Credibility over ambition, please

It is ironic that precisely at the time when growth has slowed so sharply, India is forced to embark upon sustained fiscal consolidation, which will further slow growth. Let’s be clear. India’s large and incompletely-withdrawn fiscal stimulus since Lehman crisis has been a key driver of stubbornly high inflation and unsustainably high current account deficits.

More generally, our bloated public finances have brought us dangerously close to losing our investment grade status. A downgrade may not affect the government, but will play havoc with the rupee, inflation, corporate balance sheets and external commercial borrowing refinancing.

Sustained fiscal consolidation is therefore a necessity, not a luxury. My simple point is that we are three years too late. This process should have commenced seriously in 2010 when we know growth was making a healthy comeback (and was recently revised up to 9.3%!). Fiscal laxity back then has, unfortunately, forced fiscal policy to be pro-cyclical now.

You don’t start repairing your roof leak on a rainy day. That said, the government needs to be commended for its boldness over the last six months. But that same grit and determination will need to be seen in the Budget. Markets remain obsessed with numbers. Will the deficit be reduced to 5.3% this year?

Will next year’s target be 4.8%? I would argue that the exact numbers matter less. What matters is the credibility surrounding the numbers. Reaching this year’s target would mean little if it is achieved largely by temporarily slashing expenditures or running up large arrears. And it’s okay if next year’s target is less ambitious if the underlying assumptions are realistic.

More generally, this Budget cannot simply be a statement of accounts for next year. It must also convey an unmistakable intent to correct the structural deterioration of public finances in recent years. Few will remember that India ran a primary surplus (net of interest payments) of almost 2.5% of GDP in 2005. Last year it was a deficit of 2.5% -- a worsening of 5% of GDP in the last eight years.

So what’s needed? For starters, credible revenue mobilisation. Tax revenues have fallen by almost 2% of GDP over the last 4 years. And tax administration -- though necessary – will not be sufficient to reverse the decline. A combination of base broadening and rate increases seems inevitable.

The former must bear the brunt of the adjustment, since raising rates will further disincentivise compliance. The focus must therefore be to tackle the fundamental weaknesses, instead of over-budgeting asset sale revenues to try and get by.

Most importantly, however, the Budget must lay out a realistic road-map for GST. This has the potential to be a truly game-changing fiscal reform in the medium term, if done correctly.

But revenues will not be enough. The Budget must signal a need to rationalise subsidies and, more importantly, shift the composition of expenditures towards capital (physical, human) creation.

Last year’s Budget was long on promises (reducing subsidies to 1.7% of GDP in three years) but short on specifics (how will it be done?). Furthermore, if a Food Security Act is inevitable in an election year, let’s be frank and budget for it! Similarly, cash transfers are game changing in the medium term. But given limited product and geographical coverage, will not lead to any meaningful savings in the near term. Let’s be honest about that.

Apart from credibility, it will be important to find ways to boost infrastructure financing, as well as attract capital inflows to fund the current account deficit. Why not remove the withholding tax on G-Secs and increase issuance so India becomes eligible to be included in an emerging market bond index?

That’s when we are likely to receive far more sticky, real money flows. And why not test an inflation-indexed bond to reduce gold imports?
The government has worked hard to earn back some credibility over the last six months. Now it must ensure it doesn’t throw it away.

The writer is India economist, JP Morgan