The global financial meltdown, recessionary trends in the US, Europe and Japan will have a significant impact on the Indian economy. We have already seen the liquidation and flight of foreign institutional investments putting pressure on the exchange rate, liquidating the exchange reserves, crashing the stock prices and drying up liquidity. In the prevailing environment the Indian corporate sector is unable to raise fresh funds from either the primary market or the international financial market. With the hesitancy of the banking sector to lend to the private sector, the liquidity crunch has been severe. The financial sector problem will spread to the real economy.
Indeed, the Reserve Bank of India has acted swiftly to augment liquidity into the system by reducing the CRR, SLR and the Repo rate, though the position remains far from satisfactory. The banking system has continued its hesitancy to lend to the private sector and has preferred to park its funds with the Reserve Bank. It is important to reduce the disincentive to the banks to lend to productive sectors. Further action by the Reserve Bank in terms of reducing the Repo rate and the Reverse Repo rate, besides the CRR, may be warranted to ease the liquidity situation.
In this environment what should be the role of fiscal policy to revive the economy? It is argued that the sharp decline in the crude oil price provides healthy headroom for injecting additional public spending of at least 2 per cent of GDP. But, as shown in my last column (BS, November 4), there is no such cushion. The supplementary demand for grants has released additional cash expenditure of 2 per cent of GDP and off-budget liabilities of 2.5 per cent of GDP. Indications are that the pay revision liabilities have not been fully met, provision will have to be made for the revision of UGC pay-scales and additional expenditures may have to be incurred for many of the schemes in the election year.
The slowdown in the economy is likely to impact revenue buoyancy as well and the prospect of covering the budgeted revenues does not look bright. The tax revenue was budgeted to increase over the revised estimate by about 17.5 per cent with revenue from income taxes supposed to increase by 19.8 per cent and indirect taxes by 15 per cent. The direct taxes revenue until October has grown at 29.5 per cent on a year-to-year basis and even if there is a slowdown, it should be possible to achieve the targeted increase of 19.8 per cent for the year. In the case of indirect taxes, however, there could be a substantial shortfall. The post-budget concessions in excise duties were estimated at Rs 30,000 crore. The revenue collections from excise duties so far indicate that it will be difficult to realise even the growth rate of 7.8 per cent assumed in the budget. Similarly, it would be difficult to achieve the increase of 18 per cent in customs revenue. Besides, there could be a shortfall in non-tax revenues, particularly the dividends from public enterprises. Considering all these factors, an additional revenue and fiscal deficit of 1-2 per cent is likely, which is worrisome.
Indeed, calibration of counter-cyclical fiscal policy requires increased spending during the downturn and restraint during the boom. Our inability to restrain spending during the boom leaves very little room for an expansionary stance in the present situation. Of course, the FRBMA targets are not relevant any more, for, they can not simply be adhered to. Those who claim the success of the FRBMA should realise that while it has not helped in calibrating counter-cyclical policy, it has led to creative accounting, opaqueness and reduced efficiency in expenditure implementation. The success of legislated discipline requires ownership by all spending agencies, and not just the Ministry of Finance.
In the prevailing circumstances, how much fiscal stimulus can be given? Keyness solution that government should dig holes in the ground, paid out of national savings, would be appropriate in a situation where it does not crowd out private investment. The limiting case is what Keynes called the liquidity trap where even at zero rate of interest private sector investment would not be forthcoming. This situation has not yet arisen and increased spending financed out of deficits may not result in net increase in investments. The effort should be to create conditions for private investment revival. Financing higher expenditures from borrowing would require the SLR to be increased and if the banks continue to invest in government securities above the SLR requirement, then the policy should be to dis-incentivise them from doing so. On the other hand, if the deficit is monetised, it may increase prices more than the output, if infrastructure bottlenecks persist. More importantly, it was the undesirable consequences that led to the agreement not to monetise the deficits between the RBI Governor and the Union Finance Secretary.
Much of the fiscal stimulus will have to come from reallocating expenditures to infrastructure sectors and keep the implementation of projects in sectors like roads, ports and electricity on a fast track. This is necessary not only to keep up the aggregate demand but also to free infrastructure bottlenecks. Unfortunately, there have been implementation delays particularly in roads and electricity and in the latter, often for want of coal supply tie-up. These must be addressed immediately.
On the tax side, the crisis provides an opportunity to get rid the securities transaction tax. Such taxes increase transaction costs and abolition of this tax would provide the right signal. The loss involved is not much for, although the tax is budgeted to yield Rs 9,000 crore, the actual realisation will be much less. There is also a case for reducing the general CENVAT rate from the prevailing 14 per cent to 12 per cent. This would not entail much loss of revenue for, almost 45 per cent of the Union excise duty accrues from petroleum products and another 5.5 per cent accrues from cigarettes, which are outside the CENVAT system. This will particularly help the construction industry, as almost 16 per cent of the excise revenue comes from iron and steel and its products and cement. The reduction will also help in the transition to GST by reducing the difference between the tax on goods and services. It is critical that the policy measures should activate private investments rather than creating another crisis caused by fiscal expansion.