The concept of a fiscal responsibility framework was first mooted by former finance minister Yashwant Sinha ahead of the 2001 Union Budget. At the time, the government was running a fiscal deficit close to 6 percent of GDP and Sinha felt it was necessary to bring that down.
The roadmap was laid down as part of the Fiscal Responsibility and Budget Management Act of 2003, which asked that the government’s revenue deficit be eliminated by March 2008 and the fiscal deficit be brought down to 3 percent of GDP. The framework saw early success and the Central government managed to bring down its deficit to a 30-year low of 2.5 percent of GDP in 2007-08.
Then came the global financial crisis. What followed was a period of expansion of the government’s fiscal deficit, which surged to above 6 percent in fiscal 2009 and fiscal 2010. Since then, the government has failed to bring the deficit back down to 3 percent of GDP, choosing instead, to keep pushing back the objective.
This is likely to continue in 2017-18 with the NK Singh Committee, which submitted recommendations for a revised fiscal framework on Monday, likely to give the government enough room to stretch the deficit.
Markets Building in a Higher Deficit
Few economists are expecting the government to be in a position to bring the fiscal deficit down to 3 percent next fiscal as projected.
Many have argued that a higher deficit is required to provide a buffer against the impact of demonetisation. This is despite the fact that the official estimates suggest that growth is cruising above 7 percent, which means there is little need for fiscal support.
But if you discount that official narrative, there could be some justification of going with a higher deficit for the coming year. Fiscal deficits, after all, are meant to work best when they are counter-cyclical.
As such, most economists expect the government to project the deficit at between 3.3-3.4 percent of GDP.
Goldman Sachs expects a Central fiscal deficit of 3.3 percent of GDP, 30 basis points higher than the planned 3 percent for the current year, it said in a report dated 23 January.
The lower reduction in fiscal deficit is to stimulate demand in a weak economic environment post demonetisation.Goldman Sachs
State Bank of India expects the government to pencil in a deficit of Rs 5.75 lakh crore or 3.4 percent of GDP.
The government should not get straitjacketed in the fiscal consolidation agenda so as to compromise development goals. Textbook macroeconomics suggest fiscal policy should ideally be counter-cyclical, that is, fiscal deficits should decline when the economy is expanding and increase during downturns.Soumya Kanti Ghosh, Chief Economic Advisor, State Bank of India
Bank of America-Merrill Lynch’s estimate is 10 basis points higher. It expects the government to hold its deficit at 3.5 percent, the same as the target for the current fiscal.
After paying for the 7th Pay Commission outgo, PSU bank recapitalisation and a step-up in social schemes, the government will be barely able to fund the budgeted level of public capital expenditure. Rising oil prices pose a risk.Indranil Sen Gupta, India Economist, Bank of America-Merrill Lynch
There is also a fair degree of uncertainty on how reliable the fiscal deficit numbers this year will be since the base assumption of GDP growth may go wrong because of the impact of demonetisation, which is still unfolding.
If GDP growth ends up being lower than projected, then the eventual number may rise to above 3.5 percent. In fact, State Bank of India in its report pointed out that actual fiscal deficit numbers (which are reported with a lag) have been higher even in previous years when there wasn’t this much economic uncertainty.
For instance, the controller general of accounts has revised the FY16 fiscal deficit to 4.3 percent of GDP compared to the revised estimate of 3.9 percent presented at the time of last year’s budget, said Ghosh in his report.
A similar overshoot in FY17 may be inevitable if growth is lower than expected in the current year. However, the government would do well to try and avoid this in FY18 by projecting a number closer to 3 percent. This way, even if growth is lower than expected during the year, the revised fiscal deficit number could be contained within acceptable levels.
Fiscal Implications for Monetary Policy
The government’s fiscal deficit has always been part of the monetary policy calculations. The difference now, though, is that the Reserve Bank of India is held accountable for an inflation target, which in turn, is based on a given expectation of fiscal deficit.
The deficit is actually already running higher than what the RBI would like it to.
In January 2014, when the Urjit Patel committee recommended an inflation targeting framework, it said that as a pre-condition, the goal of reducing the Central government deficit to 3 percent of GDP by 2016-17 is necessary and achievable.
The committee is of the view that the goal of reducing the Central government deficit to 3 per cent of GDP by 2016-17 is necessary and achievable. Towards this objective, the government must set a path of fiscal consolidation with zero or few escape clauses; ideally this should be legislated and publicly communicated.Urjit Patel Committee Report
A further delay in meeting that target will only complicate the central bank’s task of bringing down inflation to its medium term target of 4 percent. While the RBI has the option to maintain inflation within a band of 2-6 percent under the framework, establishing the credibility of the new framework by targeting the mid-point of that range is important for the central bank.
The uncertain global backdrop is another reason for the government to strive to achieve the stated fiscal deficit targets. Global fund flows have not favoured India in recent months. In particular, investors withdrew Rs 43,000 crore from Indian debt in 2016 and outflows have continued in January. Any uncertainty about India’s commitment to pursue prudent fiscal and monetary policies could hit India’s standing as a destination for foreign portfolio flows.
As RBI governor Urjit Patel said in a rare speech earlier this month,
For us, in India, good policy housekeeping should be the cornerstone. It is easy and quick to fritter away gains regarding macroeconomic stability. But hard and slow to regain them.
(Originally publihsed on Bloomberg Quint)
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