Fiscal deficit, the biggest challenge

Dillip Khuntia
Master of Finance & Control
Utkal University
Borrowing from the RBI has its risks; it will increase money supply and stoke inflation

It is not just the size of the budgeted fiscal deficit — at 6.8 per cent of the GDP — but the high
probability of not being able to check it even over the next two years that is causing concern.

With both government and RBI using fiscal tools to fuel economic growth and with
subsequent announcement of stimulus packages to kick start the economy Arguably the biggest
challenge before the Finance Minister, and almost certainly his successors as well, will lie in the
area of containing the government’s fiscal deficit. The announcement of a 6.8 per cent fiscal
deficit has made headlines and has, along with other factors, caused a stock market decline
which continued well into the following week. If the deficits of the States and off-budget
liabilities (such as petroleum and fertilizer bonds) are taken into account, the combined fiscal
deficit will be almost 11 per cent of the GDP.

An immediate consequence of the large deficit will be a big jump in government

borrowing. In fact, fiscal deficit is really government’s net borrowing needs. A 6.8 per cent
Central government deficit translates into Rs. 400,000 crore of borrowing during 2009-10. That
will be roughly four times the amount envisaged in the 2008-09 budget. The States may have to
borrow around Rs. 15, 000 crore.

A public borrowing programme of such magnitude will definitely crowd out private
investment and push up interest rates.

A BIG GAMBLE

There can be no doubt that Finance Minister Pranab Mukherjee has chosen a huge
gamble. From the government’s point of view, the only way a calculated risk of this magnitude
can pay off, and restore fiscal balance, will be for economic growth to accelerate to its earlier 8.5
per cent to 9 per cent levels, so that tax revenues increase substantially. At the same time,
unproductive expenditure will have to be pared down and the heavy social sector spending better
targeted.

Governments around the world have incurred deficits to finance their contra cyclical stimulus
packages. Some, like the U.K and the U.S., have incurred much larger deficits and consequently
borrowed more. Everywhere the expectation is that growth, so badly affected by the global
economic crisis, will resume. However, there is a qualitative difference between India’s
economic story and that of developed and most other developing countries except China.

India and China are among the few that are forecast to post positive growth while most others
will witness a contraction in their economies. China’s economy grew by 7.9 per cent in the
second quarter this year, due to an ambitious stimulus package and aggressive bank lending.

The stimulus packages and the policy measures enabled the economy to avert a crisis. While the
country’s GDP growth slowed down from 9% in 2007-08 to 6.7% in 2008-09 and around 7% in
the first half of 2009-10, the economy has achieved a growth rate — despite a steep decline in
exports — which is among the highest growth rates in the world during these periods.

The stimulus packages have not only enabled the Indian economy to avert a severe impact of the
global economic crisis but also sustained a high rate of growth during this period. The industrial
production has gathered momentum, other services sector is recovering, Corporate profitability
has improved quarter-on-quarter since Q3 of 2008-09. There is an expectation that exports would
return to positive growth by April 2010.

THE REAL CHALLENGE

The government treasury runs at a substantial fiscal cost; an unsustainably-high fiscal

deficit resulting in a departure from FRBM targets and fiscal consolidation. The estimated fiscal
deficit of 6% of GDP in 2008-09 and 6.8% of GDP in 2009-10 is way above the target of
restricting the fiscal deficit to 3% of GDP by 2008-09. The fiscal deficit in 2010-11 is also likely
to remain high as revenue collection may miss the target. Between 2007-08 and 2009-10,
revenue deficit has gone up more than four times from 1.1 per cent to 4.8 per cent of the GDP
and .fiscal deficit from 2.7 per cent to 6.8 per cent. Revenue expenditure has increased by more
than Rs. 300,000 crore while tax revenues have risen by just Rs. 35,000 crore. The massive
increase is due to interest payments, defence, subsidies, salaries as well as major social
programmes such as the NREGA and Bharat Nirman.

Replying to the budget debate, the Finance Minister laid stress on economic reforms and
promised action on public sector disinvestment. The fiscal deficit will be brought down to 5.5
per cent by 2010-11 and to 4 per cent by 2011-12, as stated in the Medium Term Policy
Statement.

FLAWED ASSUMPTION

There are skeptics who feel that the government is being overambitious in aiming for a
2.8 per cent reduction in fiscal deficit from the budgeted 6.8 per cent (2009-10) to 4 per cent of
the GDP by 2011-12.They have argued that such a large improvement in government finances
over a short time has never occurred before in India.

Implicit in the government’s calculations is the assumption that buoyant tax collections
will make up for half of the 2.8 per cent fiscal correction. But tax revenues depend on economic
growth and India’s growth rate, though impressive in comparison with most other countries, will
not be that robust to deliver outsized tax revenues.
SUBSEQUENT WITHDRAWAL:

Though the fiscal stimulus has helped our economy to avert a crises as severe as USA but
the reality remains that there has to be a subsequent withdrawal of the revival packages so as to
keep a fiscal balance and to avert a debt crises in future. The time has come for fiscal prudence
and discipline. It is time to review and arrive at a plan for withdrawal of fiscal stimulus
packages. The right course of action would be to consider a gradual withdrawal. A sudden and
comprehensive withdrawal could jeopardise the economic recovery that is gathering strength.

In the short run, it will surely hurt. But keeping in mind the difficult task of sustaining a
combination of high fiscal deficit, strong growth and controlled inflation, it has to be done. The
adverse impact could be offset by appropriate increase in investment, both industrial as well as
infrastructural.

A priority in that case would be to create enabling policy framework to escalate

investment . The most appropriate time to begin the process of phased withdrawal of stimulus
packages would be around July 2010, by when corporate performance during 2009-10 would be
known and reliable information on the status of global economic recovery would be available.

CONCLUSION

India will also face the head wind of drop in future savings rate as government turns from saver
to spender. It also needs to keep in mind that FY09 growth to some extent is front-ended by its
simulative policy aka high fiscal deficit. The back-ended prices for the same needs to be kept in
mind.
The government needs to focus on execution and efficiency. It needs to get bigger bang out
of every buck that it is spending. Instead of spending money it needs to invest money wisely.
Building check dams improves water level and helps in improving agriculture yield. The
withdrawal of stimulus packages is inevitable, given the need for fiscal consolidation. Under the
circumstances, continued spending by the state and central governments in creating infrastructure
is likely to remain a key engine of economic growth and the extent and phase of resurgence of
private investment activity is likely to play a critical role in shaping the trajectory of economic
growth.

REFERENCE

• Economic Survey of India

• The Economics Times
• Business Today
• The Analyst
• Business review
• www.yahoofinance.com
• www.investopedia.com
• www.google.com
• www.moneycontrol.com