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M. Ramachandran
R. Srinivasan

INTRODUCING the Fiscal Responsibility and Budget Management Bill in December 2000, the Finance Minister, Mr Yashwant Sinha, had said that the Government was determined to commit itself to fiscal discipline. The draft of the legislation emphasises the need for reducing the revenue deficit by 0.5 per cent of GDP annually. Eventually, by 2006, there will be no revenue deficit and fiscal deficit may be 2 per cent of GDP.

However, the revised estimates of these parameters for 2001-02 and the Budget estimates for 2002-03 are not in line with the avowed objectives of the Bill. Ironically, Mr Sinha mentioned in his 2002-03 Budget speech that he would place the Bill in the Budget session after considering the recommendations of the Parliamentary Standing Committee of Finance. Moreover, it would be inappropriate at the present juncture to put a constitutional cap on deficit when the economy reels under recession, as it is evident that the Finance Minister — in five budgets — is unable to contain fiscal deficit, and has also projected a huge deficit for the financial year that has just begun.

What is needed right now is a different strategy to evolve an appropriate fiscal stance, taking into account the present economic ills. For instance, real consumption growth declined from 6.5 per cent in 1999-2000 to 2.9 per cent in 2000-01 and for the corresponding period, the gross domestic capital formation fell from 15.7 per cent to 2.0 per cent. That food stock is consistently piling up while the manufacturing sector has excess capacity, underlines the need for a demand side approach. Hence, if the aim is growth-consistent with stability, then fiscal policy needs to be oriented to improving capital formation, particularly in infrastructure, reducing revenue expenditure and enhancing the government's own revenue potential.

Given the low tax buoyancy, the Finance Minister has tightened the tax instruments to enhance tax revenue, which would put further pressure on the aggregate demand to go down.

Disinvestments in public sector enterprises are the second best solution to close the revenue gap. The first best solution should be increasing the efficiency of the PSUs so that revenue potential can increase continuously. Moreover, disinvestment proceeds are a short-term revenue-raising tool, resulting in long-term revenue loss in the current account. For instance, the present Budget proposes to generate Rs 12,000 crore which would result in revenue loss of around Rs 500 crore per annum in the form of profits and dividends from PSUs.

On the expenditure side, interest payment constitutes around 35 per cent of total revenue expenditure and eats away 48 per cent of the government's revenue. This is due to borrowings and changing financing patterns of the deficit in recent times. For instance, market borrowing, mainly to provide sufficient autonomy to the RBI, has increasingly financed the deficit and as a result, there has been a consistent rise in the interest-bearing obligations of the government.

The Government has got into a vicious cycle of high deficit, large market borrowings, higher interest payments necessitating large revenue deficit resulting in high fiscal deficit. This vicious cycle should be broken simultaneously at two vital links — reduction of market borrowings and lowering of interest rates. The positive effects of reducing both the market borrowings and the interest rate will not only set public finance in order, but also provide the necessary impetus for investment.

Aiming to control the cost of government borrowing, the Budget has made some efforts to soften interest rates by making administered rates on small savings flexible in tune with the volatile market rates. Will this be an effective policy and help bring down the interest rate on government obligations? No, given the structural rigidity in the Indian financial market. There could be three important reasons for the downward rigidity of the market interest rate:

The financial institutions seek higher return on performing assets to compensate for the loss from non-performing assets. As there is high growth of non-performing assets in the banking sector, the need to charge higher interest rates on the performing assets becomes inevitable, keeping the market interest rate at a high level. The high interest rate also attracts continuous inflow of foreign exchange, which should logically result in appreciation of the rupee.

The adverse fallout of the rupee on the Indian exports is averted by the benevolent intervention of the RBI in the forex market. The RBI has been continuously buying the excess inflow of foreign exchange and accumulated foreign exchange assets of around $50 billion. The consequent increase of money supply is once again sipped out of the economy, for fear of inflation, by concomitant sales of high interest bearing bonds by the RBI. This continuous sterilisation of domestic liquidity keeps the nominal rate downwardly rigid.

Another reason for mounting interest payment could be that a major portion of public debt with long maturity accumulated during the administered interest rate regime is getting paid-off during the liberalised rate regime. Hence, to soften the interest rate, structural rigidities in the financial market should be removed, and debt growth checked to control interest expenditure.

One possible solution to control debt in the long run and reduce interest payments lies in optimal monetisation of the fiscal deficit. In fact, this will be an ideal policy when the economy is suffering from demand deficiency and the inflation is well below the threshold level. It has been observed that the growth rate of market debt is sharp when there is a deceleration of monetisation of the deficit over time. This Budget makes no mention about the proportion of fiscal deficit to be monetised, though the RBI has hinted it would be in the 20-25 per cent range of the fiscal deficit.

The hesitation to monetise the deficit always comes from the unreasonable fear of inflation.

Moreover, one of the important reasons for continuous economic slowdown is high interest cost in real terms. Given the downward rigidity of nominal interest, some inflation through monetisation, will help bring down the real interest rate that would kick-start the investment activity.

A high nominal PLR of 15 per cent and the lowest real rate of 2.7 per cent coincided with boom in investment activities in 1994-95. It is often argued that the growth of money supply not in pace with the growth of government borrowing will result in a high interest rate trap. This, apart from crowding out private investment, will create a deficit that would be unviable in the long run.

Moreover, if we allow the present structure of fiscal imbalance to continue, the Budget will soon become unviable and when there is a solvency constraint on public debt, the RBI will have to finance not only the primary deficit but also the interest expenditure, leading to higher inflationary situation.

Hence, monetising the deficit at an optimal level will be an ideal solution to prevent the economy from moving into higher inflationary spiral. This will give demand side fillip to growth and help contain deficit through netting in higher revenue.

(The authors are with the Madras School of Economics, and the Presidency College, Chennai, respectively.)

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