Don't throw the baby out with the bathwater

It would be easy to get carried away. A year ago India was the poster-child of emerging market vulnerability. Now we are the darling of emerging markets. Capital flows are surging in, the current account deficit has collapsed, the rupee has stabilised, the RBI is loading up on foreign exchange reserves, and corporate confidence seems to be returning after a historic election result.

So what's not to like? The only spoiler is that growth remains weak. For the first time in 28 years, India grew below 5% for two successive years. And with prospects of a deficient monsoon that is likely to depress the rural economy, a sharp or sustained recovery does not look imminent. So why not make this a "growth budget," as equity markets have been clamoring for? Why not boost expenditure, and selectively cut income taxes to boost aggregate demand? Won't this boost corporate profits and induce more equity inflows?

Such an approach would be a grave mistake. The fiscal consolidation that started in September 2012 has been critical to restoring macroeconomic stability in India. The deficit has been reduced by 1.2 percentage points over the last two years, which has contributed to reducing the current account deficit, keeping the rupee stable, and reducing core inflation pressures which, however, are still elevated. India's consolidated fiscal deficit – including contingent liabilities to state electricity boards – is still close to 8% of GDP, among the highest in the world. No wonder core inflation pressures have been so sticky in recent years. We have absolutely no room for any more fiscal stimulus. We made this mistake back in 2009, by rolling back the Lehman stimulus too slowly, and paid for it dearly with three years of high inflation, higher interest rates and lower corporate investment. We can't afford the same mistake again.

So the new government must pursue fiscal consolidation with the same vigor that the previous finance minister did. Admittedly, reaching the interim budget target will be difficult and so it is possible the government may ease the target slightly, to say 4.3% of GDP. But any such relaxation needs to be accompanied by a serious and credible roadmap of fiscal reforms that brings the fiscal deficit to about 3% of GDP in the next 2-3 years. This will free up more resources for private investment, and facilitate a structural step-down in policy and long-term interest rates.

There has been much talk about using asset sales (PSU disinvestment and spectrum sales) to fill the gap this year. This is understandable when the fisc is under such pressure and valuations have risen so sharply. But it cannot be a strategy for sustained consolidation. Because asset sales – unlike taxes and duties – are not contractionary. Instead, they are simply an exchange of assets between the public and private sectors. So they must be netted out to compute the true underlying fiscal stance. It is possible, therefore, that if the government raises 0.8% of GDP in assets sales this year, as seems likely, but the deficit is only reduced by 0.2% of GDP compared to last year, that the underlying fiscal stance has actually eased. So we need to be careful. What may appear to be fiscal consolidation could actually be fiscal easing.

In addition, what's desperately needed is a rebalancing of expenditures off the budget away from subsidies and consumption towards public investment. We have focused too much on aggregate demand in recent years. Now we need to boost aggregate supply. Some of this will come through greater public investment off the budget. But the bulk of it has to come through private investment, for which the government needs to double-down on easing implementation bottlenecks on the ground – land acquisition, environmental clearances, coal and raw material availability. Corporate investment as a percentage of GDP has halved in the last four years and is the key reason why India's potential growth has slipped from above 8% to below 6%.

So the new finance minister certainly has his task cut out. He needs to reduce the deficit while simultaneously boosting public investment. To do so, hard decisions must be taken on un-targeted subsidies and welfare programmes, which won't be easy in a year with a deficient monsoon. But, to its credit, the new government has made all the right noises and shown intent with the sharp rail tariff hike. We need a serious and sober budget with a five-year view. Not a Christmas tree with goodies for everyone, that equity markets are clamoring for.

"Acche Din" will eventually come. But, for that to happen, the budget needs to deliver the first dose of antibiotics.

The writer is chief India economist, JP Morgan