One-night stand or prolonged affair?

Why did the budget cause the Sensex to crash by over 1000 points, and cause global rating agencies to mutter that if India did not pull up its socks, its bonds would be downgraded? Finance Minister Pranab Mukherjee has gone on a borrow-and-spend spree to expand infrastructure and safety nets (like the employment guarantee programme). But isn’t that exactly what is needed to combat the recession and return to faster growth?

Yes, but investors worry that the spending spree is not just a temporary stimulus but an addiction to spending excesses. Overspending is a seductive temptress, and investors fear that Mukherjee is going to have not just a one-night stand but a prolonged affair.

I had hoped for a more cautious budget. Yet I am willing to give Mukherjee a chance to prove himself. He has come out with a medium term plan for reducing the fiscal deficit—the excess of government spending over revenue—from 6.8% of GDP this year to 5.5% next year and 4% the year after. That amounts to applying the brakes with a vengeance. The markets doubt if he has the political will do so.

To meet his budgetary gap, Mukherjee proposes to borrow a whopping Rs 400,000 crore from the markets this year, four times the borrowing proposed in last year’s budget. If banks have to provide all this, they will have no money left to lend the private sector, and the economy will plunge. So the Finance Secretary wants the Reserve Bank to print money to fund half the Rs 400,000 crore needed by the government. This will be the mother of all deficit financing. The RBI will be shocked, but may be obliged to comply. This may not stoke inflation immediately, but will create an overhang of money that will cause an inflationary burst when the recession ends.

Shankar Acharya, former Chief Economic Advisor, points out that in the last two years government tax revenue has risen Rs 35,000 crore but spending has gone up Rs 300,000 crore. Spending nine times as much as your income is overspending by any yardstick. Shankar Acharya says this does not look like a temporary surge that Mukherjee can reverse in the next two years. Ever-rising outlays on entitlement schemes like the employment guarantee scheme, social security for unorganized workers, and now the Food Security Act look like institutionalizing high spending and making it irreversible.

These are weighty arguments, and have driven markets into deep gloom. In India, every year is an election year, since some state or the other goes to the polls (Maharashtra and Haryana will do so soon). This tends to induce constant bursts of pre-election populism. That makes a sustained return to prudence difficult.

So, Mukherjee’s spending spree—which he calls a stimulus and critics call unsustainable overspending—carries the big risk that it cannot reversed. But we should wait and see if the risky gamble succeeds.

First, India has proved repeatedly that it is lousy at routine tasks (like teaching in government schools) but good in tackling emergency situations. Second, the very fact that markets have crashed sends an urgent message that improves the chances of a return to discipline. Third, Finance Ministers can slow down disbursements if they do desire, by being strict in following official procedures before releasing financial installments to Ministries and States. Fourth, spending Plan funds productively is always difficult: many States return vast Plan unspent every year. Fifth, some expenditures this year are one-off and will not be repeated in subsequent years (final installments of the farm loan waiver and Pay Commission arrears).

Sixth, Mukherjee’s determination to move to a Goods and Services Tax from April 2010, even if all the states are not ready, will provide an ideal opportunity to claw back the tax breaks given as economic stimuli in the last eight months. The combined GST rate of centre and states is expected to be 16%, against the Finance Commission Chairman’s recommendation of 14%. Seventh, India has proved repeatedly in the past that it can sustain high growth with a higher deficit than many economists think feasible.

None of these arguments is a clincher. Besides, many things could be worse than expected. We may suffer a major drought this year and sub-normal monsoons in the next few years. The global economy seems to be recovering, but may dip again in a W-shaped recession. Israel could bomb Iran’s nuclear facilities, sending the price of oil to $ 150/barrel.

So the sceptics do indeed have a case. But let’s wait and see. Manmohan Singh has always been a lucky Prime Minister, and his luck may still hold.

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