India’s Rising Fiscal Deficit: Should We Worry?

[Management Views from IIMB is an exclusive column written every two weeks for the Management page of by faculty members of the Indian Institute of Management Bangalore]

India’s second United Progressive Alliance Government, known as UPA-2, presented its first budget on July 6. The budget emphasized three areas for action: a) return to 8% to 9% economic growth per annum at the earliest possible time; b) more inclusive growth and c) an improved public service delivery system.

[Shyamal Roy]

Shyamal Roy


All three areas are, indeed, crucial to India’s sustained economic development. First, after impressive average growth of close to India’s potential growth of 9% per annum between 2003/04 and 2007/08, overall growth slowed down to less than 7% in 2008/09. It is projected to be at that level in 2009/10 as well.

Second, even during the period of rapid growth, the robust part of the growth has been largely confined to services and the industrial sectors. While contributing substantially to growth, they have not contributed the equivalent to employment. On the other hand, agriculture, which accounts for 60% of the labor force and close to 90% of the nation’s poor, continues to grow randomly, depending on the weather.

Finally, India’s development experience reveals that policy makers have not been particularly tardy in either allocating funds or coming out with programs (some of the programs are unexceptionable in scope and size) for social justice-oriented initiatives. But the poor outcomes, invariably, can be traced to poor delivery.

Predictably, the budget stepped up capital (investment) expenditure substantially. Also, there is a renewed thrust on infrastructure development through Public Private Partnerships. As expected, a higher allocation has been made for agriculture and various social programs. Some enabling steps have also been initiated through the rationalization of tax structure and policy.

Finally, there are hints at further reforms, including ensuring better delivery of services.

A heavy reliance is placed on enhanced government expenditure to put the economy back on course. The fiscal deficit, as percentage of GDP, is projected at 6.8% in 2009/10 compared to 6% in 2008/09 (against a target of 2.5%) and 2.7% in 2007/08.

These are the deficits of the central government. If the deficits of the state governments and other off-budget liabilities of the central government are added, the overall fiscal deficit comes to almost 11% of GDP.

A good part of the borrowing (70%) announced in the budget will be to meet the gap in the day-to-day expenditure of the government (referred to as revenue deficit in the Indian budget), which comprises interest payments, defense, salaries and pensions, subsidies and social programs. The balance is on account of the gap in investment expenditure.

The size as well as the quality of the fiscal deficit is, thus, unprecedented. The Fiscal Responsibility and Budget Management Act (FRBM), passed in the Indian Parliament with a lot of fanfare in 2004, which stipulated a fiscal deficit of 3% of GDP and zero revenue deficit by 2008/09, has been given a go by, even if temporarily.

Obviously there are concerns about what this fiscal deficit might do to the private sector business environment in India. If the deficit were financed through market borrowings that could crowd out private sector investment; if financed through money creation that could fuel inflation and, if financed through external borrowing that could upset the external sector balance.

Further, it is argued that, in an era when high fiscal deficits are a global phenomenon (the U.S. and U.K. fiscal deficits are in double digits and in the Euro zone it’s between 6% and 8% of GDP), there is a difference. In developed countries, a fiscal deficit is cyclical in nature; in India it is also structural because of various subsidies. If the deficit is of the former type, it is likely to get corrected as the economy revives; if it is of the latter type, the fiscal deficit can remain high even after economic revival.

While the above concerns may well bear out, there is also a need for rethinking the role of fiscal policy in a country like India and, perhaps, other emerging economies.

In the first place, when the constraints to growth and employment generation are more from the supply side (arising out of structural rigidities) than the demand side, private sector investment may not be very responsive to policy variables. An active role by the government may be needed to bring in private sector investment.

Second, fiscal policy cannot be looked at independently of monetary policy; in a regime of low inflation, monetary policy can be accommodative, thereby minimizing the adverse effect of a fiscal deficit on interest rates in the economy.

Third, even if it comes to the crunch, there is enough of a cushion available by way of public sector disinvestment opportunities.

Finally, the difference between revenue deficit (considered to be the unproductive part of the government’s borrowing) and deficit on the capital account (usually for creation of durable assets and, thus, productive) is outdated. Is government borrowing for human capital development through spending on primary education, primary health, R&D etc. — so very important for inclusive growth, but currently a part of the revenue deficit — unproductive?

A correct way would be to exclude such expenditure from revenue expenditure and consider those as part of capital expenditure, which will bring a return by way of intergenerational equity and tax smoothing.

Of course, the final test will be the trend in the debt to GDP ratio but research done by my student at IIMB (Sanjeev Kumar: A study on the design of Fiscal Responsibility and Budget Management Act, PGPPM dissertation, IIMB, 2008), and other scattered evidence from India, suggest that the arguments put forth above are not all jejune.

Then where is the catch? The catch is not in outlays but in outcomes. And to convert outlays into outcomes requires strong political will. It took the Government of India, for example, more than 55 years after independence to promulgate the Right to Information Act (RTI). This has made a tremendous difference to the functioning of the government.

Now, headed by Nandan Nilekani, a much respected business leader of the country, UPA-2 has started a major initiative to set up the Unique Identification Authority of India (UIAI) with a mandate to create an online database with identity and biometric details of Indian residents. The project, which is likely to be completed by 2010/11, will enable enrolment and verification of services across country.

The present government, after many years of fragile coalition governments in India, has come to enjoy political stability. This is, thus, the right time to forge ahead with initiatives that will help in increasingly narrowing the gap between outlays and outcomes.

In summary, economies like India, where structural rigidities, to varying degrees, act as barriers to entry for the private sector, fiscal policy has to play an expansionary role. The choice in such cases is not between public sector investment and private sector investment but between public sector investment and no investment. A higher fiscal deficit, then, need not result in unsustainable debt dynamics. The problem arises if outcomes are not commensurate with investments. And, that is what one needs to carefully monitor in the maiden budget of the UPA-2 government.



~ by Rithy Pheath on 11/11/2009.

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