Setting The Stage for Macro-Pivot: The 2012-13 Budget

Introduction

Many different words have been used to describe this budget. ‘Reasonable’, ‘Responsible’, ‘Sound’, ‘did no harm.’  The words that have not been used are ‘reformist’ or ‘big bang’. Those who were dis-appointed fall largely in the latter camp.  I would call it a “conventional budget,” where, by conventional I mean what one had begun to expect once the reforms of the 1990s were over.  Its main distinguishing feature is the determination to hold to fiscal deficit fixed in the budget and outlined in the long term policy stance.  This was a welcome and necessary departure from the budgets since 2009-10. For the rest it was the usual socio-political document, with a number of expenditure allocations to different groups to reassure them of its inclusive nature and incremental measure to correct small anomalies in infrastructure sectors, presumed to be the central propeller of government planned development programs.

Popular Expectations

 Some expected growth oriented budget and others feared a populist budget.  Neither the expectations nor the fears came true. Though the Finance Minister opened with a statement on the importance of economic growth for generating jobs, inclusive growth and revenues which could be used to help the poor, there was no headline making reform that could enthuse the stock markets or the domestic industrial community.  Measures to incentivize investment, savings, infrastructure, bond markets were neither much better nor much worse than those seen in earlier budgets.  Similarly there were a number of expenditures and increases in the same, directed at the Welfare of various groups, at food security and malnutrition, education and skill development, agriculture, textile workers and small industry.

Benchmark: Macro-Pivot

  Personally, the budget achieved the professed objective of the Finance minister to contain the fiscal deficit to 5.3% of GDP in 2012-13 and to reduce it to 4.8% of GDP in 2013-14.  Though the growth assumption on which this was based were optimistic, my view is that this finance minister is very serious about this objective and will therefore ensure that it is achieved.  This is an important step in restoring the fiscal sustainability and macro-economic balance, some of the most disturbing symbols of which are the current account deficit of 4.2% of GDP during the last two years and the high rate of consumer price inflation.

Why is this so important?  In a paper in 2012 I showed how many growth stars became shooting stars because they were not able to deal with macro-economic shocks emanating inside and outside their country. Thus it is essential to deal with this issue if we want to restore growth to a reasonable level and sustain it for the next few decades. Further, my analysis of the macro-economic situation in India, suggests that the best way to remove the cyclical down turn in the Indian economy is a “Macro-pivot,” which rebalances the fiscal and monetary policy, by tightening the former and loosening the latter.  Again this is based on research which showed that economies showing similar symptoms of macro imbalance as us, such a pivot led to an increase in the average growth rate in one to three succeeding years.  Further the evidence very clear when the fiscal tightening was the result of expenditure reduction but mixed or non-existent when it was the outcome of a tax increase

Fiscal Tightening

The finance minister has accomplished this reduction in the fiscal deficit by correctly focusing on the reduction of subsidies, which were the cause of the unsustainable rise in the fiscal deficit.  Further he has achieved it without cutting capital expenditure (government investment).  In fact capital expenditures are budgeted to increase by 27% in 2013-14.  There is however, one trend that has not been reversed, which needs to be, to put the fiscal deficit on a sustainable trend.  Revenue expenditures net of subsidies, are projected to increase at an even faster rate that the increase in GDP.  Thus the ratio of these expenditures to GDP is likely to increase significantly.

Further Reforms

 The finance minister has also mentioned a number of pending bills, such as the DTA, GST, Pensions and Insurance, that will help improve the investment climate.  If his expectation-hope of these bills in the budget of subsequent session of Parliament fructify, then enough momentum will be generated to return to a growth rate of over 6% in 2012-13.  If these and other administrative and procedural reforms, such as the setting up of an effective ‘Road Regulatory Authority,”  that have been talked about do not come through, then growth is likely to be around 6% (+/- 0.5%). 

A version of this note appeared in the Op Ed page of The Hindu on March 1, 2013 under the banner, “The path to Fiscal Sustainability,” at  http://www.thehindu.com/opinion/op-ed/the-path-to-fiscal-sustainability/article4463052.ece?homepage=tru

Budget Expectations, Benchmarks and Reality

Introduction

The question I as an economist, have been asked many times in the past and will after this one is, “what do you think about this budget?”  To make sense of the diverse and contradictory answers from supposedly neutral experts (that the average person will receive), one has to know the benchmark the person was using.  What were the expectations against which the budget was assessed? These related primarily to stabilizing the macro-economic situation and secondarily to boosting investment.

Benchmark

Let me therefore start by defining my benchmark.  The rate of growth of the Indian economy has been on a downtrend during the last three years to reach a projected  5% in the current year.  Over the same period, the current account deficit reached 2.8% and then jumped to an unprecedented 4.2% of GDP and investment growth halved and then halved again.  At the same time inflation measured by different indicators remained stubbornly high.  Consequently the rating agencies threatened to reduce India’s global rating to Junk status.  The political system including the government took serious note of this potential crisis in the last quarter of 2012 and started taking policy action to free the administered prices of petroleum products and increase FDI limits in Aviation and Retail.  This was good start, and helped to reverse the extreme pessimism that had gripped domestic and international investors.  Phase I of an operation to retrieve the situation and reverse the trends in investment and growth. 

Phase II of a Reform Process 

  I saw the Budget as Phase II of the process, whose focus was on reversing the fiscal trends as a critical input into overall macro-economic stabilization.  The critical test, as I pointed out in a media discussion about a month ago, would be to see if the Finance minister is able to deliver on his long term fiscal deficit strategy and the targets of 5.3% and 4.8% for the years 2012-13 and 2013-14 respectively and reverse the trend of rising subsidies and government current expenditures and transfers.  Tested against this benchmark the 2012-13 budget has done well (5.2% and 4.8%) with a few caveats. Much of the increase of the fiscal deficit in 2009-10 (the high point) was due to a jump in subsidies.  Returning subsidies to the 2% of GDP that they had stabilized at in 2007-8 was therefore an essential element of Fiscal stabilization.  A projected 10% decline in the subsidy bill is reassuring even if this decline is exaggerated.   However total current expenditures are projected to increase by about 14% next year, above the projected growth of GDP of 13.5%, which in my view is based on an optimistic growth projection.  Thus current expenditures net of subsidies will increase as a proportion of GDP.  This up trend is a little worrying as the revenue deficit (RD) will only decline by about 0.5% of GDP even under the optimistic growth projection.   As the RD is approximately equal to the Governments Investment – saving gap, the impact on the current account deficit (0.5%) is not sufficient to bring it down below 3.6% or so.  On the other hand, capital expenditures have increased by 27%, thus this reduction has been achieved while raising government investment, which should have a positive effect on overall investment.

Mesures & Reform Hints

There are also some measures in the budget to increase private investment and savings.  The introduction of an investment allowance for large investors has however, been accompanied by rise in surcharges on corporate profits.  This fiscal twist (positive and negative) could in principle bring forward and accelerate private investment expenditures.  This will however, only happen if the promise that the rise in surcharge is temporary is believed by investors?  Credibility is the key to its success.  There was also some expectation that clear explicit administrative and procedural measures would be taken to reverse what has been perceived as creeping return to permit-inspector raj in the revenue (tax) department (CBDT, CBEC).  The budget did not, unfortunately, give a convincing demonstration of this reversal.

Phase III Vital

There is an underlying concern that many in the UPA and in other parties do not realize the seriousness of the situation, in which the rate of growth of GDPMP is likely to be an abysmal 3.5% in 2012-13 and are again becoming complacent that the measures already taken will propel us back to 6.5% and then to 8%.  In my view this will not happen without further policy, regulatory and institutional reforms.  I look forward to phase III of the reform process that can make this return to sustained high growth likely. 

A version of this note appeared on the Op ed page of the Indian Express on March 1, 2013 under the banner, “Reform Phase II,” http://www.indianexpress.com/news/reform-phase-two/1081357/

Macro Pivot: The Rebalancing of Indian Economy

Background

       The global financial crisis hit India along with many other countries across the World. Liquidity collapsed, World demand for tradable goods and services shrank and growth fell.  As soon as the shock was appreciated, the RBI responded by expanding liquidity and access to domestic funds. Despite the urgings of market analysts, multilateral institutions (World Bank, IMF) and many Indian academics that India had no "Fiscal space," we in Economic Division of  the Finance Ministry advised the decision makers to let the fiscal deficit double to 5% of GDP in 2008-9 to counter the precipitous fall in aggregate demand.  This involved not only politically driven expenditure measures but also temporary reductions in excise duties. The very difficult technical task of explaining this reversal of the signal achievement of the FRBM in 2007-08, a central fiscal deficit of 2.7% of GDP, was left to the chief economic advisor. Despite an even higher actual deficit of 6% of GDP, this was successfully accomplished by convincing financial analysts, investors and the media. A V shaped growth recovery from 3.9% in 2008-9 to 8.5% in 2009-10, led by an increase in the rate of growth of capital formation (investment) from -5.2% in 2008-9 to 17.3% in 2009-10, was the reward for these measures.  Though WPI inflation fell sharply from 8.1%  in 2008-9 to 3.8% in 2009-10, CPI IW inflation rose further from 9.1% to 12.4%, suggesting that retail margins may be expanding because of rising transport costs between the periphery and the Center of urban agglomerations and the rising cost of land and real estate in urban areas.

Fiscal Bubble

Of-setting this achievement in 2008-9, was a failure to convince the bureaucratic and political leadership in 2009 (till my departure in November), that the Fiscal deficit of the Center and the States be brought back expeditiously to below 3% (respectively) as soon as  8% growth was restored. Instead of reversing the temporary excise tax reductions and expenditure/subsidy increases, the deficit rose further to 6.5% of GDP in 2009-10.  This set the stage for a bubble in 2010-11 that raised WPI inflation to 9.6%, CPI IW inflation to 10.4%, and growth of investment and GDP to 15.2% and 10.5% respectively. Though the current account deficit remained at a historically high level of 2.8% of GDP it reached in 2009-10 this was due in 2010-11 to an unbelievable 40.5% growth in exports.  Some of the analysts who had opposed the fiscal expansion in 2008-9, justified the fiscal expansion in 2009-10, and are now again criticizing the fiscal expansion in 2008-9.  It is a serious macro-economic error to think that the best macro policy for India was the same in 2010-11 as it was in 2008-9, or that the best macro policy for India is the same as that for the USA or EU. 

Macro-economic Re-balancing

     The need for re-balancing fiscal and monetary policy has become progressively more urgent since 2010-11.  With a projected fall in the growth rate of GDPMP to 3.3% in 2012-13 and CPI IW inflation stubbornly high at 10%, an immediate re-balancing of fiscal and monetary policy is needed in India.  A macro-pivot, which reduces the fiscal deficit and puts it on a clear downtrend to 3% of GDP accompanied by an equally sharp loosening of the monetary policy.  This will have the effect of reducing demand for non-tradable goods (natural plus artificial like QR constrained agriculture) and to stimulate private investment and demand for consumer durables.  This will help correct the cyclical elements of the problem. 

    Much more policy, regulatory and institutional reform (referred to in the US and EU as structural reform) will be needed to remove sectoral bottlenecks and put the economy on a sustained 8% growth path.

Paradox of Fiscal Tightening: Expenditure Cut is Expansionary (Deflationary) in India (EU)

The RBI Governor has been quoted as saying that there is not much scope for either fiscal or monetary expansion.  Analytical pieces and editorials in newspapers have echoed the same sentiments with respect to fiscal expansion but have been more ambivalent about monetary easing.    This assumes that an increase in the fiscal deficit and a loosening of the monetary policy will both be expansionary. The analysis that leads to the formulation of this choice in this manner is flawed for India.  Since 2009, the Indian economy has been in a situation in which a sharp reduction in the fiscal deficit will be expansionary, particularly when combined with a loosening of monetary policy.

The economic environment in which the USA and EU have been in since 2010-11 is fundamentally different from that in India. Thus one has argued for the last three years at the IMF board (as ED) that the Euro area and the EU must not cut expenditures (or raise taxes) in the short term, and focus fundamental tax and expenditure reform on putting fiscal deficits on a clear down-ward trajectory over the medium-long term.  In other words, our advice to the Euro area and the UK was to eschew immediate fiscal contraction and focus on more durable fiscal and structural reforms.

 At the same time, for India one has argued for a reversal of the expenditure expansion that was undertaken in 2008-9.  Fiscal expansion was essential in 2008-9 when global demand collapsed, but was no longer necessary once India’s growth recovered to 8%, which one expected to happen in 2009-10.  Thus the process of restoring the fiscal deficit to 3% of GDP, attained in 2007-8 should have begun from the 2009-10 budget and been completed by 2011-12.  Though in 2009, the growth rate for 2009-10 was merely a forecast, by the time of the 2010-11 budget, growth was restored firmly to 8%-8.5%, the underlying or potential growth rate of the Indian economy and a sharp reduction in the fiscal deficit in the next two years would have restored it to the 2007-8 level.

Why this difference in advise for the EU and India.  The EU and particularly the Euro area was in the midst of the worst financial crisis since the Great Depression.  Banks balance sheets were in chaos requiring extraordinary support from governments and Monetary authorities, virtually zero interest rates, inflation close to zero and threatening to turn into deflation and low or declining current account deficits. Further the crises affected virtually all developed countries in the world so there were no independent drivers of demand and growth.  China with one of the lowest private consumption rates in the world and a huge surplus on the current account was also dependent on outside drivers of demand rather than being an independent driver. In this situation, fiscal contraction across the Euro zone and in UK turned out to be severely deflationary as predicted by several observers (including us), contradicting the conventional wisdom enamored of the IMF and board members from the EU countries.  In other words, the traditional neo-Keynesian model was much more appropriate for the EU and the Euro area than the favored monetarist model (the conventional wisdom ).

Paradoxically the conventional global wisdom is currently relevant to India and has been since 2010-11.  An IMF review of pre-crisis research on Developed countries complemented by updating of findings confirmed that historically, fiscal contraction (expansion) had stimulated (reduced) average growth in 3-5 years following the change.  This was universally true when the contraction was the result of expenditure reduction and less so when it was the result of tax increases.  In trying to explain the reason the researchers discovered that the successful cases were all linked to an expansionary monetary policy.  They concluded that a reduction in government expenditure increased allowed Central banks to loosen monetary policy and effectively stimulate private investment and consumption.  In contrast, a rise in taxes had a negative effect on private investment and consumption and offset much of the benefits of monetary expansion.

An analysis of the macro-economy of India during the last 3 years shows, a rising current account deficit,  stubbornly high inflation, rising rural and urban real wage rates, falling saving rates, a rising gap between bank lending and deposit rates and high gold imports.  All these are indicators of a mis-match between supply and demand at different levels: sectors such as agriculture and energy, factors such as land and skilled labor and aggregate supply and demand for natural resource and (artificial, policy created) non-tradable.  Based on this analysis one has urged for the last two years a sharp reduction in the fiscal deficit through a reduction in subsidies accompanied by an equally sharp easing of monetary policy.  The two together would have an expansionary effect and reverse the cyclical elements of growth decline.  A restoration of the economy to its growth potential of 8% to 8.5% would require more policy and institutional reform. 

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A version of this note appeared on the Op Ed page of the Economic Times, Monday 18th February, 2013 under the banner, "The Paradox of Fiscal Tightening." http://economictimes.indiatimes.com/opinion/comments-analysis/spending-cuts-by-trimming-subsidies-will-spur-growth-in-india-but-same-wont-work-in-eu/articleshow/18551276.cms