A global recession will pose enormous fiscal challenges. India must be prepared

India is currently the world’s fastest-growing major economy. Hurrah. But the combined fiscal deficit of the Centre and states exceeds 10% of GDP, horrendously high by international standards. High fiscal deficits can spur high growth for some time, but then end in bankruptcy. India itself broke out of the Hindu Growth Rate of 3.5% in the first three decades of Independence, and soared to 5.3% in the 1980s. But that owed so much to rising fiscal deficits that it ended in bankruptcy in 1991.

Montek Singh Ahluwalia, former deputy chairman of the Planning Commission, has long stressed the need for fiscal consolidation. Macroeconomic stability is fundamental for sustained growth. Without that, government overspending (high fiscal deficits) spills over into national overspending (high current account deficits), high inflation and the emptying of forex coffers. India is a long way from such a sorry end. But a global typhoon is coming, every weakness will get magnified, and investors will get magnified, and investors will punish emerging markets when they are most vulnerable. India must prepare for the storm.

Understandably, the central fiscal deficit soared to 9.6% to combat Covid in 2020-21. It came down in 2021-22 to 6.9%. I expected a much sharper fall in 2022-23. But Nirmala Sitharaman reduced it to just 6.4% to stimulate growth. She proposed gradually reducing the deficit to 4.5% by 2025-26, forgetting altogether the earlier Fiscal Responsibility and Budget Management (FRBM) target of 2.5%. Today, that looks not just timid but plain imprudent, with Ukraine stoking global havoc.

Globally, high fiscal and monetary stimuli became fashionable in the last decade. Adherents of Modern Monetary Theory (MMT) claimed countries could print money without inflation to stimulate growth. For some years, enormous fiscal and monetary stimuli did, indeed, spur growth while creating little consumer price inflation, though asset price inflation was enormous. Now the chickens have come home to roost. US inflation has soared to 9.1%, the highest rate for 40 years. Gone is the illusion that high fiscal and monetary stimuli do not matter.

The US Fed is reversing course, and so must India. The Reserve Bank of India (RBI) must raise interest rates in line with US rates to avoid a mass exit of foreign investors. And Sitharaman must get fiscally tough.

A Stab at Stability
Ahluwalia’s book, Backstage: The Story Behind India’s High Growth Years, argued that macroeconomic stability required GoI to cut its fiscal deficit to 3-4% of GDP. More recently, Ahluwalia said that macroeconomic stability required India to cut the combined fiscal deficit of the Centre and states from 10% to at least 5%. Another 2% of spending might be needed for tackling climate change, and an additional 1% for defence and infrastructure. So, he argued, India needs a whopping 8% turnaround in the fiscal deficit.

The prospects of reducing the combined fiscal deficit by even 5% are zero. Indeed, reducing the Centre’s deficit by just 1% of GDP is politically difficult, given competition between parties in freebies – which Narendra Modi has called ‘revadi’ (sweetmeats). Arun Jaitley tried hard, but in five years, reduced his fiscal deficit by barely 1% of GDP despite creative accounting.

Earlier, Pranab Mukherjee found it very tough to reduce the fiscal deficit, after letting it soar to 6.9% to tackle the 2008 Great Recession. It is politically easy to stimulate the economy through high spending and tax cuts, but politically difficult to slashing spending and raise taxes.

An International Monetary Fund (IMF) economist has pointed out that high fiscal deficits in India have created a high public debt entailing high interest payments. Such payments are 30% of total revenue against a median of just 10% in comparable countries. India, too, needs to get its interest costs down to 10% of revenue. That means a huge fiscal turnaround of the sort suggested by Ahluwalia, but abhorred by practical politicians.

A global recession is coming. Normally, countries combat recession with fiscal and monetary stimuli. That would be suicidal in the current context. India’s fiscal deficit was down to 2.5% of GDP when the Great Recession struck, and Pranab Mukherjee was justified in increasing it to 6.9% to tackle the problem. But, this time, the starting point itself is 6.9% of GDP in 2021-22. The current year’s deficit projection of 6.4% will go awry thanks to the cutting of fuel taxes, increased fertiliser subsidies and extension of the free feeding programme for political reasons.

When recession strikes, many political voices will demand fresh stimuli, taking the deficit back to 9.6%, as in the Covid year. But global investors will view that as irresponsible populism. The mass exit of foreign investors in the last six months has already taken the rupee from ₹74 to ₹80 to the dollar.

If the fiscal deficit rises fast to combat a recession, a further exodus of dollars may push the exchange rate past ₹90 to the dollar. That will hugely worsen imported inflation, public misery and budgetary calculations.
But if no fiscal stimulus is allowed, that, too, will mean deep misery. No soft options are in sight. Much pain lies ahead.
This article was originally published in The Economic Times on July 26, 2022.

Leave a Comment

Your email address will not be published. Required fields are marked *