Global Outlook

Testing times

Contributed by Nirmal Bang

By Nirmal Bang

In the recently announced monetary policy review, Reserve Bank of India (RBI) Governor D Subbarao said, “A bigger risk to short-term economic management and medium-term economic prospects emanates from the large fiscal deficit.”

In simple terms fiscal deficit is the negative gap between higher government expenditures and lower revenues. The government fills this gap by borrowing against government securities. In July ’09 Subbarao had said, “Managing the government borrowing programme to finance the large fiscal deficit posed a major challenge for the Reserve Bank.”

So, is higher government borrowing bad for the Indian economy? The answer is quite subjective. Typically, higher borrowing requires higher debt servicing that is interest payments.

“So when a government borrows more and hence incurs higher interest payments, less money is spent on productive purposes,” explained an economist. But then the other way to look at it is to understand what made the government borrow more.

After the global financial crisis erupted, the government of India, like other governments around the world, got into a damage control mode. While the Reserve Bank of India (RBI) was loosening it monetary policy by cutting interest rates, the government announced a series of stimulus packages to give growth boosters to get the ailing economy back on its feet.

The counter-cyclical public finance measures taken by the government as part of crisis management were necessary. “Indeed they were critical for maintaining demand when other drivers of demand had weakened,” said Subbarao. But as recovery gains momentum, it is important to have co-ordination between fiscal and monetary exits. “The reversal of monetary accommodation cannot be effective unless there is also a roll back of government borrowing,” said Subbarao.

For both short-term economic management and medium-term fiscal sustainability, it is imperative that the government returns to a path of fiscal consolidation. The consolidation can begin with a phased roll back of transitory components.

Beyond that, in the interest of transparency and predictability, the government should ideally do two things: firstly, it should indicate a road map for fiscal consolidation and secondly, it should spell out broad contours of tax policies and expenditure compression that will define this road map, advised Subbarao.

But why does Subbarao give this direct advice and why should the government read his advice cautiously? As part of the stimulus measures, the government had announced lots of cuts in taxes and levies. In the first eight months of 2009-10, revenue mobilization was half the budgeted amount mainly on account of a decline in the indirect tax revenue.

Despite registering higher growth in April-November ’09 than in April-November ’08, non-tax revenue as a per cent of budget estimates was lower during April- November ’09. The auction of the third-generation (3-G) spectrum, which is budgeted to yield Rs 35,000 crore, has not yet taken place. The gross fiscal deficit is estimated to exceed Rs 4,00,000 crore in 2009-10.

The huge gap will again be filled with additional government borrowing and that too in a market where the Reserve Bank is worried about liquidity adding to inflation woes. The 75 basis points (hundred basis points make a percentage) hike in the Cash Reserve Ratio is estimated to flush out Rs 36,000 crore worth liquidity from the system.

Even as government borrowing increased abruptly during 2008-09 and 2009-10, the Reserve Bank had managed to bolster liquidity through a host of measures that included front loading borrowing programme, unwinding market stabilization securities (MSS) that banks had invested in during the tightening phase. Open market operations (OMO) also came to the rescue as the system was flush with liquidity.

“Those liquidity infusion options will not be available to the same extent next year,” said Subbarao. On top of that, there will be additional constraints too. “Inflation pressures will remain and private credit demand will be stronger with the threat of crowding out becoming quite real,” Subbarao informed.

The advice from Reserve Bank can be taken as a precursor to some strong action from the government in the forthcoming budget. “The government would act in any case,” said an economist. There are reasons why the government will act.

“As economies around the world try to find their footing in a fragile recovery, sovereign creditworthiness has come under intense scrutiny,” said Standard & Poor's Ratings Services in a publication titled ‘Asia-Pacific Sovereign Report Card: 2010 Will Be Testing For Policymakers’.

"While unprecedented fiscal and monetary stimuli appear to have helped avoid a double-dip recession, they have also led to a number of unwelcome consequences such as soaring government debt burdens, price distortions or overcapacity in some sectors, potential new asset bubbles and bad loans," said Standard & Poor's credit analyst Elena Okorotchenko.

While Asia-Pacific sovereign ratings fared better than other regions, six out of 21 sovereign ratings currently retain negative outlooks in the year 2009. India is one of the six sovereigns.

In early February, credit rating agency Fitch Ratings affirmed India's long-term foreign and local currency issuer default ratings (IDR) at 'BBB'. While it kept the outlook on the long-term foreign currency IDR as stable, the IDR on the long-term local currency IDR is negative.

“Fitch regards the deterioration in India's public finances since 2008 as partly structural, putting negative pressure on the local currency rating that will require substantive fiscal reform to redress,” said Andrew Colquhoun, Director in Fitch’s Asia-Pacific Sovereign Group. “The foreign currency ratings remain well-supported by foreign investment prospects and by the world's sixthbiggest stockpile of foreign reserves,” Colquhoun added.

India’s general government budget deficit rose in FY09 to 11.6% of GDP, from 6.4% a year earlier. Now, Fitch projects only a small reduction in the deficit to 10.7% of GDP for FY10, which takes the general government debt stock to a projected 83% of GDP by end of FY10, undoing the results of the fiscal consolidation achieved since FY04.

The government’s abandonment of the fiscal targets laid out in the Fiscal Responsibility and Budget Management Act of 2003 leaves India without a credible fiscal framework to constrain policy and reduce its debt ratios.

Recently, the Central Statistical Organisation (CSO) shifted the base year for India’s national accounts from 1999-2000 to 2004-05 and improved its coverage. The change in base year could lower all deficit calculations as a percentage of GDP.

So, should investors be happy or worried? The answer is both. In its bid to rely less on borrowing, the government would focus on non-tax revenue sources. Disinvestment is one tool which may come handy and the government is already acting on it.

Non-debt capital receipts during April-November ’09 exceeded budget estimates on account of higher disinvestment proceeds (Rs 4,305 crore) than was budgeted (Rs 1,120 crore).

“Disinvestment sales will help the government’s fiscal financing needs, keep government bond yields from ratcheting up and also increase the absorptive capacity of the economy to foreign flows,” said Goldman Sachs India chief economist Tushar Poddar in a mid-January report which highlights disinvestment as one of the four important themes for 2010.

Central government enterprises have assets amounting to nearly 30% of the GDP, which if privatized and used to retire debt, could have large benefits in reducing the debt ratio and the interest bill, the report stated.

On the flip side, Reserve Bank is clearly on the exit path and interest rates are expected to go up owing to rate hikes in future. In this situation, lesser liquidity and more supply of government securities will put pressure on interest rates.

When private credit demand picks up, there is a fear they will be crowded out. Costly credit will have implications on the general balance sheet of India Inc at large. So, when you feel the time is interesting, remember it’s testing as well.