Expand Or Consolidate: How Jaitley Can Deal With His Dilemma

Since Raghuram Rajan has more or less ruled out monetary easing the only boost for the economy can come from fiscal expansion.  What should Arun Jaitley do?

Finance Minister Arun Jaitley is a trifle confused. Speaking at the ET Global Business Summit, he is supposed to have pointed to the sharp division of opinion on whether or not the government should relax the fiscal deficit target to push growth or stick rigidly to the fiscal consolidation glide path.

His chief economic adviser Arvind Subramaniam wants him to go easy a bit, but the Reserve Bank of India governor Raghuram Rajan and Niti Aayog vice-chairman Arvind Panagariya have warned him about the dangers of doing so. All of them are weighty voices. And then there are sundry economists on both sides of the divide though the pro-easing group has more numbers. So whom should Jaitley and his team listen to?

Let’s look at why the Rajans and Panagariyas are fiscal martinets. Delivering the C. D. Deshmukh memorial lecture in Delhi on Friday, Rajan warned against jeopardising macro-economic stability. This will be a platform to build growth and depends a lot on the credibility of the government’s statements. A debt-fuelled growth could undermine this stability, he said and pointed to the example of Brazil which logged 7.6 per cent growth in 2010 on the back of a substantial stimulus – the central bank was forced to reduce rates, resulting in a credit spree that borrowers are now not in a position to pay back; there were subsidised loans to corporations; price controls on oil and gas; huge increase in government pensions; and a political reluctance to deal with a burgeoning budget deficit. Last year, Brazil’s economy declined by 3.8 per cent, its debt got labelled as junk and the country is at the edge of an economic precipice. “As Brazil’s experience suggests, the enormous costs of becoming an unstable country far outweigh any small growth benefits that can be obtained through aggressive policies,” Rajan said.

Now, holding up Brazil as an example of the dangers of a debt-fuelled expansion is perhaps not right. Brazil made many mistakes in its boom years that India did not and its economy was overly dependent on the commodity boom and on China as a customer. There were many other structural problems with its economy.

But, still, Rajan has a valid point about the risks of aggressive policies. And the credibility of the government is also called into question if it deviates from its own fiscal consolidation path. But what is to be done when the economy sorely needs a demand boost?

The latest quarterly OBICUS (order books, inventories and capacity utilisation survey) of the RBI for the second quarter of this fiscal (July-September) paints a pretty glum picture. Factories are producing less goods than they were built for – from 73.6 per cent in the fourth quarter of 2014-15, capacity utilisation came down to 71.3 per cent in the first quarter and is now down to 70.6 per cent. Stocks of both raw materials and finished goods are piling up. Inventories as a percentage of sales has been moving up steadily – from 17.8 per cent in the third quarter of 2014-15 to 20.5 per cent in the second quarter of this fiscal in the case of finished goods (which means products are not finding buyers). Railways carries a lot of inputs for factories – between April and December 2015, railway freight moved up only 1 per cent.

Exports have been declining for 13 months in a row thanks to a global slump and clearly domestic demand is not filling up the gap entirely. “The demand deficit is far too serious,” says D. K. Srivastava, chief policy advisor at Ernst & Young who was a member of the Twelfth Finance Commission. Demand boost can come either through fiscal policy or monetary policy. But, Srivastava points out, since Rajan is ruling out any monetary easing because of concerns over inflation, then the fiscal policy route will need to be taken.

Those arguing for some easing are not asking for all fiscal caution to be thrown to the winds. “This is not about raising the fiscal deficit target or moving it on a different trajectory, but about just reducing the pace of consolidation for a specific purpose,” says D. K. Joshi, chief economist at Crisil.

It is not also about the government going on a mindless spending spree, ratcheting up the subsidy bill or poorly targeted welfare schemes or giving a consumption boost that will only fuel inflation like what happened during the United Progressive Alliance government days. While a consumption-driven boost next year is inevitable because of the Seventh Pay Commission payout, the spending bias has to be in favour of what Pronab Sen, chairman of the National Statistical Commission calls “anything that creates capacity – capital expenditure, skill development, education, health”. That is the consensus among the pro-expansion group.

What will fiscal easing do to debt-GDP ratios? In his lecture, Rajan warned that more spending will hurt debt dynamics. India’s debt-GDP ratio is currently at 67 per cent, which is a far cry from the 80 per cent levels it was in the early 2000s. Sen and Srivastava both feel this gives enough headroom for some stimulus, provided it is targeted at productive spending. “There is scope to relax till we reach potential growth,” says Srivastava. “Once that hump is crossed, the situation can be reviewed.”

Ways can be found to push spending without fuelling debt. States, for example, can be encouraged to uses whatever fiscal space they have to undertake capital expenditure. The Fourteenth Finance Commission had allowed states extra borrowing room of 0.5 per cent of GDP over and above their fiscal deficit cap of 3 per cent if they fulfilled two conditions – a debt-GDP ratio of below 25 per cent (which will give a 0.25 per cent relaxation) and an interest payments to revenue receipts ratio of below 10 per cent (another 0.25 per cent relaxation). The central government has not accepted this recommendation of the Commission. Srivastava feels it should and even if it does not, states should push for it. The consolidated debt-GDP ratio is at 21.2 per cent (2014-15 budgeted estimates) but the consolidated interest payments-revenue receipts ratio is a smidgeon higher at 10.4 per cent.

But there is a slight problem here. While at least a 0.25 per cent boost without overall fiscal deficit targets going awry appears possible looking at the consolidated debt-GDP position of states, the picture is not so rosy when one looks at individual performance. Many of the non-special category states (basically the larger states which do not depend overly on grants from the centre) have debt-GDP levels above the 25 per cent mark.

Another way to push spending without breaching fiscal deficit targets, says Srivastava, is for the government to get public sector companies which are sitting on huge reserves to start investing in expansion projects and to encourage special purpose vehicles in infrastructure. That will give an additional spending of 1.5 per cent. Whether the public sector will invest in expansion in a time of low capacity utilisation is a moot point, but the SPV route is certainly worth exploring.

But when assessing these options and perhaps deciding to take the fiscal expansion route, Team Jaitley must also take care to see that this is accompanied by a clear exit path and simultaneous serious efforts to address the many structural problems the economy is labouring under. This is absolutely essential. Otherwise Rajan’s warnings may well be proved right.