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Focus on fiscal not monetary issues
January, 08th 2010

The government must get its priorities right in exiting from the financial stimulus of 2008-09. Exit is important but not urgent. The world might suffer a double-dip recession in 2010, so exit must not be too fast. Although inflation in India is very high, it is concentrated in food items after a major drought, and this situation cannot be rectified by tight money.

So, first priority should be fiscal consolidation, at a measured pace. Within fiscal consolidation, top priority should be given to slashing subsidies for petroleum products. However, this is a politically-difficult exercise that the government has long dodged, and it will happen, if at all, only in dribs and drabs. The next priority in fiscal consolidation is to reverse, at a measured pace, the cut of 6% in excise duty and 2% in service tax as part of the financial stimulus.

The government should increase excise duty by 1% and service tax by 0.5% every quarter, starting in the April-June quarter. Within 12 months, a decision will also have to be taken on the shift to a universal goods and services tax (GST). A sub-committee of the Finance Commission is said to have recommended rates of 5% and 7% respectively for the new central and state GST.

These rates would be ideal once all production is captured in the tax net through serious systemic reform. Pending that, we could consider rates closer to 8% apiece for the central and state GST. If all goes well and the GST provides a huge revenue bonanza by massively checking evasion, GST rates can be lowered later. But it would be very risky to do so straightaway.

Monetary policy merits much lower priority in exit policy. Bank credit to the commercial sector has been decelerating for months, and surplus liquidity is sloshing around in the financial system. This is the very opposite of overheating. The RBI can raise the cash reserve ratio, mopping up surplus liquidity.

But it should not raise interest rates at this stage, when a double-dip recession is still a possibility. If, instead, the world economy strengthens, and non-food inflation accelerates in the next six months, that will be the right time to hike interest rates.

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