Don’t give up on fiscal consolidation

Deviation from the consolidation path will affect government’s credibility

It is important for policymakers to not shift focus fromlong-term objectives for short-term gains. The mid-year economic review, released by the finance ministry last week, argued in favour of relaxing the fiscal deficit target in order to address demand issues in the economy. The government would do well to avoid any such temptation.

While the government is confident of meeting the fiscal deficit target of 3.9% of the gross domestic product (GDP) in the current year, bringing it down to 3.5% of the GDP in the next fiscal year will be challenging.

As has been highlighted in this space before, there are a number of reasons why the path of fiscal consolidation will get increasingly difficult from here on.

For example, in the current year, the government benefited a great deal from lower oil prices, both in terms of containing the subsidy outflow and mopping up revenue by increasing taxes. It is highly unlikely that such gains will be available even next year. Further, the implementation of the Seventh Pay Commission recommendations is likely to increase expenditure by 0.65% of the GDP.

The fall in nominal GDP growth because of a sharp decline in international commodity prices is also complicating the fiscal management. In the current year, for example, the economy is expected to grow at 8.2% in nominal terms, compared with the budget estimate of 11.5%. This, according to the review, will raise the deficit target by 0.2% of the GDP.

In fact, nominal growth has slipped below the cost of borrowing, and if things remain this way, it will affect the debt dynamics for both the government and the private sector. But the current situation could well be an aberration because of the collapse in commodity prices and things may soon stabilize. India has not faced problems of lower nominal growth in recent times despite lower real growth as economic mismanagement of the previous government made sure that inflation was always at higher levels.

But since nominal growth has declined significantly, the review suggested that medium-term fiscal framework should be reconsidered. Also, in the area of monetary policy, it raises the question whether there is space for greater flexibility in interpreting inflation objectives.

It is important to appreciate that the present macroeconomic stability has been attained after a fair amount of difficulty and must be preserved, especially in the current global environment. Any deviation from the fiscal consolidation path will affect the credibility of the government and will raise questions about its ability to reach the desired goal of consolidation. This government has already pushed the target for bringing down the fiscal deficit to 3% of the GDP by a year. Further delay can dent financial market confidence in a significant way. To be sure, the quality of expenditure has improved and increase in capital outlay will benefit economic activity. However, it is equally important that the government adheres to the fiscal consolidation roadmap and manages this transition well.

Similarly, there is absolutely no need to redefine monetary policy objectives. This debate has been settled. It will not help anyone’s cause if monetary policy is adjusted by looking at the nominal GDP growth or lower capacity utilization in the industrial sector on one day and consumer price inflation on the other. This will only induce uncertainty and complicate matters both for the financial markets and the real economy.

Therefore, the government should avoid picking the easy route of pushing growth by running a higher deficit. Instead, what the government needs to do at this stage is to nurture the economic recovery through structural reforms, and by removing supply side barriers, which will help economic activity and boost revenues. The government also needs to think about reviving the disinvestment programme which can provide a steady inflow for capital expenditure.

The very idea of reconsidering the fiscal consolidation roadmap should immediately be taken off the table as it could potentially backfire by hurting market confidence.

Should the government adhere to the fiscal consolidation roadmap