13 February 2015

Don’t obsess over growth

Jahangir Aziz
February 13, 2015 

One can understand the temptation to use fiscal policy to support growth, given that its main driver — corporate investment — has shown no signs of life; exports remain weighed down by real exchange rate appreciation; rural consumption is floundering amidst declining real farm income; and inflation has tumbled to its pre-2007 level. Notwithstanding the new GDP growth numbers that suggest India is doing swimmingly well, almost all high-frequency activity indicators point to a much weaker economy. It is one thing for India’s growth to struggle in the face of global headwinds intensifying, but optically quite different if it happens in a year when developed market growth jumped 0.5 percentage points, oil prices fell 50 per cent, and the 10-year US treasury rate declined 70 basis points over the year.

But breaking away from the planned fiscal consolidation path would be very dangerous. Let me cite two reasons. First, foreign portfolio inflows in 2014 were predominantly driven by bond ($26 billion out of $42 billion) and not equity purchases. These investors have put their faith in the government’s promise to keep macroeconomic policy aimed at preserving stability and focus on reforms to boost growth. Any sign of the government wavering on this promise will weaken foreign investors’ faith.

Second, didn’t we just try doing that over 2009-12 with disastrous consequences? Recall that the government provided 3 percentage points of GDP of fiscal support in 2008-09. Over the next three years, the fiscal injection was withdrawn at a glacial pace, despite strong domestic growth. This flared up inflation and widened the current account deficit, pushing India towards a balance of payments crisis in 2013 that was narrowly avoided.

Many have argued that this time it is different. Unlike in the past, now the higher deficit will be used to fund investment and not consumption. It is true investment is critically needed to ease supply constraints, not only to raise productivity but also to reduce medium-term inflation. However, there is little evidence to suggest that higher spending on infrastructure necessarily delivers “higher and better quality” growth or raises productivity. Nevertheless, a government can increase capital spending if it so desires. But it needs to do so within the envelope of the planned fiscal consolidation by rebalancing expenditures and not adding to the deficit. A higher deficit pushes up aggregate demand in the near term, whether it funds consumption or investment. More importantly, there is no macroeconomic justification for easier fiscal policy. It is not that global headwinds have intensified. Rather, growth in the G-3 economies is expected to rise, oil prices to remain very low, and global monetary conditions likely to soften, even if the US Federal Reserve starts normalising its policy rate given the outsized quantitative easing by the European Central Bank and the Bank of Japan.

So what should the budget focus on? With this being only the second year of the government, the budget should stop obsessing with growth in 2015 and focus on the medium term. Let me touch on three such issues.

India’s fiscal problem is not that it spends too much but that it earns too little. The long-awaited national GST holds the promise of increasing indirect tax collection, but it still has many unresolved elements, including the rate structure and the compensation for states’ potential revenue losses. Importantly, albeit relatively low, India’s indirect tax collection is not where the trouble lies. It is with the pathetically low direct tax collection (2 per cent of GDP in income and 3.5 per cent of GDP in corporate taxes). And the solution is made more difficult because big businesses (listed companies) and formal salaried workers appear to be paying their fair share of taxes. The underpayment lies with the self-employed and SMEs, that is, the non-salaried middle class. Increasing direct tax collection will require a more progressive tax structure and a few thousand additional income tax officers.

Then there is India’s uneasy relationship with disinvestment. Successive governments have rationalised selling state assets under funding pressures in the guise of “unlocking the true value” of state-owned enterprises. This has resulted in perennially searching for the highest price, which, in turn, has resulted in unwarranted delays, heavy reliance on insurance companies to backstop sales, and missing budget targets.

There aren’t easy solutions without making two major changes. First, the government needs to recast the budget accounting by treating disinvestment proceeds as a deficit financing item — consistent with international standards — and not as part of revenue. Second, it needs to alter the rhetoric rationalising disinvestment along the following lines. Over the years, the government has created assets (namely public-owned commercial enterprises) because financial markets and the private sector were not sufficiently developed to undertake large and risky investments. As markets and the private sector have developed, this need has dissipated. In its place, the need today is to finance large infrastructure projects and many more hospitals and schools. This requires swapping the old assets with new. State ownership remains the same. It is just not in commercial enterprises. Once these are done, the government can then announce a three-to-five-year disinvestment plan and appoint independent investment bankers to sell the assets as and when they deem commercially appropriate. The sale proceeds would be deposited in the government’s account with the RBI and immediately used to buy back government debt. This would mean each year’s deficit is financed only through market borrowing, exerting more pressure on the government’s debt management, but it should not affect medium-term interest rates much.

On the expenditure side, better targeting of subsidies is clearly needed and welcome. However, in the public discourse, many seem to conflate subsidies with social protection. It is accepted that eliminating subsidies improves economic efficiency. However, this does not mean that there is no need for social protection programmes. Indeed, the elimination of subsidies should be undertaken simultaneously with the expansion of targeted and demand-driven social and unemployment protection programmes. Is this efficient? It is, because these allow the budget to be efficiently counter-cyclical — as a key objective of any modern budgetary framework. The MGNREGA was designed to be such a programme but clearly lost its way over the years. It needs to be redirected, not eliminated.

While one might disagree with the specifics of these suggestions, it is time to modernise India’s fiscal framework. That is, focus the discretionary part of the budget on achieving medium-term growth and the non-discretionary part on providing automatic countercyclical support to the economy. These changes can only be made when time is on the government’s side. Given the government’s large majority in Parliament, the time is now.

The writer is chief Asia economist at J.P. Morgan. Views are personal

No comments: