Economic Survey for IAS by civils360
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Fiscal Framework: The World is Changing, Should India Change Too?

  • Introduction

    • There has been a steady decline in the fiscal deficit from 4.5 percent of GDP in 2013-14 to 4.1 percent, 3.9 percent, and 3.5 percent over the successive three years.
    • After Global Financial Crisis(GFC) the monetary easing has run its course, attention has increasingly turned to the role of fiscal policy.
    • The new view of fiscal policy shifts the emphasis from stocks to flows, arguing for greater activism in flows (deficits) and minimising concerns about the sustainability of the stocks (debt).
  • India and the World: Flows

    • The case for activist fiscal policy in the advanced economies (AEs) rests ultimately on two pillars: weak economic activity and the inability to address this problem through monetary policy
      • These considerations have some resonance in India
      • India is still afflicted by the twin balance sheet problem, which is holding back investment and credit growth and hence overall economic activity.  Deleveraging has still not played itself out and hence the debt overhang will continue to constrain economic activity (see Chapter 4>> Click Here)
      • The need for counter-cyclical policy cannot, therefore, be ruled out
    • India’s situation differs from that of the AEs in some important ways
      • Indian growth rates are substantially higher, while inflation rates are also substantially greater.
      • As a result, monetary policy is nowhere close to the zero lower bound, reducing the need for fiscal activism.
      • Because inflation is already relatively high, a counter-cyclical policy has to be much more sensitive to triggering higher inflation.
    •  Two episodes of Indian macro vulnerability in the last 35 years—1991 and 2013—were associated with, even preceded by, large increases in fiscal deficits.
      • In the early 1980s, there was an expansion in spending and deficits in response to accelerating growth. The inability to rein in these deficits played a key role in undermining India’s external situation, which led to the balance of payments crisis of 1991.
      • The difference between the 1991 and 2013 episodes is that in the former there was a fixed exchange rate which created a full-blown crisis, whereas in the latter the exchange rate was floating, which attenuated disruptions in other asset prices.
    • . During India’s fiscal stance has an inbuilt bias toward higher deficits, because spending rises pro-cyclically during growth surges, while revenue and spending are deployed counter-cyclically during slowdowns.
    • This pattern creates fiscal fragility.
  • India and the World: stocks

    • India also appears to have a stock problem, in that its debt-to-GDP ratio is higher than many other emerging markets
  • Fiscal commitment
    • India shares with AEs the experience of not having defaulted on its domestic debt either de jure or de facto (through long periods of high inflation)
      • In that sense, India is very different from many other emerging markets, especially those in Latin America (and Russia) which have defaulted on their domestic obligations.
      • In the recent past, India’s highest level of debt has been 83 percent of GDP and it has made sure that its debt service obligations have been conscientiously met
    • India’s experience on its external debt obligations is instructive.(Crisis of 1991)
      • When doubts about India’s ability to meet its debt service obligations to foreign creditors arose in 1991, the government took extreme measures to reassure creditors that it had no intention to default.
      • Gold from the RBI was flown in a special plane and placed in the vaults of the Bank of England to provide collateral and demonstrate India’s seriousness about its debt obligations
  • Debt dynamics
    • In AEs, low inflation rates and weak economic activity in the aftermath of the financial crises have reduced nominal growth, which on its own would create debt fragility. But at the same time secular trends related to high savings, ageing, and a worldwide increase in demand for safe assets have reduced equilibrium interest rates, as well
    • In India, things are rather different. India is on a convergence path. Being relatively less developed, its growth rate for the next decade or two is likely to be substantial. This dynamic has been evident for the last two decades. The country has grown at just over 6 percent in real terms for 35 years and the scope for continuing this convergence remains considerable. India can grow conservatively at about 7-8 percent for the next 15 years (5.5-7 percent in per-capita terms). This combined with an inflation target of 4±2 percent implies that nominal GDP growth over the next decade or so will be in the 11-14 percent range.
  •   The vulnerability is the country’s primary deficit, that is the shortfall between its receipts and its non-interest expenditures
  • Put simply, India’s government (centre and states combined) is not collecting enough revenue to cover its running costs, let alone the interest on its debt obligations.
  • At such rapid rates of growth, substantially greater than those of its peers, its primary deficit should have been much lower than others; instead, it has been significantly greater
    • As a result of running a primary deficit, the government is dependent on growth and favourable interest rates to contain the debt ratio.
    • It follows that if one-day growth were to falter and interest rates to rise on a sustained basis, the debt ratio could start to spiral upwards.
  • Conclusion

    • In many ways, then, India’s economy is converging toward the large, open, prosperous economies of the West. But its trajectory is different in one fundamental way
    • While India’s pace of growth has quickened in the past quarter century, the dynamism of advanced countries has ebbed, particularly since the Global Financial Crisis.
    • Back in 2003, there was common agreement that fiscal rules were better than discretion, that fiscal policy should be aimed at medium-term objectives such as reducing the stock of debt rather than shorter-term cyclical considerations.
    • Now, advanced countries have moved away from these principles toward greater fiscal activism, giving counter-cyclical policies much more of a role and giving correspondingly less weight toward curbing the debt stock
    • But India’s experience has taught the opposite lessons. It has reaffirmed the need for rules to contain fiscal deficits, because of the proclivity to spend during booms and undertake stimulus during downturns
    • Even as these basic tenets of the FRBM remain valid, the operational framework designed in 2003 will need to be modified to reflect the India of today, and even more importantly the India of tomorrow.
    • This, then, will be the task of the FRBM Review Committee: to set out a new vision, an FRBM for the 21st century