Withstanding the stimulus

The Interim Budget for 2009-10 announced on February 16 was dismissed by India Inc and the markets for its total lack of imaginative stimulating steps. Apparently stung by the reaction, the Finance Minister has now come forward with cuts in excise duties and service tax of 2 per cent each effective immediately.

The excise duties essentially impact white goods, cement and automobiles. It will take some time for the price reductions to take effect assuming, as Government expects, that the producers pass through the duty reductions to the consumers.

In effect, this is the third fiscal stimulus package, estimated to cost nearly Rs 29,000 crore. Its impact on fiscal deficit figures is obvious.

The already large borrowing requirements also will correspondingly increase further. This fiscal stimulus package, whatever its effect on the growth of the economy, has scared the rating agencies out of their wits, so to say. The rating agency Standard & Poor’s has downgraded the outlook of the economy to negative. Obviously, this will have impact on foreign perceptions of India’s creditworthiness.

The Chief Economist of Standard & Poor’s has, in an elaborate explanation, pointed out that the fiscal consolidation gains of P. Chidambaram’s Budget for 2008-09 have been wiped out and these are the concerns that led to the rating agency recommending a change in the outlook to negative. The fiscal deficit numbers as a result of the latest fiscal stimulus package are not much worse than those stated in the Interim Budget.

It is a fact, however, that all economies of the world are facing a difficult time and India is not alone in having a fiscal deficit of this order. The rating agency cannot, however, be faulted in bringing to the surface the declining state.

It must be admitted that the reduction in the fiscal deficit/GDP ratio is only to the extent of 0.48 per cent if the full impact of the tax cuts are taken into account for the next year. This means that the fiscal deficit/GDP ratio for 2009-10 will come to nearly 6 per cent for the Centre alone.

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The US model

The rating agency has sounded an alarm and it is for the Government to take necessary action to rectify the fiscal position by the time the full Budget is unveiled.

It is perhaps appropriate to mention that the US Administration has shown the way to the rest of the world not only in announcing large-sized fiscal stimulus packages but also in formulating action plans to get over the debt problem resulting from it. The Obama Administration has been canvassing a bi-partisan Summit to work out means for reducing the debt over-hang resulting from the fiscal stimulus packages.

Downgrading rating

The estimates are that the fiscal stimulus packages announced by Obama will increase the fiscal deficit of the US’ fiscal deficit/GDP ratio to nearly 9 per cent in 2009 and it could come down to 1.1 per cent only after a decade on the assumption that some of the tax cuts introduced by George Bush would not be continued. Obama proposes to make an overhaul of the US’ healthcare system and thus reduce the large deficit.

To the best of my knowledge, no rating agency has so far downgraded the US’s sovereign outlook to negative. This is in spite of the fact that the US’ deficit is primarily funded by foreign sources, such as the savings of the Asian nations.

Again, the highly-stretched balance sheet of the US Federal Reserve reflects the weakness of the US’ financial system as a whole. However, the downgrading of the US does not seem to be in the offing. If it does happen, God help the Asian nations whose reserves are parked in US Government’s securities.

Be this as it may, the impact of the Standard & Poor’s downgrading of India to negative outlook would not have repercussions on Government’s borrowings since it does not borrow abroad.

It shall be primarily reflected in higher interest rates demanded by foreign lenders for loans to Indian entities. It can also affect the perceived attractiveness of the Indian market to FIIs as it makes a lowering of the indicators of the economy’s strength.

'Broad interest rate trends benign'

This is not a fact that can be ignored because we depend very much on international capital flows to bridge our current account deficit. It is, therefore, the path of wisdom to start working out a fiscal adjustment framework on an all-party basis so that fiscal correction can be aimed at within a reasonable period of time.

The Finance Minister had an unenviable task. He had to release all the information on concessions extended by Government before the announcement of elections.

A fiscal adjustment framework has to wait for the next elections. It is to be hoped that the Parliamentarians will start the task of fiscal reconstruction with the same gusto and enthusiasm with which they welcomed the latest stimulus package of Pranab Mukherjee.

It may perhaps be argued that there is still scope for the RBI to intervene and enable the large borrowing programme of the Government to be carried through smoothly.

In my view, this is fantasy. It is not possible for the RBI to create means of non-inflationary financing of the large order of deficit, now visualised in the Budget together with the impact of the additional fiscal stimulus.

It is a different matter that the RBI has to send a message to the Government that with the best possible monetary easing, it is not advisable to try to bridge the large borrowing requirements of the Government through clever monetary adjustments.

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Timely wake-up call

It is, however, agreed that monetising the debt, which is equivalent to printing money to finance the deficits, may be definitely inflationary. I hope both the Government and the RBI will work out an agreed plan to get out of the mess which the present situation has created.

Politics dictates that this cannot be finally resolved till the elections are over. But, the think-tanks of the Government and the RBI should start working the ways of getting out of the situation created by the fiscal stimuli.

The declining oil prices and the brighter possibility of the US economy reviving with consequent positive impact on Indian exports give us hope that there may be flexibility even in the current situation.

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