Fiscal discipline: now comes the hard part

Despite improvements in the recent period, deficits need further trimming

Macroeconomic conditions in India have improved a great deal since the second half of 2013, when the country narrowly avoided a ratings downgrade to junk after the so-called “taper tantrum”. The Indian rupee was in a free fall and the economy was stumbling towards a crisis thanks to economic mismanagement in the preceding few years. The three most important indicators of economic health were flashing red: inflation, current account deficit and fiscal deficit.

Much has improved since then. The current account deficit and inflation are now under control, and there has been a considerable improvement in the fiscal position, though the consolidated fiscal deficit of the Indian government is around five percentage points higher than the average of its emerging market peers. Yet, the policy establishment has had good reasons to hope for a ratings upgrade, which will improve India’s standing in the global financial markets.

However, Standard & Poor’s, a rating agency, last week dismissed all such hopes, at least for now, citing the state of public finances as a key constraint for an upgrade.

While some enthusiasts in New Delhi may not agree, the reality is that despite improvements in the recent period, government deficits need further trimming, even as the task ahead will be made challenging by the prospect of higher salary and pension commitments. The one-time dividend from lower global energy prices has also been used; there is no similar windfall likely next year.

The coming Pay Commission recommendations will increase pressure on both central and state government finances. The government has accepted the One Rank One Pension scheme for the armed forces. Debt-laden state electricity boards will have to be rescued at some point in the near future, possibly by transferring part of the debt to the books of state governments (though that will not be a permanent solution to a persistent problem).

Further, the central government may have to infuse more equity in the public sector banks to help them deal with their bad loans, meet global regulatory requirements and enhance their lending capability.

The government also has to push capital expenditure to revive economic growth in the absence of investment activity in the private sector. And slower expansion in nominal gross domestic product essentially means that the denominator of the fiscal deficit and public debt ratios is growing at perhaps its slowest rate in a decade.

All these factors put together will make further fiscal consolidation a tough task—and will test the commitment of the finance ministry.

One way forward for the government is to aggressively push growth through reforms. Faster growth is the best way out. The second United Progressive Alliance government managed to follow a reckless fiscal policy yet keep the public debt burden under control by inflating away its debts.

What India needs as part of a sustainable fiscal correction is faster real growth, which will also help tax buoyancy.

One immediate policy option needs to be activated. As noted by the 13th Finance Commission, the government should use disinvestment to increase capital expenditure—a sort of asset swap. While the current government in New Delhi showed the intent to aggressively use the disinvestment option, and had set a praiseworthy target for the current year, the movement in the first half of the fiscal has been poor.

While many would disagree with the assessment of credit rating agencies, and their action (or lack of it) during and after the financial crisis has certainly not enhanced their credibility, it does not hurt to take their evaluation positively. It is indeed true that general government deficit in India has been on the higher side compared with its emerging-market peers and other middle-income countries.

Therefore, the necessary fiscal adjustment will not only be credit positive, but will also enhance India’s ability to absorb shocks emanating from global markets and create conditions for sustained higher growth in the medium to long run.