Why Govt of India Isn’t Acting Like a Spender of the Last Resort

It’s 2019, and you are out watching an international cricket match.

You didn’t book tickets quickly enough and are sitting in one of the upper stands, pretty far away from where the action is.

Instead of sitting and watching the match, you stand up to get a better view. Of course, by doing this, you end up blocking the person behind you. He also has to get up to get a better view of the cricket.

When he does this, he ends up blocking the view of the person behind him. And so, it goes. Pretty soon, everyone in the rows behind you has also stood up to get a better view.

Economists have a term for a situation like this. They call it the fallacy of composition or the assumption that what’s good for a part (that’s you in this case) is good for the whole (the people sitting behind you) as well.

As economist Thomas Sowell writes in Basic Economics-A Common Sense Guide to the Economy: “In a sports stadium, any given individual can see the game better by standing up but if everybody stands up, everybody will not see better.”

So, why are we talking about cricket and sports here? What’s true about watching sports in a stadium is also true for the economy as a whole.

John Maynard Keynes, the most famous and influential economist of the twentieth century (and perhaps even the twenty first), came up with a concept called the paradox of thrift, where thrift refers to the entire idea of using money carefully.

Keynes studied the Great Depression of 1929. He concluded that during tough economic times, when the going is difficult, people become careful with spending money and try and save more of it. While this makes perfect sense at the individual level, it doesn’t make much sense at the societal level because ultimately one man’s spending is another man’s income.

If a substantial portion of the society starts saving, the paradox of thrift strikes, incomes fall, jobs are lost, businesses shutdown and the governments face a pressure on the tax front. The government also faces the pressure to do something about the prevailing economic situation.

This is precisely the situation playing out in India currently. The paradox of thrift is at work. Bank deposits between March 27 and September 25, the latest data that is available, have gone up by 5.1% or Rs 6.9 lakh crore to Rs 142.6 lakh crore. This is twice more than the increase that happened during the same period last year.

As far as loans are concerned, outstanding loans of banks have shrunk during this financial year. On the whole they haven’t given a single rupee of a new loan  (loans are again meant to be spent).

Keynes had suggested that during tough economic times, when the private sector, both individuals and corporations are not spending much money, the government needs to step in and act as the spender of the last resort. In fact, Keynes rhetorically even suggested that if nothing, the government should get workers to dig holes and fill them up, and pay them for it.

When the workers spend this money, it would start reviving the economy. Economists refer to the situation of the government spending money in order to get economic growth going again as a fiscal expansion or a fiscal stimulus.

Since the start of this financial year, everyone who is remotely connected to economics in India in anyway, be it journalists, economists, analysts, corporates, fund managers and even politicians, have been demanding a bigger fiscal stimulus from the government to get economic growth going again.

The government has responded in fits and starts. Last week the central government came up with a few more steps including the LTC cash voucher scheme, special festival advance scheme, loans to states for capital expenditure and an additional capital expenditure of Rs 25,000 crore.

The fact that one week later one’s not hearing much about these moves, tells us they have already fizzled out. They didn’t have much legs to stand on in the first place. Let’s look at these moves pointwise before we get into greater fiscal stimulus as a strategy, in detail.

1) The government announced last week that in lieu of leave travel concession (LTC) and leave encashment, the central government employees can opt for a cash payment. This money has to be used to take make purchases.

LTC is a part of the salaries of central government employees. Instead of traveling in these difficult times in order to avail the LTC, the employees can opt for a cash payment. But this cash payment comes with certain terms and conditions.

Employees who opt for an encashment need to buy goods/services which are worth thrice the fare and one time the leave encashment. Only the actual fare of travelling can be claimed as a tax exemption. Tax has to be paid on the money spent on other expenses during travelling, like hotel and restaurant bills.

This money will have to be spent on buying stuff which attract a minimum 12% goods and services tax (GST), by paying through the digital route to a GST-registered vendor. It is expected that the scheme will cost the government Rs 5,675 crore. Over and above this, it will cost the public sector banks and public sector units another Rs 1,900 crore. This works out to a total of Rs 7,575 crore.

The question is will people opt for this scheme or not, given that they need to spend money out of their own pocket (i.e. their savings) in order to get a tax deduction. It needs to be mentioned here that the increase in dearness allowance of central government employees has been postponed until July 1, 2021. This will act against the idea of spending. Also, there is paperwork involved here (always a bad idea if you want people to spend money).

2) Over and above this, all central government employees can get an interest-free advance of Rs 10,000, in the form of a prepaid RuPay Card, to be spent by March 31, 2021. This is expected to cost the central government Rs 4,000 crore. It’s not clear from the reading of the press release accompanying this announcement, whether it’s compulsory for central government employees to take this card, given that this money will have to ultimately be repaid.

Also, this is not fiscal expansion in the strictest sense of the term given that LTC is already a part of the employee pay and has been budgeted for. As far as the Rs 10,000 being given as an advance is concerned, it is an interest free advance. The government will bear the interest cost on this, which will be an extremely small amount. The employees will have to repay the advance.

3) The central government is also ready to give state governments Rs 12,000 crore for capital expenditure. These loans will be interest free and need to be repaid over a period of 50 years. This money needs to be spent by March 31, 2021. A state government will be given an amount of 50% of what it is eligible for first. The second half will be given after the first half has been spent.

One can’t really question the logic behind this move. But the question that arises here is, are state governments in a position to spend this money in the next five and a half months?

4) Finally, the government has decided to spend an additional Rs 25,000 crore (over and above Rs 4.12 lakh crore allocated in the budget) on roads, defence, water supply, urban development and domestically produced capital equipment. Again, one can’t question the basic idea but one does need to ask here whether this is yet another attempt to manage the narrative.

The total capital expenditure that the government has budgeted for this financial year is Rs 4,12,009 crore. In the first five months of the financial year (April to August 2020), the government has managed to spend Rs 1,34,447 crore or around a third of what it has budgeted for. Last year, in the first five months, the government had spent around 40.6% of what it had budgeted for.

In this scenario, it is more than likely that the government will not get around to spending the extra Rs 25,000 crore. The government systems can only do a certain amount of work in a given period of time, their scale cannot be suddenly increased.

If one doesn’t nit-pick with the four above points, it needs to be said that the amounts involved are too small to even make a dent into the economic contraction expected this year. The economy is expected to contract by 10% this financial year. This means destruction of Rs 20 lakh crore of economic value, given that the nominal GDP in 2019-20, not adjusted for inflation, was Rs 203.4 lakh crore.

The government expects the moves announced last week to boost the expenditure in the economy by Rs 1 lakh crore. The mathematics of this Rs 1 lakh crore is similar to the mathematics of the Rs 20 lakh crore stimulus package (which actually added up to Rs 20.97 lakh crore) earlier in the year. As we saw earlier, the chances that the government ending up spending the Rs 4.12 lakh crore originally allocated for capital expenditure is difficult. Hence, how will it end up spending the newly allocated Rs 25,000 crore?

The government also expects the private sector spending to avail of the LTC tax benefit to be at least Rs 28,000 crore. What no one has talked about here is the fact that while there is an income tax benefit available, one also needs to pay a GST. Net net, there isn’t much benefit left after this. For someone in the marginal bracket of 20% income tax, after paying a GST of 18% to make these purchases, there isn’t much of a saving. Also, to spend three times the amount to avail of tax benefits, isn’t the smartest personal finance idea going around.

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In the recently released OTT series Scam 1992 – The Harshad Mehta Story, there is a scene in the second episode, in which a newsreader is seen saying that this year’s budget has a deficit of Rs 3,650 crore for which no arrangements have been made (or as the newsreader in the series said, jiske liye koi vyawastha nahi ki gayi hai).

Given that the makers of the series have stuck to details of that era as closely as possible, I was left wondering if the Rs 3,650 crore number was correct or made up. I went looking for the budget speech of 1986-87 made by the then finance minister Vishwanath Pratap Singh, and found it.

This is what Singh said on page 32 (and point 168) of the speech: “The proposed tax measures, taken together with reliefs, are estimated to yield net additional revenue of Rs 445 crores to the Centre. This will leave an uncovered deficit of Rs 3650 crores. In relation to the size of our economy and the stock of money, the deficit is reasonable and non-inflationary [emphasis added].”

The number used in the series is absolutely correct. Hence, the makers of the Scam 1992, have gone into this level of detailing.

Dear Reader, you must be wondering by now, why have I suddenly started talking about the budget speech of 1986-87. This random point in the OTT series made me realise something. At that point of time, the government could get the Reserve Bank of India to monetise away the fiscal deficit or the difference between what it earned and what it spent.

This meant that the RBI could simply print money and hand it over to the government to spend it. Of course, money printing could lead to a higher amount of money chasing a similar number of goods and services, and hence, higher inflation. This explains why Singh in his budget speech emphasises that the uncovered deficit of Rs 3,650 crore will be non-inflationary. Not that he knew this with any certainty, but there are somethings that need to be said as a politician and this was one of those things.

As a result of two agreements signed between the RBI and the government (in 1994 and 1997) and the Fiscal Responsibility and Budget Management (FRBM) Act, 2003, the automatic monetisation of government deficit was stopped.

The government funds its deficit by selling bonds to raise debt. The FRBM Act prevented the RBI from subscribing to primary issuances of government bonds from April 1, 2006. In simple terms, this meant that it couldn’t print money and hand it over directly to the government by buying government bonds.

Now why I have gone into great detail in explaining this will soon become clear.

As I wrote at the beginning of this piece, many journalists, economists, analysts, corporates, fund managers and even politicians, have been demanding a greater fiscal stimulus from the government. In short, they have been wanting the government to spend more money than it currently does.

The International Monetary Fund  recently said that India needs a greater fiscal stimulus. Former Chief Statistician of India Pronab Sen has gone on record to say that India needs a fiscal stimulus of Rs 10 lakh crore. Business lobbies have demanded stimulus along similar levels.

The question is why is the government not going in for a bigger stimulus? The answer lies in the fact it simply doesn’t have the money to do so. The gross tax revenue of the government has fallen by 23.9% this year. Hence, it doesn’t even have enough money to finance the expenditure it has budgeted for. So, where is the question of spending more?

Of course, people who have been recommending a larger fiscal stimulus understand this. They simply want the RBI to print money and finance the government expenditure. Well, the RBI has been indirectly doing so. Take a look at the following table.

RBI –The Rupee Machine.

Source: Monetary Policy Report, October 2020.

What does the table tell us? It tells us that between early February and end September, the RBI has pumped in Rs 11.1 lakh crore into the financial system. How has it done so? Simply, by printing money in most cases. This does not apply to the cash reserve ratio cut, which meant banks having to maintain a lower amount of money with the RBI and hence, leading to an increase in the money available in the financial system to be lent out.

Here is the thing. The RBI prints money and buys bonds to introduce money into the financial system. Of course, it does not buy these bonds directly from the government. Nevertheless, even this indirect buying ends up financing  the government  fiscal deficit.

How? Let’s say the government sells bonds to finance its fiscal deficit. The financial institutions (banks, insurance companies, provident funds, mutual funds etc.) buy these bonds directly from the government (actually through primary dealers, but let’s keep this simple because the concept is more important here).

When they do this, they have handed over money to the government and have that much lesser money to lend. By printing money and pumping it into the financial system, the RBI ensures that the money that banks have available for lending doesn’t really go down or doesn’t go down as much, because of lending to the government.

Hence, in that sense, the RBI is actually indirectly financing the government. (It’s just buying older bonds and not newer ones).

The point being that despite the 1994 and 1997 agreements and the FRBM Act of 2003, the RBI is already financing the government fiscal deficit, albeit in an indirect way.

Of course, this financing is only enough to meet the current budgeted expenditure of the government. The thing is that the journalists, economists, analysts, corporates, fund managers and even politicians, want the government to spend more.

In fact, people in favour of a larger fiscal stimulus are okay with the RBI financing the government directly instead of this roundabout way. It seems that might be possible as well. As Viral Acharya, a former deputy governor of the RBI, writes in Quest for Restoring Financial Stability in India, published in July earlier this year:

“A recent amendment of the RBI Act allows the central bank to re-enter the primary market for government debt under certain conditions, annulling the reform of 2003 and recreating investor expectations of deficit monetization.”

Hence, the RBI can directly finance the government fiscal stimulus by printing money, buying government bonds and giving the government the money required to spend.

The question is why has the government not gone down this route? The fear of an even higher inflation seems to  be the answer. If there is one thing in economics that the current government is bothered about, it is inflation, in particular food inflation. The food inflation in September 2020 stood at 10.7%. During this financial year, it has been at a very high level of 9.8%.

The money supply in the economy (as measured by M3) has gone up at a pace greater than 12% since June, thanks to the RBI printing and pumping money into the financial system. For fiscal expansion more money will have to be printed and pumped into the financial system, hence, there is the risk of inflation rising even further.

A few experts have said that in a situation like this growth is more important than inflation. Some others have said that inflation is not a real danger currently.

A government focussed on narrative and perception 24 x 7 would not want to take the risk of inflation at any point of time, especially when food inflation is already close to 11% and there is grave danger of it seeping into overall retail inflation (as measured by the consumer price index).

There are other risks to printing money directly and the country’s public debt going up. Foreign investors can leave India. The rating agencies can cut the ratings. (You can read about it here). This stems from the fact that investors are not as comfortable holding investment assets in a currency like the Indian rupee vis a vis a currency like the American dollar or the British pound or the currency of any other developed country.

As L Randall Wray writes in Modern Monetary Theory: “There is little doubt that US dollar-denominated assets are highly desirable around the globe… To a lesser degree, the financial assets denominated in UK pounds, Japanese yen, European euros, and Canadian and Australian dollars are also highly desired.” This allows these countries to print money in a way that India cannot even dream of.

Also, if the government wanted to go the fiscal stimulus route, it should have done so at the very beginning. But instead it chose monetary expansion, with the RBI printing money and pumping it into the financial system, cutting the repo rate or the interest rate at which it lends to banks and getting banks to lend to certain sectors.

All this, in particular money printing by the RBI to drive down interest rates, has already led to the money supply going up. A larger fiscal stimulus will lead to the money supply going up even further increasing the possibility of a higher inflation.

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There is a new theory going around especially among the stock market wallahs who think they understand economics.

The foreign currency reserves with the RBI have gone up from $440 billion towards the end of March to around $509 billion as of October 9. What if a part of this can be converted into rupees and the money can be handed over to the government to spend, is the crux of the new theory going around.

Only someone who does not understand how these foreign currency reserves ended up with the RBI in the first place, would suggest something like this. The RBI buys foreign currency (particularly the American dollar) in order to intervene in the foreign exchange market.

Let’s say a lot of foreign money is coming into India. This increases the demand for the rupee and it leads to the appreciation of the rupee. The appreciation of the rupee makes imports more competitive, hurting domestic producers (not good for atmanirbharta). It also makes exports uncompetitive. In this scenario, the RBI intervenes. It sells rupees and buys dollars (Of course, these rupees have to be printed or rather created digitally these days).

The point being that the dollars end up on the balance sheet of the RBI, only after it has introduced rupees against them into the financial system. So, where is the question of printing and introducing more rupees against the same set of dollars?  (Which is why I keep saying that stock market wallahs should stick to earnings growth and not make a fool of themselves by coming up with such silly theories).

One way of raising money against these foreign exchange reserves is to borrow against them. But that would make India look very desperate and weak on the international as well as the domestic front. Do we really want to do that?

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Does all this mean that the government can’t do anything? Not really. I had written about lots of solutions a few weeks back.

One thing that the government needs to pursue seriously is an asset monetisation programme. This involves selling its stake in public sector units which are in a position to be sold. Even public sector units that cannot be sold have a lot of land lying idle.

This land needs to be monetised. This will take time. Nevertheless, the thing is that the Indian economy will need massive government support even in 2022-23. And if the government starts the monetising process now, it will be prepared in 2022-23 to help the economy.

Fiscal stimulus is already on, why doesn’t the govt try lowering taxes?

keynes_395

Media reports suggest that the central government is planning a fiscal stimulus. In simple English, what it basically means is that it is planning to spend more than what it had budgeted for, during this financial year.

Fiscal stimulus is an idea that politicians have latched on to for nearly eight decades since the British economist John Maynard Keynes published his tour de force The General Theory of Employment, Interest and Money in 1936. What Keynes suggested in this book was that in a tight economic situation, cutting taxes, so that people would have more to spend, was one way out to revive economic growth.

But the best way was for the government to spend more money, and become the “spender of the last resort”. Also, it did not matter if the government ended up running a fiscal deficit in doing so. Fiscal deficit is the difference between what a government earns and what it spends. When Keynes wrote this book, governments budgets used to be balanced (i.e. expenditure was more or less equal to revenue).

It wasn’t fashionable for governments to run a fiscal deficit back then, as it is now. Given this Keynes suggested that in a tight economic situation (the world was going through what we now call the Great Depression) it made sense for the government to spend its way out of trouble. And if that meant running a fiscal deficit, so be it.

Since then, it has been time honoured tradition for politicians and a section of economists to talk about the government spending more, in times of economic trouble. The idea being that with the private consumption slowing down, if the government spends more, incomes will go up, and this will help in reviving private consumption expenditure, which in turn will push up economic growth.

QED.

In fact, the government has already started providing a fiscal stimulus to the economy, during the first few months of this financial year. Take a look at Figure 1.

Figure 1:

Fiscal stimulus 1

Source: www.cga.nic.in and www.indiabudget.nic.in

What does Figure 1 tell us? It tells that between April and July 2017 of the current financial year, the government has already touched 92.4 per cent of the fiscal deficit target that it had set at the beginning of the year. As is obvious from Figure 1, this is way beyond what usually happens.
Now take a look at Figure 2. It plots the proportion of government expenditure carried out during the period April to July (the first four months of the financial year) against the total expenditure achieved/planned for the financial year.

Figure 2:

fiscal stimulus 2
Source: www.cga.nic.in and www.indiabudget.nic.in

What does Figure 2 tell us? It tells us that during a normal year, the government spends around one-third of the total expenditure during the first four months of the year. And this is a logical thing to do, given that four months constitute one-third of a year.
This time around, the government expenditure during the first four months of the year is at 37.7 per cent of the total expenditure that the government plans to incur during the year.

What Figure 1 and Figure 2 tells us is that the fiscal stimulus is already on. If the government continues to spend at the same rate as it is currently, it will end up spending 13 per cent more than it had planned at the beginning of the financial year. This will push up the budgeted fiscal deficit by around 51 per cent (assuming government revenues remain the same).

This will push up the fiscal deficit to 4.9 per cent of the gross domestic product(GDP) against the set target of 3.2 per cent of the GDP. Now what the government needs to decide is whether it should continue spending money at the rate that it currently is.
Also, what this means is that people who are now asking for the government to unleash a fiscal stimulus, probably do not know, that a stimulus is already on.

In fact, the government spending more than the usual, helped the GDP grow by 5.7 per cent during the period April to June 2017. In fact, if we leave out the government expenditure from the GDP, the non-government part, which constitutes close to 90 per cent of the GDP, grew by just 4.3 per cent. Hence, the impact of the fiscal stimulus is clearly there to see.

The trouble is that most fiscal stimuli flatter to deceive. It does help in pushing up economic growth initially, but ends up creating more problems, which the economy has to tackle in the years to come.

India’s last experience with a fiscal stimulus was disastrous. It was unleashed in 2008-2009. It propped up economic growth for a couple of years. But it also led to high inflation and high interest rates. It also led to banks going easy on lending and in the process ended up creating a massive amount of bad loans, which the system is still trying to come out from.

Also, it is worth remembering that the state governments run fiscal deficits as well. During 2016-2017, the combined fiscal deficit of the central government as well as the state governments had stood at 6.5 per cent of the GDP, down from 7.5 per cent, in 2015-2016. During this financial year, many state governments are expected to run higher fiscal deficits because they have waived off farmer loans. With the central government also spending more, the combined fiscal deficit will cross the 7 per cent level and that is not a good thing.

People in decision making should remember these points raised above. The trouble is politicians like to look up to the next election. And the fiscal stimulus that has been unleashed now is likely to keep perking up economic growth over the next year or two and this will help the incumbent government in the next elections. Having said that, as I mentioned earlier, it creates other problems in the time to come.

Also, it needs to be clarified here, that Keynes wasn’t an advocate of a government running high budget deficits all the time. Keynes believed that, on an average, the government budget should be balanced. This meant that during years of prosperity, governments should run budget surpluses. But when the environment is recessionary, governments should spend more than what they earn, even running budget deficits.

But over the decades, politicians have only taken one part of Keynes’ argument and run with it. The idea of running deficits during bad times became permanently etched in their minds. However, they forgot that Keynes had also wanted them to run surpluses during good times.

To conclude, other than the government spending more, Keynes also talked about lowering taxes. Why doesn’t the government try and lower the GST rates to start with?

The column originally appeared on Firstpost on September 23, 2017.

India does not need a fiscal stimulus

indian rupeesIn the recent past there has been talk of the government launching a fiscal stimulus in the next budget. Fiscal stimulus essentially refers to the government increasing public spending. The idea is that with the government spending more money, economic growth will be faster.
If the new gross domestic product (GDP) numbers are to be believed, India is likely to grow at 7.4% in this financial year (2014-2015). And at that rate of economic growth a fiscal stimulus may clearly not be required.
Nevertheless, high frequency data suggests otherwise. Exports fell in December 2014. The number of stalled projects continues to be huge. The car sales remain muted. Bank loan growth continues to remain slow. The bad loans of banks, especially public sector banks, continue to remain high. And corporate profitability continues to remain dull.
With these factors in the background, there might be pressure on the government to launch a fiscal stimulus. The question is would a fiscal stimulus be appropriate at this point of time?
One reason offered in favour of a fiscal stimulus is that the
combined fiscal deficit of the central government plus the state governments has been falling over the years. It had reached 9.33% of the GDP in 2009-2010(GDP at current market prices as per the old GDP series). Since then the combined fiscal deficit has come down to 6.78% of the GDP in 2013-2014. It is expected to fall further to 6.03% of the GDP in 2014-2015. Fiscal deficit is the difference between what a government earns and what it spends.
Since the combined fiscal deficit has fallen over the years, the government might as well spend some more money in the next financial year, is one logic being offered. There are a number of reasons why this does not make much sense.
First and foremost, the fiscal deficit as a proportion of GDP has fallen primarily because the GDP at current market prices has gone up dramatically between 2007-2008 and 2013-2014, at the rate of 14.7% per year. Much of this increase was due to the high inflation(at times greater than 10%) that had prevailed during this period.
Hence, the fiscal deficit to GDP ratio has come down primarily because the denominator (i.e. the GDP) has gone up at a very fast rate due to inflation. Along similar lines the general government liabilities which includes total debt of the central as well as state governments, loans from the central government to state governments and other liabilities, has fallen over the years. In 2008-2009, the general government liabilities were at 70.6% of the GDP. By 2013-2014, they had fallen to 65.3% of the GDP.
As economist Tushar Poddar
of Goldman Sachs wrote in The Economic Times recently: India’s stock of government debt has been eroded by high inflation in recent years.”
Hence, just looking at the fiscal deficit to GDP ratio or the general government liabilities to GDP ratio is not enough. What we also need to take a look at is whether the ability of the government to service the absolute debt that it has accumulated over the years has gone up. And this is where things get interesting.
One of the ways through which the government repays debt is through the tax revenue that it earns. Chetan Ahya and Upasana Chachra of Morgan Stanley in a recent note point out that the tax revenue earned by the central government as a percentage of the GDP has been falling over the years.
In 2007-2008, this had stood at 11.9% of the GDP. By 2013-2014, it had fallen to 10% of GDP. And in 2014-2015 it is expected to fall further to 9.6% of the GDP. What this means is that the ability of the government to service the debt that it has already accumulated has come down over the years.
Further, interest payments as a portion of the total expenditure in the annual budget of the central government have started to shoot up again. As e
conomists Taimur Baig and Kaushik Das of Deutsche Bank Research point out in a recent research note: “India’s central government spends nearly a quarter of its total spending on servicing the large debt burden. Despite the decline in the debt/GDP ratio in recent years, interest spending has begun to rise again, both as a share of GDP and a share of total spending.”
In fact, the interest that the government pays on its outstanding debt is the biggest line item in the budget. As Baig and Das point out: “Indeed, interest spending is bigger than any other line item in India’s current expenditure (e.g. defence, subsidies, health, and education) budget. Bringing this down would create valuable space for other far more important expenditures.”

Interest spending taking up a large chunk of the budget

Source: CEIC, Deutsche Bank

Also, it is worth remembering that countries do not operate in isolation. While the fiscal deficit and the overall liabilities of the government may have come out as a proportion of the GDP, they still remain high in comparison to other countries. As Poddar points out: “At 6.7% of GDP in 2013-14, the general government fiscal deficit[combined fiscal deficit of centre and states] is significantly higher than the Asian average of under 2% of GDP.”
Further, government borrowing tends to crowd out private sector borrowing and ensures that interest rates remain high. As Ahya and Chachra of Morgan Stanley point out: “
We believe that national fiscal (central plus state government) deficit below 5% of GDP will be ideal to allow real borrowing cost for the private sector to reduce meaningfully and encourage private investment.”
To conclude it is worth pointing out what economists Baig and Das of Deutsche Bank Research point out: “A
1% of GDP reduction in deficit leads to growth rising by 0.4% within 2 years subsequent to the effort. Most interestingly, the effect is persistent…suggesting a lasting impact on growth from fiscal consolidation.”
What all this clearly tells us is that the government should continue on the path of fiscal consolidation that it had laid out in the last budget. The finance minister Arun Jaitley had said in his budget speech that the government wants to achieve a fiscal deficit of 3.6% of the GDP in 2015-2016 and 3% of GDP in 2016-2017. He should continue working towards these goals.


The column originally appeared on www.equitymaster.com as a part of The Daily Reckoning, on February 12, 2015