Finance commission as a ratio percent of own revenue-to-revenue expenditure shows a varying performance by the different states. The average of all states over 2005-06 to 2007-08 was 62.4 percent, with 19 states, more than half, exhibiting index value below the national average. Reducing this unevenness is essential for managing India’s fiscal risks.

The average public sector saving between FY 05- FY 10 was only 2.7 percent of GDP (8 percent of Gross Domestic Saving) while the corresponding figure for public sector capital formation was 8.5 percent of GDP (24 percent of the Gross Domestic Capital Formation). Such a large mismatch implies that the public sector is using household and business sector savings to finance its expenditure.

The above suggests that policy initiatives will need to be aimed at mitigating fiscal risk, rather than at traditional deficits alone. Fiscal risks includes risks arising from off budget transactions from accrued liabilities which are not recorded under cash accounting system, such as accrued pension and health care benefits, and contingent liabilities arising from implicit and explicit government guarantees and others.

Even after significant reduction in public debt to GDP ratio from 81 percent in 2004 to 64.1 percent in 2010, India’s public debt levels remain high. Slower real GDP growth (the current Union government policies have significantly contributed to lowering potential growth to 5.5 to 6.5 percent range from earlier 7 to 8 percent rate); and fiscal slippages reflected in continuing high deficits, including persistent revenue deficits implying current revenue does not even cover current expenditure such as salaries, pensions, and increasing entitlement-based subsidies suggest rising public debt to GDP ratios, as well as higher fiscal risks.

India has so far been able to sustain its public debt levels and fiscal risk due to several reasons. Overwhelming proportion of India’s debt is internal (90.4 percent as at end September 2012, a decline from 93.3 percent in 2010); importance of state-connected financial entities in ownership of debt; relatively longer maturity periods, and through not permitting financial institutions to pursue market-based opportunities, called “financial repression”. But these devices are increasingly less effective and desirable as India’s integration with the world economy become larger and more intricate; and as India’s GDP increases at about 12 percent nominal rate from a current level of USD 1800 Billion.

The additional areas requiring policy measures include improving on low level of cost recovery on social and economic services as emphasised by the 13th Finance commission; rationalising petroleum and energy related pricing and other policies; improving tax administration and compliance efficiency; improving outcomes of subsidies and tax expenditures; greater competence in undertaking divestment and in auctioning of key property rights; and using government assets more productively.

In conclusion, managing India’s public debt sustainability and fiscal risks and achieving fiscal consolidation will require greater focus and competence in public financial management by the Union, State, and Urban and Local governments. Technological fixes such as use of Aadhar cards, or in the manner in which benefits of government schemes and programs are delivered (such as the Direct Benefit Transfer providing cash as being experimented with for some schemes in select districts), are unlikely to be effective in achieving fiscal consolidation. Wide ranging and substantive improvements in public financial management will require supply side reforms, and a growth strategy, which enables benefits of knowledge economy to be realised.

Photo: Meena Kadri


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