No free lunches here

Indian Express, 28 February 2008

One of the biggest concerns about Budget 2008 is that the UPA might decide to do a big borrow and spend budget. As reported in the Indian Express, an AICC think tank headed by Veerappa Moily has asked the government to postpone FRBM targets by three years. The logic given is that the government needs to spend more in a year that will see some state elections and that will be followed by general elections. This development is disturbing given that off budget subsidies like food, fertiliser and oil bonds have already been kept out of the ambit of the FRBM. A recent IMF study pointed out that there has been no fiscal consolidation under the UPA. After taking off budget subsidies into account, the central government deficit has been at 4.5 percent for the last three years.

Further, in its January 2008 report, the Economic Advisory Council to the Prime Minister has pointed out that its July 2007 Outlook estimate of off balance sheet liabilities at about 2% of the GDP might be an underestimate in view of rising oil, fertilizer and food prices. On top of all these reports, is the spectre of largesse by the UPA for government employees through the Sixth Pay Commission.

Record high tax revenue collections have allowed the government to raise expenditure without there being a big increase in deficits. However, high revenue growth has come from both better efficiency in collection and high growth of GDP. In the coming year, if Indian industry witnesses a slowdown, signs of which are already visible in the latest two months of IIP data, it might mean bad news for tax collection. Custom duty collections which have given high indirect taxes will also slow down with slower import growth.

There are those in the Left and even in the Congress, who do not support the idea of fiscal consolidation. It seems to be a good idea to borrow and spend if it gets votes. However, if it is such a good idea when why would the UPA have even tried to talk about carrying through with the FRBM and trying to implement it when it came to power? Should it not have gone for the borrow and spend strategy right from day one? Large fiscal deficits could have supported even bigger expenditures on roads, schools, debt relief, free power, subsidies and many populist measures along the way. There have, after all, been many state elections during these years.

There are many reasons why borrowing and expanding government expenditure is not a good idea. The higher demand that it generates puts upward pressure on inflation. The government already pre-empts a large share of household financial savings. More borrowing puts upward pressure on interest rates. Not only do domestic borrowing costs go up with large deficits, as India's fiscal deficits go up, its country credit ratings go down, and even external finance for Indian corportes becomes more expensive. High domestic and external cost of capital puts downward pressure on profitability and investment.

These unpleasant elements of the deal put pressure on the government not to borrow large amounts. Given the economy's performance in terms of growth and inflation the govenment is comfortable in borrowing upto only a certain amount. Hence, budget deficit numbers are usually a talking point when the budget is announced.

Moreover, interest payments reduce the flexibility of the government to spend on other items. Debt holders have to be paid first, before anyone else. Interest payments on government borrowing have been rising over the last few years as the public debt has grown bigger. In 2002-03, interest payments were 80 percent of the fiscal deficit. By 2007-08, they were estimated to rise to 105 percent of the deficit. So for example, in 2006-07 the central government borrowed Rs 1.5 lakh crore. Out of this Rs 1.46 lakh crore was used up in making interest payments. In 2007-08 however, the budget estimate was that not only would the entire borrowing of Rs 1.5 lakh crore would be used for making interest payments, interest payments would also dig into tax revenue. Interest payment in the year were budgeted to be nearly Rs 1.6 lakh crore. I suspect that revised estimates for interest payments in 2007-08 will show up to be even higher due both to the rise in interest rates and a larger spend on MSS interest payments.

The budget had underestimated the increase in bond issuance for the `Market Stabilisation Scheme' (MSS), a mechanism devised in 2004 to sterilise RBI's foreign exchange intervention. It expected to add Rs 10,000 crore to the stock of MSS. During the year, however, the RBI aggressively pursued a policy of interevening in foreign exchange markets pushing up liquidity in the system, and then mopping it up by selling MSS bonds. Nearly Rs 1 lakh crore of MSS bonds have been sold this year. This is likely to have cost the government at least, Rs 10,000-15,000 crore in interest payments. Indeed, we are now at a point where the annual MSS issuance is almost bigger than the fiscal deficit itself. Interest payments on MSS are, as yet, a small part of the overall problem. But the stock of MSS bonds is growing very rapidly and will increasingly start mattering in the overall interest burden. In other words, interest payments are already very high, and rising. A large borrowing program will be unwise.

The above arguments largely say that a large borrow and spend budget is bad in the long run. How about in the immediate run up to the election? Here again the Congress and the Left appear to be ignoring one of their most important political constraints - inflation. Given the voter aversion to inflation, the Congress cannot risk an expansionary budget that may push up inflation. Recently in Davos Finance Minister P. Chidambaram said, " I will not be politically in trouble if my growth rate slows down to 8.5 to 8 per cent. I will be in greater trouble if my inflation rises to 6 per cent this year." Considering that consumer price inflation in December was already at 5.5 percent, he clearly has a tight rope walk on February 29.

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