Tuesday, 12 February 2013

Can't figure it away

Indian Express, 12th February 2013

Arguing over GDP numbers won't convince investors. Government must focus on fiscal correction

The ministry of finance has responded strongly to the Central Statistics Office (CSO) estimates for GDP growth of 5 per cent in 2012-13, saying that it is an underestimation. Normally, it would be surprising to see the ministry respond to growth numbers as loudly as it has done this time. But in this case, it was not entirely unexpected. The CSO's estimates can upset the finance ministry's promise of a lower fiscal deficit number. On his recent foreign tour, Finance Minister P. Chidambaram promised a 5.3 per cent budget deficit. This rests not only on projections of revenue, expenditure and the gap between them, but also on the denominator, GDP.

All the important assumptions made in the projections for the 2012-13 budget deficit have gone awry. During April-October, tax revenues grew by 14.54 per cent. This was lower than the 20 per cent growth assumed in the budget. Expenditure growth, at 14.6 per cent, on the other hand, was higher than the 13 per cent expenditure growth.

The fiscal situation is already difficult. With unmet disinvestment targets, a large subsidy bill that has yet to be impacted much by higher fuel prices and a newly launched cash transfer scheme that is unlikely to give efficiency gains or any reduction in expenditure in this budget, cutting expenses on the big ticket items is not easy. The finance ministry's credibility is already fragile. The CSO's GDP estimates can further hurt it. A smaller GDP number will yield a higher fiscal deficit to GDP ratio.

Under the current system of budget making, the government makes an assumption of GDP growth while preparing estimates for the budget. The ministry has insisted that growth will be 5.5 per cent. Since these are all only projections of production in the economy till March 31, 2013, it is surprising how anyone can be very confident about what GDP growth is going to be. Indeed, during the last two years, most projections of GDP growth for India have been slashed. The IMF's projection for GDP growth for India in 2012 is 4.5 per cent. Looking at the relentless decline in investment growth, it seems a more plausible estimate than the ministry of finance's 5.5 per cent. Even if the ministry is seeing green shoots of recovery, none of the publicly available indicators show them yet.

As it is natural for the government to try to show a low ratio for the fiscal deficit, it has the incentive to choose an implicit GDP growth rate that is higher, making the budget deficit ratios smaller. The best way to address this issue is to set up an independent panel to provide GDP forecasts.

Today, there are a number of independent forecasts for the Indian economy being made by those monitoring the economy. In general, these forecasters are conservative in that they tend to move with the consensus and their assessment may not be very far from what the government itself is saying. However, to the extent that they are not conflicted, in that they are not producing the budget revenue and expenditure decisions and the deficit ratios, the forecasts they produce are independent. These should go into the budget process.

Chidambaram has made an effort to cut expenditure and raise revenues in the last few months. Many positive steps, especially where policy decisions were in his hands, have been taken. The significance of cutting the deficit and its impact on the economy is high at this moment. A clue lies in the fact that the FM undertook a foreign tour to reassure foreign investors at a time when he would normally be busy with the details of the budget. The macro picture of the budget is extremely important today and that is why, perhaps, the ministry responded so strongly to the CSO estimates.

The reasons for the importance of the macro picture lie in the difficulties currently being faced on the balance of payments. India has had a large current account deficit of 5.4 per cent of the GDP. This means India needs to keep up an inflow of capital despite falling growth and worsening public finances. This can be done if foreigners are assured that in the long run, India is a good investment opportunity, that India is on the path of implementing reforms that will ensure a strong currency. A decline in capital flows can cause a rupee depreciation. A rupee depreciation would put further pressure on the fuel subsidy bill as the price of every barrel of imported oil will increase. Further, it will put pressure on domestic prices. While it is unlikely that a small change in the fiscal deficit number would stop foreign capital from flowing into India, it shapes views on future current account deficits and the strength of the rupee.

In addition, a large fiscal deficit could cause a ratings downgrade for India. This would increase the cost of borrowing by Indian companies abroad. Domestic credit growth has declined. Banks are reluctant to lend because their own balance sheets are not looking healthy. External financing is relatively cheaper, but only so far as the credit rating is good and the rupee is not expected to depreciate. Both these require the fiscal deficit to remain low.

A slightly higher denominator in the budget deficit to GDP ratio may appear good in the immediate context. But if the health of India's fiscal condition does not improve, no one is going to be fooled for long. The difficulty may get worse if the current account balance does not improve. Instead of focusing on how to defer the bad news, the government needs to focus on how it will actually do a fiscal correction. If the government is going to introduce the Food Security Act, there should be a clear indication of what it means for this year's and the following year's government expenditure. Unless such careful analysis is done of various government programmes, no amount of relatively good news obtained by arguing over GDP figures is going to convince any investor that India is worth the risk.

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