Big Question: Why Did NDA Buy Chidambaram’s Budget Fudges And Future Fiscal Headaches?

Why is the Narendra Modi government struggling to revive growth less than 15 months from the next general elections?

There can be many answers to this question, but one key reason is this politically inexcusable one: it failed to move away from the budgetary fudges and accounting fictions of Palaniappan Chidambaram, Arun Jaitley’s predecessor as finance minister. As a result, it has less fiscal leeway to raise spending in the last lap before the 2019 general elections.

After managing the fisc reasonably well for more than three years, the National Democratic Alliance (NDA) is now faced with the economically challenging probability of a serious slippage in the fiscal deficit this year. Inflation, interest rates, and other problems could now creep out of the woodwork.

Let’s be clear. Chidambaram’s fiscal roadmap was all smoke and mirrors, not real. Thus, when he left his successor with a fiscal deficit target of 4.1 per cent of gross domestic product for 2014-15, the real figure was much higher. Jaitley walked into his trap, and is now paying the price for it. Worse, Jaitley will now be entering into serious Chidambaram-style book fudging so as to make his real deficit appear palatable to the financial markets.

On 27 December 2017, the Finance Ministry announced that it will be borrowing Rs 50,000 crore more in the current fiscal year ending March 2018, as the economy is still to pick up steam, and with goods and services tax (GST) collections dropping off steeply in November.

Two things are obvious: one, the fiscal deficit target of 3.2 per cent for the year is now shot to pieces; and second, the higher borrowings have already sent bond yields soaring, with the 10-year benchmark GOI bond now crashing to give a yield of 7.3-7.4 per cent – one per cent higher than the lowest point reached over the last 52 weeks, according to Bloomberg data.

The rise in yields adversely impacts the already difficult twin balance-sheet problem, with banks now facing a depreciation in their bond portfolios, and over-leveraged corporations having to reckon with the reality that borrowing costs can no longer fall further. There may still be some leeway for some banks to cut rates, since they did not pass on the Reserve Bank of India’s previous rate cuts (about 1.75 per cent since January 2015) fully, but that’s about all. On Monday (1 January 2018), the State Bank of India cut its base rate by 30 basis points (100 basis points make one per cent), but the cuts are unlikely to get any deeper. For all practical purposes, rates have probably bottomed out.

The Finance Ministry has tried to soften the blow for the bond markets by announcing that it will be buying back short-term treasury bills worth Rs 61,203 crore, and that the net borrowing will thus be far less, but this will fool no one: borrowing with long-dated securities and short-term T-bills are not the same. One kind of debt is on your books for years; the other can be liquidated anytime cash flows increase.

So, when Jaitley presented his first budget in July 2014-15, he inherited a budget and fiscal deficit target of 4.1 per cent that was essentially a lie. The fiscal deficit for that year was actually much higher, and by retaining Chidambaram’s fiction, Jaitley was indirectly committing himself to continuing with this fudge. He was a bit lucky later that year, when oil prices started crashing, but this year, when oil prices are again acting up, he is going to pay the price for persisting with Chidambaram’s legerdemain.

Put simply, Jaitley made two cardinal errors – both politically and economically damaging. It would have suited the incoming NDA government to restate Chidambaram’s accounts and show a higher deficit and then work out a new fiscal roadmap that was realistic. If done in 2014 itself, the markets would have understood the logic and ignored this change. But, by now loosening the fiscal target 15 months before a general election, he is making the markets edgy about what could come next.

The second error was to ignore the ballooning bad loans problem with banks. Any two-bit economist worth his salt could have told you that Chidambaram was leaving behind a basket of bad apples in public sector bank portfolio, and the sooner it was tackled, the lower the costs would be. The reason why bad loans are now soaring towards Rs 10 lakh crore is this: when bad debts are left to fester, they keep accumulating interest charges and other costs, thus growing bigger every year. Chidambaram underprovided resources for recapitalising banks in his budget. The banks did their own fudge by not recognising bad loans in order to show they had enough capital. Jaitley continued with this bad idea to show a better fiscal deficit. The cost of recapitalising banks in 2014 would have been far lower than it is now, when Rs 2.11 lakh crore have to injected – Rs 1.35 lakh crore from recap bonds, and Rs 76,000 crore from budgetary allocations. This, again, will be another fudge, as recap bonds are essentially government debt masquerading as equity in banks’ books. But they will probably be shown as a below-the-line item outside the official fiscal deficit figure.

If the recapitalisation had been done in 2014, not only would the cost have been much lower, but the government could also have laid the blame for it at UPA’s door. By delaying this decision till late last year, the NDA lost an opportunity to fix banks – and the blame for their troubles on Chidambaram and Pranab Mukherjee. This is both politically and economically damaging. Now, more budgetary fudges are the only option.

For the usually politically-savvy Modi government, leaving the most economically difficult problems till the end shows a clear lack of forward planning. Logically, any incoming government should assume that budgetary spends will have to be higher when it is up for re-election, and front-loaded the painful parts of its economic medicine.

Instead, we not only have a fiscal headache looming, but also the possibility of rising interest rates later this year if inflation revives. The fiscal deficit could slip next year too, as revenue flows from the biggest tax reform ever attempted by any government in India – goods and services tax (GST) – remain weak. GST will take time to deliver, given its complexity and difficult first phase of implementation. It was politically and economically foolish to leave the strong medicine to the last.

The NDA will now be party to Chidambaram’s dodgy management of his budget accounting books.

(A part of this article was first written for DB Post)