Context

In the run-up to the budget, there was enormous pressure on the finance minister to launch a fiscal stimulus so as to pump-prime the economy. That she did not succumb to the temptation is a big relief.

Why fiscal stimulus is unwarranted?

• There is already considerable stimulus in the system. 
• Excessive fiscal deficit: To her credit, the finance minister took a step towards transparency by admitting to off-balance-sheet borrowings of 0.8 per cent of GDP for both the current and next fiscal year.
  • Acknowledging that the fiscal deficit would actually be higher at 4.6 per cent and 4.3 per cent of GDP respectively. This is already excessive.
• Unrealistic projection of revenue growth: Add to this the unrealistic projections of revenue growth and disinvestment proceeds for next year and we have a potentially unsustainable fiscal situation.
  • Any stimulus on top of this would have been clearly

Possibility of undermining the RBI’s efforts

Fiscal pressure could harm the RBI’s efforts to revive the economy in the following ways-

• Harming long term investment rates: Fiscal pressures will undermine the Reserve Bank of India’s struggle to revive investment by bringing down long-term interest rates.
• Rating downgrades: It could result in a sovereign rating downgrade and jeopardise efforts to attract foreign capital.
• Increase in inflationary pressure: It can stoke inflationary pressures, something we cannot afford when inflation is above the RBI’s target rate.
• Pressure on the external sector: And most importantly, it can lead to pressures on the external sector.
• Past experiences: The balance of payments crisis of 1991 and the near crisis of 2013 in the wake of taper tantrums were, at their heart, a consequence of extended fiscal profligacy.

Counter-arguments of the supporters of the stimulus and fallacies in it

• Low Debt-to-GDP ratio: It is argued that our debt-to-GDP ratio is low in international terms.
  • Misleading comparison: The data don’t bear this out. In any case, our experience, as well as research, shows that international comparisons of debt-to-GDP ratios, without reference to other parameters, are misleading.
• Debt in domestic currency: It is also argued that we do not need to worry because our debt is mostly in domestic currency unlike that of many emerging economies.
  • The fallacy in this argument: Our debt in the domestic market didn’t protect us from previous crises, and there is no reason to believe that it will protect us from the next one, especially as our foreign debt is proportionally higher than before.
• Robust foreign exchange reserves: It is argued that our foreign exchange reserves are robust and a balance of payments crisis is improbable. Such complacency is misplaced.
  • Fallacy- No forex is large enough in bad times: We should not forget the lesson that in good times any amount of forex reserves looks like it is too large, but in bad times no amount of reserves is large enough.

Quality of fiscal consolidation

• Quality a cause for concern: As much as the headline fiscal deficit numbers are a cause for concern, the underlying quality of fiscal consolidation is a bigger concern.
• Increasing revenue deficit: Conveniently off the radar, the revenue deficit, far from coming down, is actually going up.
  • Two-third borrowing to finance revenue expenditure: This year, more than two-thirds of what the government is borrowing is going to finance current expenditures like salaries, pensions, interest payments and subsidies.
  • That ratio will rise to three-quarters next year.
  • Crowding out of the expenditure: This debt-financed revenue expenditure is simply unsustainable as it will increasingly crowd out capital expenditure.
• Red flags on the state finances.
  • Another dimension of the quality of fiscal consolidation is the combined fiscal position of states which is, in fact, the big elephant in the room.
  • Together, states spend one-and-a-half times more than the Centre.
  • Larger development impact than Centre: Studies show that how efficiently states spend their money has a much greater development impact as compared to the Centre.
  • Red flags by the RBI on states finances: The states are not doing a good job. In its latest annual report on state finances, the RBI raised several red flags on state finances-
  • states’ increasing weakness in their own revenue generation.
  • Their unsustainable debt burdens.
  • And their tendency to retrench capital expenditures in order to accommodate fiscal shocks such as farm loan waivers, power sector loans under UDAY and a host of income transfer schemes.
  • Consequences in the market: The market will penalise mismanagement of public finances; it does not care who is responsible — the Centre or states — for an unsustainable fiscal stance.

Conclusion

• The fear of one-off fiscal stimulus becoming permanent: By far the biggest fear about a fiscal stimulus is that it is tempting to plunge into a spending programme saying it is a one-off and will be withdrawn when the pressure eases. Experience shows that it is very difficult to bail out. It is good that the finance minster avoided doing any such thing.
  • As Milton Friedman famously said, there is nothing more permanent than a temporary government programme.
• Need to kick-start the private investment: What the economy needs for a sustained turnaround is kick-starting private investment.
  • Implementation of reforms: A necessary condition for inspiring investor confidence is the implementation of structural and governance reforms. This will be a long-haul.
  • That the budget did not launch the journey is a big disappointment. But, at least, the budget did not make a bad situation worse by embarking on fiscal adventurism.
  • It’s better, as Keynes said, to be roughly right than precisely wrong.