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February 21, 2008

Indian Economy|Public Finance

Budget for Growth

By Nitin Desai


Next week the Finance Minister will present what may be the last substantive budget of this administration.  The record of his tenure in the Ministry looks.  The 8-9 per cent growth in GDP, low inflation and rising foreign exchange reserves speak well for macro-economic management, though the most important contribution of the Minister may well have been to let the economy race ahead and contain pressures for more applying the brakes.  On the fiscal front the Minister is surely justified in taking some personal credit for improved tax compliance and rising tax revenues, the implementation of the FRBM, the agreed road map to a unified structure of indirect taxation and the simplified Income Tax Code that has been promised. 


The Finance Minister faces an important test in what may well be his last budget.  He will be expected to address three main questions:

  • What do we need to do to maintain the growth momentum in India in the face of global turbulence?
  • How do we enhance the flow of investment into long-gestation infrastructure projects?
  • How do we satisfy the political demands for populist measures in this election or pre-election year?


Take the first question. Global turbulence will affect growth in India through two main routes.  The first is through the impact of a slow down in OECD economies on exports and the other is via the capital market.


Export growth has already been affected by the rupee appreciation.  The April-December 2007 figures released a few weeks ago show a 16 per cent increase in dollar terms over the previous December and a 21.8 per cent increase for the nine-month period over the corresponding period in the previous year.   In rupee terms, which is what matters to the local exporter, the two growth rates come down to 2.5 per cent and 7.8 per cent respectively.  This suggests that there is little by way of volume growth and the contribution of exports to GDP growth will surely be lower this year.  And this is before the full impact of a US slowdown or recession is felt.  Exports now account for nearly a quarter of corporate sales and a much larger proportion in unincorporated enterprises in garments, gems and jewellery, etc.  Hence, a volume slow down will also affect employment growth and investment intentions.


The Prime Minister’s speech to FICCI suggests that we can expect some boost for exports in the budget.  Ideally the answer to the export slow down should lie in maintaining a competitive exchange rate.  But managing the exchange rate is difficult with the growing unpredictability of global capital flows and the continuing downward pressure on the dollar.  Hence exporters may look for a more predictable fiscal sop.


A more immediate impact will be through the capital market and the consequent impact on investment.  The high growth rates that we have seen since 2003 owe a lot to the spectacular improvement in corporate finances.  Corporate profits after tax grew by an average of 47 per cent in the four years ending in March 2007.  What is even more important, the proportion of profits retained increased sharply and the corporate savings rate doubled from 3.9 per cent in 2002-03 to 7.8 per cent in 2005-06.  Indian corporations also tapped global markets in a big way and all this financed a massive increase in corporate investment.


With defaults spreading and credit remaining tight in the USA and other OECD countries the ability of Indian companies to raise capital abroad for their domestic investments or their overseas acquisitions will be reduced.  The impact of global turbulence on domestic capital markets through contagion of sentiment and lower FII flows will also lead to tighter conditions in the domestic primary market. We have already seen some early casualties in the IPOs that had to be withdrawn recently.   This along with the slowing down of profit growth will surely affect corporate investment plans which were booming in the wake of the spectacular increase in profits. Hence the FM may do something to boost corporate investment intentions.


A closely related issue is the need to boost the flow of capital for mega projects in the infrastructure sector where investment needs over the next five years have just been jacked up to $490 billion.  With world markets the way they are, DFI flows can make only a modest contribution The domestic equity IPO route has also been roiled by recent investor experience and large IPOs for mega projects are going to be difficult in a nervous share market. The rising flows of private equity may help but at high cost.  Basically infrastructure projects need debt finance and the limited amounts that flowed into that because of the capital gains set off route available till recently has also dried up.  The FM may well have to revive that route or present some other concession to make it possible to raise debt finance for infrastructure.


So much for growth.  But what about equity or “inclusion”, to use the current mantra, that is reflected in the third question above?  This is the area where, the general election due next year and the State elections scheduled for this year, may lead to the announcement of flashy but half-baked and ill-considered development schemes, debt write-offs and what not..


Development schemes must be discussed in the planning process and not cobbled together for the budget speech.  The FM can boost development spending by stepping up the budgetary support for the plan as presented by Yojana Bhavan.  That however will have little or no political impact.  Not that many votes have been won by the various Pradhan Mantri Yojanas that have been launched over the years. What is required is sleight of hand where the cards which are already dealt are reshuffled and made to look like a full house.   The FM should try and satisfy his political masters and associates by repackaging existing schemes and coming up with a consolidated number on the extent of budget support for “inclusive” growth.  He may be able to get away with that and some rate changes aimed at the urban middle class.


Next week the FM must act to protect the growth prospects for the economy and fend off pressures for spending proposals that supposedly boost the electoral prospects for his party.

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