Economic Survey 2016-17: Chapter-05: Fiscal Framework: The world is changing should India change too ?

In this chapter, the survey has reviewed the trends in fiscal policies around the world, comparing with those of India and done a critical assessment of India’s fiscal activism and FRBM Act of 2003. It also tries to provide an insight into what should India’s fiscal policy ahead.

Fiscal Activism

We all understand that monetary policy and fiscal policy are two main public finance policies for the governments around the world. The classic Keynes theory of “pump priming” is known to all of us.  Pump priming implies more money supply in economy and near zero interest rates. The objective of pump priming is to stimulate an economy in recession.

In today’s sense, one of the instruments of pump priming is Quantitative Easing {QE}.  The survey highlights that after the 2008 Global Financial Crisis, the advanced economies experienced very low demand, low inflation, low employment and low economic growth thus making a downturn cycle. In such circumstances, the monetary policy makers of those countries took the path of quantitative easing i.e. supplying money in economy thereby bringing interest rates to near zero. Under monetary policy, they had no further options available, so to further stimulate the economy, they turned to fiscal policy instruments under the so called “Fiscal activism“. Fiscal policy deals with the taxation and expenditure decisions of the governments including debts and public spending. The path chosen by the advanced economies under fiscal activism was to shift the emphasis “from debt to spending.” The more public spending is there, more will is generate economic activities. Thus, Fiscal activism implies that there is minimum concern about debt and greater emphases on public spending.

Why Fiscal activism?

There are several reasons for adopting this type of strategy. Firstly, it can be used in times when interest rates are near zero and no further viable options are available under monetary policy. Secondly,  fiscal policy is effective in increasing GDP, it would lead to increase in tax revenue, meaning fiscal activism can partly pay for itself. Thirdly, the debt levels don’t bother much because interests are already near zero.

Thus, the case for active fiscal policy in the advanced economies is mainly viable because of inability of addressing the same problem via monetary policy.

Case for India

Though India is not facing such a severe problem of economic downturn yet, the survey analyzes the fiscal activism with respect to the Twin Balance Sheet Problem of the country. First, let’s see how India’s case is different. Firstly, the growth rates in India are substantially high and inflation rates are also substantially higher. Secondly, interest rates in India are nowhere near to zero.

Using these arguments, survey says that India should not do what west is doing because our circumstances are entirely different from them. Thus, India should stick to its path of fiscal consolidation and  should NOT indulge itself into adventures  of fiscal activism.

The 1991 and 2013 experience

The survey uses 1991 and 2013 experience to further its point cautioning India to keep away from fiscal activism. In early 1980’s, the government had increased the spending to accelerate the growth, which resulted in higher fiscal deficits. But then, there was inability to rein in these deficits. This worsened the external situation and BoP crisis in 1991.

A similar path was taken by UPA government in 2000s. During the mid-2000s growth boom, the UPA government introduced new spending programs which could not be continued when government receipts fell. After the Global Financial crisis, the budget deficit of the country rose sharply due to fiscal stimulus by the government close to 4% of GDP. But this was not withdrawn at time and it led to a near-currency crisis in 2013. However, in 2013, it did not turn up to be a full blown crisis. This is because of the difference between 1991 and 2013 episode that in the former there was fixed exchange rate which created a full blown crises, where as in the latter the exchange rate was floating, which attenuated disruption in other asset prices.

Turning to Debts

The debt-GDP ratio of India is higher than many other countries, but that is not the only problem.  The major problem is that India has a higher primary deficit {shortfall between receipts and non-interest expenditures}. This implies that governments in India {both centre and state} are not collecting enough revenue to cover their running costs, let alone the interest on its debt. Although having a large primary deficit is found in many other emerging economies but India is quite vulnerable because we have high interest rates as compared to other countries.  As a result of running a primary deficit the government is dependent on growth and favorable interest rates to reduce the debt ratio, which means if one day growth were to weak and interest rates to rise on continues basis, the debt ratio could start spiral upwards. At this point there could be possible of debt explosion, its not theoretical possible but it’s exactly what happened in Greece. Generally India undertakes policy related fiscal adjustments only gradually.

Fiscal Activism: Gyan for Finance Ministry and Way Forward

In the light of the above discussion, let’s try to crystallize what Gyan has been given by Survey to Finance Minister and what are policy suggestions. Firstly, the survey points out that India’s fiscal position has an inbuilt bias towards higher deficit and it must be the aim of the government to prevent high spending during booms and constrains during downturns. Thus, it cautions the government against UPA likes doles {it’s worth recall that UPA had written of loans of farmers worth Rs.60,000 crore in 2008. This was one of the many instances of fiscal adventurism. The current government is committed to fiscal consolidation (from 4.5% in 2013-14 to 3.5% target currently)}. Secondly, it says that India has great track record when it comes to fiscal commitments, because India never defaulted on its domestic and external debt commitments. In that sense India is very different from many other emerging markets especially those in Latin America and Russia which have defaulted on their domestic obligations. Thirdly, it calls for updating of the FRBM Act, 20013 which was enacted at a time when India’s economy was relatively smaller and far behind than other emerging markets. This will be the task of the FRBM Review committee to set out new vision on FRBM for the 21st century.