Even though growth is faltering and recession is staring hard at some European nations, they have been on an austerity drive—something India should strive to do. The New Year resolution of the government, if there’s one, should be to bring down the fiscal deficit. If indeed the government dares to do so and makes a short-term compromise with growth, the markets will reward India.
The February budget estimate of fiscal deficit was 4.6% of gross domestic product, but now, by the government’s admission, it can go up to 5.1% even as most analysts believe it can be as high as 6.1%. If that happens, about Rs 1.35 trillion will be needed to plug the hole.
Why will the government miss the fiscal deficit target? There are reasons—a rise in expenditure in terms of subsidies on the one hand, and declining revenue, on the other.
The government will find it difficult to meet the disinvestment target of Rs 40,000 crore with the stock market in a firm bear grip and foreign investors selling more Indian stocks than buying. So far, it has raised only Rs 1,144.5 crore through a follow-on offer of shares in Power Finance Corp. Ltd. It is exploring private placement of stakes in some firms and also a buy-back by companies to generate money, but none of the ideas may succeed.
Additional expenditure for oil, fertilizer and food subsidies will be around Rs 1 trillion, and on top of that there will be a Rs 10,000 crore additional interest cost for higher market borrowing. Tax collections have been sloppy. In the December quarter, advance corporate tax paid by Mumbai-based firms that roughly account for one-third of all-India tax collections was almost flat.
Where will the money come from? Already, the government has increased its borrowing plan in the second half of the fiscal year by Rs 52,800 crore (this was because small savings collections dropped), taking the annual borrowing programme for fiscal 2012 to a record high of Rs 4.7 trillion. With a higher fiscal deficit, the borrowing has gone up further and this will crowd out private investments.
Intelligently, the government is raising the bulk of the money through short-term treasury bills. It will ease pressure on the banking system—as foreign investors normally prefer short-term government paper—but to do so, the government should be in a position to pay back the money next year. This means the fiscal deficit must come down. This is challenging as the proposed food security entitlements alone will add an at least Rs 27,000 crore burden on next year’s budget.
The Reserve Bank of India (RBI) is caught in a bind. It cannot cut the banks’ cash reserve ratio, or the portion of deposits that banks need to keep with it, to release liquidity as banks can use the money to punt on the currency, which is under pressure. Besides, liquidity will also fuel inflation. RBI has been buying bonds from banks to make sure that they have money to buy government bonds. This is backdoor monetization of fiscal deficit, forbidden by an Act of Parliament.
Apart from making sure that the government succeeds in raising money, the central bank’s bond-buying programme also helps bring down bond yields. This ensures that the cost of government borrowing is not too high and, at the same time, balance sheets of banks are protected. When bond yields rise, prices fall. Under accounting norms, banks need to make good the difference between the price at which they bought bonds and their current price, by setting aside money. This hits their profitability.
This is a band-aid approach of keeping the system stable and making both banks and the government happy but it can’t go on forever. If the government is not able to bring down the fiscal deficit, it will continue to borrow money from the market, elbowing out private investments. A higher fiscal deficit will also fuel inflation. Even though wholesale price inflation in November came down to 9.1%, the lowest in a year, the non-food manufacturing inflation, a proxy for core inflation, continues to be high. As long as this doesn’t come down, the central bank can’t cut its policy rate.
A depreciating rupee will also add to the core inflation as the cost of imports is rising. The gap between money spent on imports and earned on exports is rising and since the investment scenario is bleak, most imports are for consumption. This is not helping the economy in any manner. The flow of foreign portfolio investments used to take care of this gap, but this is not happening any more as investors are losing faith in India’s growth story.
A lower fiscal deficit will help convince them to come back to India as it will bring down inflation and ensure growth in the long run. For that, the government needs to take some hard decisions. For instance, even if it decides to wait for a political consensus on issues such as foreign direct investment in retail and higher foreign stakes in insurance firms, it can free the diesel price, cut other subsidies, raise excise and corporate and even personal income tax.
Instead of doing that if it continues to depend on the central bank to cover up its policy paralysis, it can give the Fiscal Responsibility and Budget Management Act a quiet burial and RBI can start printing money. If RBI starts printing money to take care of the fiscal deficit, which it used to some years back, the hefty government borrowing programme will not crowd out private investment but it’s a dangerous solution as it will fuel inflation and currency depreciation.
The conundrum can end only if RBI puts its foot down and says no to accommodating the government’s market borrowing. It’s not an easy task but the central bank must do so to ensure the nation’s economic security.