India can sustain a fiscal deficit of 6%

A sustained and synchronised recovery path

The three important reason for the currently stagnant economy are (i) a monetary policy which is not synchronised with the fiscal (ii) disconnected with the rest of world in real terms in an increasingly open economy and (iii) mistaking risk aversion for sustainability (of government debt and deficits). Our FRBMs are forcing the government think more like an individual in retirement mode: pay off debts and resist fresh ones as if its sources of income are to dry up soon.

Considering the current strengths, the following can be the action agenda for getting out of the current rut. The aim is to have integrated fiscal and monetary policies. The sustainability of these are demonstrated later.

  1. RBI to maintain real interest rates (RIR) at +/- 0.5% of select competing countries/economies. This will preserve India as an attractive investment destination for inbound investments besides staying competitive for domestic investor. This has become disengaged of late due to nominal anchoring in an open economy, as can be seen in the chart. Since 2013, our Real Interest Rates has gone off into a different orbit.

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  1. RBI to target a GDP deflator of 6% p.a. for the medium term. This together with RIR will establish the target nominal interest rates. Within this food and essential inflation may be targeted at 3-4% to ‘protect the poor’.
  2. Government to aim at Tax GDP ratios in line with other countries (those chosen for real interest rates) – increase it by 2-3% over next 5 years.
  3. Target real growth rate and spend as if we are growing at 7%. If government continues to spend at 7% when the economy is growing at 10%, lower spends will cool down the economy and when the economy is growing at 4% act as a booster – an automatic stabiliser.
  4. Central Government to increase its debt levels to 52.5% from the present 47.8%. The overall debt limit is to be 60%, with 7.5% being kept as ‘Cushion’ to be tapped only for tackling extreme exigencies like prolonged war, events like oil shocks, extreme natural national calamities, 1997/2008 type of contagious external shocks, etc. Any deviation to be brought back to these levels within 2 years of economy retracting to the anchor assumptions of 7% real growth and GDP deflator of 6%.
  5. Government to switch over to accrual accounting from cash accounting and integrate extra budgetary resource (EBR) within the meaning of fiscal deficit. (One reason why the interest rates for the government has not fallen in line with the steep fall in fiscal and primary deficit numbers is the EBRs and Government compete in the same market for the same investors. And since there are multiple agencies placing essentially the same instrument, the pricing power of the central government gets diluted).
  6. Although Industry and agriculture are State subjects, CG will play the stabilisation and balancing role for business cycles.
  7. Subsidy list and quantum to be agreed between states and centre. Subsidies to be limited to basic necessities of food, clothing, shelter, and creating conditions for equality of economic and social opportunities including education, skills, basic healthcare and hygiene. All other subsidies to be part of state budget for which a limit as % of States GSDP to be applied. No subsidies to be mandated on non-government players.

Sustainable glide path

The above are tested below for sustainability of debt/GDP levels, primary and fiscal deficits. These are demonstrated below using standard equations laid out by IMF, Economic Survey (2016-17) and FRBM review committee report.

The government should increase its debt to 52.5% in 3 years. This would involve much higher primary deficits on which additional interest will have to be paid. The governments revenues grow at nominal rates of growth say 13% year on year. But Primary deficits which add to debt have to be serviced at 7-8% only. So one has to balance and equate the additional taxes with serving costs of PD. This is signified by the FRBM review in its report as pdt = (gt-rt)/(1+gt)*dt  (derived from the equation in page 54 of report). Table 1 captures the sustainability.

A primary deficit level of 2.3% is consistent with 52.5% debt/GDP levels and 8% GOI borrowing rate. Based on the above assumptions it is possible to sustain a fiscal deficit at 6% at the Central Government level alone. If we want to rein-in the states, we can mandate them to maintain NIL primary deficits. The sustainable fiscal deficits are given by FDs = Dt * (g/1+g), where FD is sustainable fiscal deficit and g is nominal growth rate. Table 2 lays out the sustainable debt levels across various growth rates and debt levels.

Slide3Table 3 lays down the glide path based on above recommendations. The switch over from cash to accrual accounting might gobble up 2-3 lac crores, which is accommodated by the higher PD targets in Yr1. Since there are already ‘incurred’ expenditure the inflation effect will be muted. By Yr 2, it can keep ready viable public projects. As can be seen, it is eminently feasible.

 

Government has enough firepower to spend its way out of recession

Government is needlessly self-shackled.

V Kumaraswamy

The Government looks like a batsman wanting to play only copy book orthodox shots in death overs of a T20 cricket match. The wherewithal and the government’s ability to spend are far better than when we faced sub-5% growth last. Yet the government seems morally shackled and too ideologically paralysed and unaware of its fiscal strengths.

The virtuous looking dogmas that is sustaining the present pall of gloom are (i) that the fiscal deficit targets given are inviolable and the present situation does not call for any counter cyclical action due to shortcomings in FRBM Act or the Review Committee, (ii) the Inflation Targets (4 +/- 2%) developed by the RBI are a kind of moral or constitutional obligation, (iii) better prices mean better welfare for the people and (iv) the masochist pride over currency values – an overvalued currency is a sign of strength.

The assumptions behind false prides attached of currency values and welfare effect of cheaper prices needs to be shed. But here we will see how despite the vastly superior financial fire power at its disposal, the economy is unable to take benefit of it – rather such inaction seems to be the root cause of the problem. The assumptions concerning fiscal and inflation bounds need to be revisited by more pragmatic economists.

First the monolithic way Inflation targets have been prescribed. It will be tough to find in economic history how a fledgling economy trying to graduate from lower income to low middle contained its inflation at 3-4% or those who grew at 7-8% with such low inflation consistently. Any growth will expand demand which will mostly increase the prices while interacting with an upward sloping supply curve. Even if the current excess capacities, will require better prices to restart. There are no flat supply curve commodities especially with people’s growing quality and brand consciousness. The more the demand growth fuelled by growth in economy the more the inflation is likely to be. To prescribe a 4% central rate and follow it up with hysterical reaction even when the economy gets close to it is a sure way of supressing demand. It appears that over the last 3-4 years the low target of 4% has pulled down our growth rate to 4-5%.

No doubt the poor need protection. But when the same poor is borrowing at 3.5% per month and in some daily loan cases that much for a day, to target interest rates’ closest economic cousin inflation at 4% to protect them seems absurd and ill conceived.

Second, the fiscal deficit targets. The dissent note of the former CEA points out several lacunae in the approach and final recommendations of the recent FRBM review Committee. The report is not comprehensive nor does it deal with appropriate counter measures for various contingencies. The 3% wait either ways before Government can act is far too wide and as the ex CEA points both magnifies over heating and further depresses an economy in distress.

The government has to be complemented for the way it has built the Balance Sheet strengths of the economy but the costs it is paying is too much in current terms. Chart 1 calculates the revenue receipts, expenditure and subsidies as a % to GDP for the period 2008-09 to 2018-19 and compares how these % measure up if 2008-09 is the base year.  As can be seen, revenue receipts of the central government have fallen by 5% but the expenditure has fallen by 20% and subsidies by 32%. Even if the fall in subsidies is due to plugging of leakages, it still means contraction of government expenditure going into private hands. Moral issues aside, it will still have its economic impact. The Central Government’s capital expenditure have moved but in narrow range (albeit downwards) and have not compensated for it. Government’s fiscal rectitude has of course brought down the CG’s debt as % to GDP from 56.1% to 47.8% and the fiscal deficit from a high of 6.46% to 3.34% today. It has been commendable but it has also taken its toll.

The difference between the nominal growth rate (g) and the (nominal) interest rates that the government (r) borrows is an important measure of how sustainable the deficits can be, and ‘g’ is most likely higher than ‘r’. The government’s ability to raise taxes is a function of nominal GDP but it has to pay only ‘r’ to sustain such deficits. But as Chart 2 shows despite our great fiscal restraints, this gap has been on continuous decline, reflecting an unexplained inability to use its strength to bring down yields on government securities.

One reason may be the ‘black’ fiscal deficits – amounts parked outside through extra budgetary resources or instruments issued by CG allied institutions which compete for the same kitty as CG’s debt on eligibility criteria and hence are having their impact. And if there are multiple agencies placing essentially the same instrument, the pricing power of the central government takes a beating. Even if in the short run, it may be irksome it may be more prudent to consolidate the black and white fiscal deficits and manage them as one.

Given its enormous strengths the Government should be bold enough to cast aside (at least for sometime) the needless and contextually out-of-sync inflation and fiscal targets and spend its way to revive the economy. The government can as a first measure raise upto 1-2% of GDP and firstly clear all its pending bills (to NHAI contractors, Fertiliser subsidies and capital expenditure payments for railways and defence) that every Govt does to manage fiscal numbers. Since these expenditures have already been incurred in the past most likely there won’t be inflation from these. The balance can be for newer capital expenditure or paying off state GST dues.

I hope the government overcomes academic impositions with practical actions.

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