No policy steroids needed

The economy is finally repairing after the policy mayhem of the last two years. The growth upturn is likely to be modest, and while inflation and the current account deficit will remain high, these are also moderating. At this juncture, it is important to allow the economy to heal by returning policymaking to some sense of stability, rather than trying to hasten the recovery with policy steroids. Clearing the backlog of project approvals, completing the unfinished existing reform agenda and putting the budget on a path of steady consolidation are daunting enough tasks. Doing just these would be sufficient to bring corporations out of the trenches and resume investing. This is not exciting, but we could all do with some steady stewardship of the economy.

Since taking office last September, Delhi's new economic management team has done a commendable job in reversing some of the policy damage of the past in a short time. But the reform blitz has done what it was supposed to do, that is, demonstrate the government's political fortitude and shrug off the label of "policy paralysis" that had come to be conjoined with it. There is no need to pick up reforms just to prove a point, given that they are political lightning rods. Rather, the government needs to do more of what it did last month, namely, pushing forward the reform agenda with less fanfare, but more effect. The compromise on the GST and the increased approvals of projects are likely to have a bigger impact on the economy than they have had on headlines.

Much has been made of reports that the government plans to cut overall spending by nearly Rs 1 trillion in the remaining months of this fiscal year. In fact, government spending had already been squeezed sharply in the last two quarters. At current run rates, spending on roads, defence and rural activities were unlikely to have come close to their budgeted allocations. So, it appears likely that the real intention of the announcement is to stop the year-end flurry of writing cheques just to meet budget targets.

But even with these spending cuts, reaching the revised fiscal deficit target of 5.3 per cent of the GDP in FY'13 is going to be a daunting task. However, the fiscal outturn for this year isn't that interesting anymore. Instead, how large the oil subsidy bill ends up being, and how low tax collections get are really the only matters of interest remaining. This is because it was the palpable underestimation of the subsidy bill and the overestimation of tax revenues that rendered the FY'13 budget dubious within days of its announcement.

For FY'14, the government has promised a deficit target of 4.8 per cent of the GDP. This is a large adjustment, especially with GDP growth unlikely to be much higher than 6 per cent. Consequently, the quality of the adjustment will be closely watched. If the revenue projections are based on a reasonable nominal GDP growth (say around 11-12 per cent) and oil subsidies on import price averaging $105-110 a barrel and the USD/INR exchange rate around Rs 53-54, the deficit target will be credible. Otherwise, it could well meet the same fate as the last budget.

Many believe that the forthcoming budget will be a bouquet of election giveaways. However, one doesn't get that feeling for two reasons. First, it would be completely out of character for this economic team to squander the hard-earned credibility of the last six months. Moreover, this team knows only too well that the threat of a credit downgrade is still alive. A misstep now could well force the credit rating agencies to act before the May 2014 elections. Second, and a bit cynically, why give out election sops now? Yes, there are several state elections coming up, but the big one is still 15 months away. Isn't it more effective to give the sops in a supplementary budget later in December?

Behind the headline numbers, how next year's budget is financed will matter. This year, budget financing turned out to be reasonably benign, with the RBI helping out with large purchases of government bonds and subdued credit demand. This may not be true in FY'14. If there is any marked upturn in the credit cycle, which is likely if corporate investment rises even modestly, then interest rates could come under pressure if both the government and private sector compete for the same pool of deposits. One way of mitigating this is to materially increase foreign holdings of government securities and reduce the ineffectual withholding tax. Some have been exhorting the government to issue US dollar debt. This is a veritable can of worms that should not be opened. Many countries have paid a heavy price for eyeing this as an easy financing option.

But more than the numbers or the financing, people will be looking to this budget for policy and reform guidance. If there is just one thing expected from the FY'14 budget, it is a road map on the GST. Just like the direct cash transfer, the GST is game-changing. It will establish a single national market for the first time and greatly enhance the medium-term fiscal space warding off a credit downgrade. But having witnessed many false dawns, the market's and investors' faith is running thin. If the budget is silent or sketchy on the details, serious questions will arise about the government's commitment to consolidation. Cutting the fiscal deficit to 3 per cent of the GDP over the medium term is neither tenable nor advisable on expenditure cuts alone. New revenue measures are needed, not via some ad hoc increase in the income tax rate on the "super rich", but by expanding the tax base through the GST.

The other issue that the government needs to address, although not necessarily in the budget, is the massive rise in the indebtedness of large infrastructure companies. Banks have been restructuring these loans at a rapid pace in the last six months, but that isn't solving the funding rut. Underlying the rise in the infrastructure credit and liquidity risks are corporate decisions taken in 2007-08 on assumptions that turned out to be terribly wrong, including continued underpricing of tariffs. We can say these corporations and banks went into the loan agreements with their eyes open and should pay for it. But that won't get infrastructure investment going. We haven't developed a sufficiently strong line-up of second-tier infrastructure companies who can take the ball and run on their own, while foreigners remain daunted by local business conditions. The government or the RBI will eventually need to get involved in the debt restructuring with their balance sheets. The sooner we accept this, the quicker the investment cycle can restart.

Last, allocations for the courts and law enforcement need to be raised substantially. India spends (both as a share of the GDP and per capita) very little on its courts and law enforcement bodies. Much of this is the responsibility of the states but as in the case of urban renewal, there is clearly space for the Central government to help out. The recent public outcry over legal reforms is unlikely to change things if we do not provide the courts and police with adequate resources. Justice, as they say, has a price.

The writer is senior Asia economist at JP Morgan Chase. Views are personal

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