A 1991 redux in Budget critical to the India story

In recent years, the Union Budget has been losing its policy-making primacy — and rightly so — because important ones are being rolled out on-the-go.

But, pardon the cliché, this time it is different, because of the macro- and socio-economic backdrop: high food inflation, tight liquidity, slow pick-up in investments, deteriorating current-account position, risk to fiscal consolidation, increasing dosage of monetary tightening, scams and ensuing state assembly elections.

All of this means the Union Budget this time would be a seminal event.

The trade-off between growth and inflation, and loose fiscal policy and tight monetary policy is tough for finance minister Pranab Mukherjee.

On the one hand, there is robust growth in consumption from almost all sections of the society and on the other there is the relentless rise in soft and hard commodity prices including crude oil because of improving growth outlook in the US and heightened portfolio and hedge fund activity in the commodity space.

Over 80% of the emerging economies are facing inflationary pressures today.
The price of crude oil, which poses a significant macro risk to India, has been lifted further by the ongoing uprising in Egypt.

The Reserve Bank of India has not been successful in its attempt to find a magic wand to tame inflation either.

Despite increasing the repo and reverse repo rates 7 times since March last and keeping liquidity in the deficit mode since the middle of 2010, inflation remains at elevated levels.

It is important to note that inflation in India is a structural, supply-constraint driven issue, which essentially limits the ability of monetary policy in tackling it.
Any excessive tightening from current levels will, in fact, be counterproductive as very clearly stated by the RBI in its third-quarter review of monetary policy on January 25.

Last year, it was relatively simple for the finance minister to choose between inflation and growth.

But this year, there are good chances of growth being traded for inflation due to the upcoming assembly elections in Tamil Nadu, Kerala, West Bengal and Assam.

This political event will also spur some populist measures including, presumably, a further relaxation in income tax slabs to keep the middle-class happy.

To be sure, the finance minister can try out few other solutions. In the short term, he can tinker with import duties, excise duties and octroi to tame inflation. And slam the brakes on runaway government expenditure.    

The money received from the auction of 3G licenses, which is capital in nature, has been used to meet short-term revenue expenditure and the ever-growing problem of handling the supplementary Budget.

The long-term solution to taming inflationary pangs is to attack supply-side constraints, which call for increasing capacities. This, in turn, needs acceleration in both public and private investments.

There is a dire need for better roads, warehousing and infrastructure facilities. In their absence, after every 2-3 years of super growth, we will continue to hit supply roadblocks leaving the economy grappling with ever-higher inflation.

Further, the government needs to focus on execution of promises made in the last two years in terms of development of roads, infrastructure and power.

The Budget this time should lay down a final roadmap for the implementation of the Direct Taxes Code and the transition to the proposed Goods & Services Tax regime next year.

These will not only provide guidance to future growth but also increase investor and decision-maker confidence in the execution capabilities of the government.

This will go a long way in attracting long-term capital to fund India’s development.

Foreign direct investment (FDI) inflows, which averaged over $25 billion during the last three years, are clearly slowing down this year.

For April-November 2010, they are down 26% to $14 billion.

So why is FDI crucial? Because it is a good hedge against extremely volatile foreign institutional investor (FII) flows.

During the last three fiscals, FDI has trumped FII inflows. Note also that when FIIs were net sellers by $10.7 billion in fiscal 2008-09, FDI inflows to India amounted to $27.3 billion.

Not many would disagree with the fact the forthcoming Budget needs to be an evolutionary one like - just like the epochal 1991 pronouncement of the then-finance minister Manmohan Singh.

If the government doesn’t do so now, we could be more entrenched in the vicious cycle of high inflation, low demand, low investments and ultimately lower-than-potential economic growth.

This is the time for meaningful reforms in many areas — something that has been lacking in the last few years.