Budget Stimulus is not Enough

This year’s budget is not simply an election budget. It is also an anti-recession budget. It seeks explicitly to stimulate the domestic economy in the face of the coming global slowdown.

Yet the exercise will have at best very partial success, for two reasons. First, the finance minister is bound to sacrifice growth for inflation control in an election year. He knows that voters are not notably grateful for an additional 1% of GDP growth, but are notably angered by a 1% increase in prices. Second, current policies are so badly designed that much of the real stimulus will leak out of the economy into imports (especially oil), stimulating OPEC rather than India.

What should India do to combat the coming global slowdown? The answer is complicated by the fact that commodity prices have shot up even as world economic growth has slowed. The price of oil has touched a staggering $109/barrel, wheat is up 100% and iron ore 65%.

In recessions, commodity prices typically plunge along with economic activity. But maybe not this time. A mild global recession will reduce GDP growth from 10.5% to 9.5% in China, and from 8.5% to may be 7.5% in India. But these rates are still very high, and will consume a lot of commodities. Today developing countries account for the lion’s share of world GDP, and are at a commodity-intensive stage of consumption. So, some slowdown in Asian GDP may not slow down commodity prices.

For finance minister Chidambaram, this poses an acute problem. The classical way to combat a recession is to stimulate the economy through fiscal policy (cutting taxes, increasing government spending) and monetary policy (lower interest rates to stimulate housing, consumer credit, and industrial investment). Problem: the additional stimulus might translate into higher prices as well as higher growth.

The growth stimulus in the budget has takenmany forms. The exemption limit for income tax has been raised from Rs 1.1 lakh to Rs 1.5 lakh per year, tax brackets have been widened, Cenvat has been cut from 16% to 14%, additional excise cuts have been decreed for the auto sector, pharma and paper. Customs duty was to be cut to ASEAN levels, but this has been postponed, to boost domestic industry in view of the appreciating rupee and global slowdown.

The massive farm loan waiver has been seen mainly as a populist attempt to win the next election. But it also represents a big boost in rural purchasing power, and so is an anti-recession tactic. High government spending boosts purchasing power, and the budget has substantially increased outlays on rural infrastructure (irrigation, roads, power, telecom) and social spending (employment guarantee, education, health). This represents synergy between the twin aims of winning votes and stimulating the economy.

Fiscal deficits are normally increased in a recession to stimulate demand. Chidambaram, however, proposes to cut his fiscal deficit to 2.5%, from 3.1% in 2007-08. Caveat: the Pay Commission award will raise this by may be 0.5% of GDP. Besides, under-recoveries in oil, fertilisers and food represent an implicit fiscal deficit of a whopping 2-3% of GDP. These under-recoveries are only partly covered by oil and fertiliser bonds — huge arrears to the fertiliser and oil industries remain unpaid.

So, the fiscal deficit is not low and falling, it is high and rising. Every time the world price of oil, fertilisers and wheat rises while Indian prices are held constant, the implicit government subsidy (and hence implicit fiscal deficit) goes up. But while this may shock fiscal fundamentalists, Keynesians will applaud it as an anti-recession stimulus.

I am not among those cheering. Keynesian economics was formulated for a closed economy. But India is now substantially an open economy. So, a budget stimulus can stimulate imports rather than domestic production. In India, the biggest stimulus by far is the implicit and rising subsidy for oil, which raises oil import demand. This stimulus leaks out of the Indian economy to countries from whom we import (notably OPEC countries), and to that extent is wasted.

Besides, a budgetary stimulus may stimulate prices as much or more than growth. If the economy has much spare capacity, a stimulus may mean more production. But if there is little spare capacity — which is the case for most commodities — a stimulus will raise mainly prices.

India, and indeed the world, is running short of commodities. The farm loan waiver will increase rural demand for food, and that may stoke food inflation. Chidambaram may not raise prices in the public distribution system, but the bulk of the population depends on open market purchases.

He can aim at higher supplies by banning all exports of rice, though that might antagonise rice farmers. He could ban exports of maize and dairy products, and increase imports of wheat, to be sold at controlled prices through ration shops. Nevertheless, since world prices are far above Indian prices, inflation will tend to rise.

As for monetary policy, the RBI has announced no interest rate cuts, though Chidambaram has obliged government banks to cut their lending rates a bit. India is not following the lead of the US in cutting rates sharply because Chidambaram is scared of inflation. He will slash interest rates only when prices are firmly under control, and that seems unlikely in the immediate future.

Many economists will argue that monetary policy can control only core inflation, and not the food or fuel prices, the ones Chidambaram is most worried about. Nevertheless, he is so worried about inflation that he is reluctant to use monetary policy to stimulate the economy.

Finally, stock markets have slumped globally with the global economic slowdown. Initial public offerings of top-notch companies like Wockhardt and Emaar have flopped. So, another source of investment has been curtailed.

In sum, the government’s attempts to stimulate the economy in the face of a coming recession are half-hearted, misdirected and technically flawed. So, they will have only a partial impact. Expect a significant slowing of growth, with serious pain in some sectors.


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