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February 15, 2012

Indian Economy|Public Finance

A Budget Score Sheet

By Nitin Desai


Tomorrow the Finance Minister has to present a budget that will revive investor confidence, restore fiscal balance and rescue the electoral prospects of his badly battered party.  Corporate leaders, the domestic and foreign commentariat (including yours truly) and the FM’s party colleagues will be marking his performance from these perspectives.  Here is a score sheet for what we can reasonably expect in the budget tomorrow in pursuit of these three goals.

Take first this business about restoring investor confidence. Capital formation in the corporate sector rose from 10.3% of GDP to 17.3% of GDP in 2007-08 and that is a big part of the story of high growth since 2003-04. But since then there has been sharp downward trend and in 2010-11 this had fallen to 12.1% of GDP.  The chances are that the numbers for this financial year,when they come out, will show a further decline going by the 2.2% decline in investment (GFCF) revealed by the GDP numbers for the first three quarters of the year. Anecdotal evidence suggest that corporations are postponing planned projects, diversifying into overseas investments or just sitting on cash.

This fall in investment has to be reversed if we are to restore confidence in the prospects for high growth at the levels projected by the Planning Commission. One test for the budget is whether it does enough towards this end. 

The one instrument totally under his control is the  direct public investment included in the budget; but, given the compulsions about restoring fiscal balance, it would be unreasonable to judge his performance by the scale of effort on his score. A more reasonable expectation would be some measures to boost the corporate incentive to revive mothballed projects and step up their pace of investment by 50% or thereabouts over the next couple of years so that we get back to 2007-08 ratio of corporate investment to GDP.  The interest rate is not a budget measure and the FM can signal intentions but not much more than that. He can and will probably fiddle with depreciation rates and some other bits that affect the incidence of corporation tax but not on a scale that could lead to the sort of investment boost suggested here.

In the minds of corporate leaders the big issue which needs to be resolved is the log jam in investment clearances.  This is a matter that is only partially under the control of the Central Government and many of the clearances involve State Governments.  Many pious statements have been made about the need for speeding up clearances.  What the budget will have to present is something more than that, for instance an empowered committee of Central and State ministers to prepare  proposals for decision by the NDC so that here is a buy in by all the authorities concerned.

How can one judge the adequacy of the scale of effort on this score? Perhaps  with two indicators -- the enthusiasm with which the corporate sector receives his proposals (suitably discounted for their usual grumpiness about governments) and the stock-market response.  The latter also has some direct instrumental relevance for boosting investment by reviving the moribund IPO market and the confidence of overseas portfolio investors and for the budget deficit by helping to ensure that disinvestment is smoother than the recent ONGC   fiasco.

The restoration of fiscal balance is the second major head in the score card. It could be argued that the economy does not face a major inflation risk and, in the interests of stimulating growth, the budget should be expansionist and delay the deficit adjustment.  However if the primary requirement to revive growth is to boost investment than a lower deficit is necessary to allow a reduction in interest rates and to maintain sovereign ratings that influence the rates charged on external commercial borrowings. This last concern is particularly important as a safety measure given the volume of ECB that has to be rolled over this year.

The Government's fiscal deficit widened from 2.5% of GDP in 2007-08 to a budgeted 4.6% and a likely actual closer to 5.5% in the current fiscal year.  This is on the GOI definition which counts capital receipts like 3G licence fees and disinvestment sales on the revenue side. Initially the widening was due the fiscal stimulus that was deemed necessary after the global financial crisis broke in 2008. But the overshoot on the deficit now is really because of over optimistic revenue projections and serious underestimation of the revenue burden.

In absolute terms this years fiscal deficit may be of the order of Rs. 5,00,000 crores, about 20% higher than the budget projection.  The minimum that the commentariat expects is to hold it at this years projected level with some expectation that at least a beginning will be made to move back to the rate required by the medium term fiscal projections of the Finance Commission. But the real issue is not just the projected reduction but the credibility of the expenditure and revenue projections that underlie it. As far as the latter is concerned any projection above a 12% increase (GDP growth 7% and inflation 5%) will have to be justified in terms of built-in buoyancy, special receipts or additional mobilisation.

The biggest challenge for the FM is the third part of the score card-the stuff that he has to do to revive the electoral prospects for his party.  The biggest mistake would be to respond to the poor performance in UP and Punjab by trotting out yet another round of cash for rural uplift.  The Samajwadi party swept the polls because Akhilesh Yadav came across as a person who wanted to open opportunities for young people with better education, English in schools, computers and so on.  A more inspired electoral response would be to do something special for education and skill development.  A  more conventional but still acceptable response would be some income tax sops for the middle classes.  So let us wait and see which way the FM and his party move.

The FM will undoubtedly seek to address all three concerns.  The big test is where does he do just what is required to get pass marks and where does he try and ace it.  That will tell us whether this Government still has the will to govern.

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