On July 24, 1991, when Manmohan Singh, then finance minister (FM) of India, rose to present the ‘historic’ budget, the Indian economy was tottering. Foreign exchange reserves, at less than $1 billion, were barely enough to cover a few weeks of imports and the country was on the verge of defaulting on its debt obligations. India’s short-term foreign debt (due for repayment in less than a year) stood at $13.6 billion while total forex reserves (including gold) totalled just $5.8 billion. The country had already suffered the ignominy of pledging its gold reserves to raise foreign loans to tide over the immediate crisis. The oil shock after the August 1990 Gulf War (oil prices tripled during this period), and two years of political instability, had left India facing its worst financial crisis in its post-Independence history. Though the $250 billion economy was growing at 5 percent, inflation was running amok (it touched a peak of 16.7 percent in August 1991), fiscal deficit was over 8 percent of the GDP and the rupee, pegged at Rs 14 a dollar, left exports wholly uncompetitive.
The Congress government led by PV Narasimha Rao, which came to power in June 1991, had devalued the rupee by 18 percent and announced a new export-friendly trade policy. The world expected a lot from Singh’s maiden budget. And he did not disappoint.
Singh charted a new course by exposing the controlled Indian economy to market forces. The liberalisation he unleashed ended License Raj, allowing industry to add capacity based on market demand and supply, opened up the economy to foreign competition by reducing import duties and took steps to rein in the unsustainable fiscal deficit by increasing the prices of petrol, diesel, kerosene, LPG and fertilisers. The Opposition accused the government of selling out to the International Monetary Fund and the World Bank. But, barring a minor rollback in fertiliser prices, Singh managed to get his budget proposals through Parliament.
Twenty-five years on, when incumbent FM Arun Jaitley rises to present the 2016 Union Budget on February 29, the now $2 trillion Indian economy is in a sweet spot with strong macro-economic parameters. Inflation is low at less than 6 percent, interest rates are falling, fiscal deficit (3.9 percent) is manageable, the rupee is stable (compared to other emerging market currencies) and forex reserves are comfortable at $349 billion. Despite headwinds in the form of a sluggish external environment, India grew at 7.2 percent in 2014-15 (as per the Central Statistics Office) and is expected to grow at 7.6 percent in 2015-16. In fact, last year, the Indian economy has achieved the distinction of becoming the fastest growing major economy in the world.
These favourable conditions, however, do not make Jaitley’s job any easier. The public and industry both expected the Narendra Modi-led NDA government, which came to power in 2014, to quickly accelerate the economy and usher in the promised ‘achhe din’. That it is still work in progress has proven to be frustrating. “This is a very important Budget. The Modi government should get the resource allocation and execution right. It is almost two years into this government and it cannot be talk, talk and talk. You cannot blame the Opposition for all the challenges,” says Vijay Govindarajan, the Coxe Distinguished Professor at Tuck School of Business in the US, and a keen India watcher. The government’s pro-growth credentials are at stake like never before. About 96 percent of the CEOs and CFOs surveyed in the Forbes India-BMR Advisors Pre-Budget Poll have said that Budget 2016 will be very important in strengthening the government’s pro-growth image.
If, in 1991, the world expected Manmohan Singh to show that India had the wherewithal to overcome its financial crisis, it now expects Jaitley to lay down a clear roadmap to take the Indian economy to the next level of growth.
But it is in this that the FM faces many a dilemma.
Dilemma 1: Public Investment vs Fiscal consolidation
In last year’s Budget, Jaitley deferred the fiscal consolidation roadmap by a year and used the resources so released to boost public investment in infrastructure by Rs 70,000 crore. Consequently, resources were pumped into roads, urban development and railways. As of last November, spending in the road sector rose by 63 percent, urban development by 31 percent and railways by 12 percent.
In the run-up to this year’s Budget, the chorus for doing an ‘encore’ to up public spending at the cost of fiscal consolidation has reached high decibel levels. Reason: Despite last year’s public investment boost, the overall investment as a share of the GDP stood at just 31.2 percent in the first six months of the current fiscal (2015-16) as against 38.6 percent in 2007-08 when the investment cycle peaked.
Proponents of public investment, such as Dani Rodrik, professor of International Political Economy at Harvard University, use this data, and the fact that two other engines of growth—exports and private investment—are not delivering, and consequently holding back the economy. Exports are expected to decline by 13 percent this fiscal and private sector investment as a share of GDP has gone down from 17.3 percent in 2007-08 to 12.6 percent in 2013-14. “In the current state of our economic cycle, public investment will crowd in private investment,” says Ajit Ranade, chief economist at Aditya Birla Group.
Differences of opinion have emerged on whether it should be at the cost of fiscal consolidation. “It is important for us to send the right signal about our commitment to fiscal prudence,” says Ranade. Samiran Chakraborty, chief economist-India at Citibank, agrees. “We cannot be delaying it every year. We will lose our credibility,” he says.
Reserve Bank of India Governor Raghuram Rajan waded into this debate while delivering the 4th CD Deshmukh Memorial Lecture and urged the government to stay on the path of fiscal consolidation. “The consolidated fiscal deficit of the states and Centre in India is by far the largest among countries we like to compare ourselves with; presently only Brazil, a country in difficulty, rivals us on the measure,” he had said.
But a majority of the 30 economists that Reuters polled recently preferred higher public spending even if it means a slight slippage in reaching the fiscal deficit target of 3 percent of GDP. Rodrik recently argued in a newspaper article that “if public investment serves to accumulate instead of spending on salaries and subsidies it is a viable growth strategy in a hostile global economic environment”. Even rating agencies Standard & Poor’s and Moody’s have said that India’s sovereign rating will not be affected if the government steps up public spending and defers fiscal deficit targets.
What they have not indicated is how far the government can go. “Considering that the fiscal multipliers in the economy are presently low, public investment will crowd in private investment only if the quantum of investment is large,” says Chakraborty. “That means government deviating from its fiscal target by a large margin.” Such a move could push up market-linked interest rates resulting in a capital outflow from portfolio investments in government and corporate debt (which stands at $60 billion) apart from triggering a rating downgrade. India is currently at the lowest notch of investment grade.
Dilemma 2: Reviving private investment using fiscal incentives vs Conserving resources
Jaitley had recently said that he will focus on reviving private investment. “Any economy needs multiple engines of growth,” he had emphasised. Now, economists expect him to offer fiscal incentives. But will that work?
Consider that private sector investment has declined for many reasons. Domestic demand has been low, with no clear signals of revival. Industry typically looks at a five-to 10-year outlook for making an investment decision. Exports have also been declining. All these factors have left industry with low capacity utilisation (below 75 percent). Also, companies have been squeezing their assets more effectively in recent months and that is reflecting in higher operating margins. According to Morgan Stanley Research, operating margins of companies are approaching an all-time high and are at 27.5 percent. That apart, corporates are over-leveraged. Private sector debt at present equals 70 percent of GDP, compared to 40 percent when the investment cycle picked up in 2004-05. Then there is the issue of high interest rates.
The Free Trade Agreements (FTAs) that India has signed with many of its trading partners are also thwarting a revival in private sector investment. Take the steel sector, for instance. Import of finished steel rose by 7 percent in 2014-15 and 30 percent in 2015-16, taking advantage of zero or negligible duties. Today, imports account for 15 percent of India’s demand, while capacity utilisation is under 80 percent.
From a global perspective, FTAs have an impact in other ways too: Under FTAs, it makes sense to manufacture in the most efficient region, and export. But tax anomalies in India complicate matters. “While SEZs are offered tax benefits for exports, they have to pay duties for sales within India. This makes importing from another country cheaper,” says Ranade. “India must first sign FTAs with its SEZs.”
Considering these issues, offering fiscal incentives may be akin to throwing good money after bad; Jaitley could instead focus on improving the ease of doing business, help companies deleverage their debt and finance stalled projects.
Dilemma 3: Boosting consumption vs Encouraging savings
Boosting consumption is one way to get the industry to utilise excess capacity and start investing. Jaitley could choose to use this strategy to convert some of his challenges into opportunities.
Dilemma 6: Rural distress and long-term pain vs Short-term relief
The rural sector, reeling from two consecutive monsoon failures, will get significant attention in this budget. About 302 of the 640 districts in the country have experienced deficit rainfall. Rural demand for tractors, two-wheelers and FMCG products has fallen. Poor rainfall and the lack of long-term investment in agriculture are beginning to hurt India’s food security. In January, the country imported corn for the first time in 16 years. Experts warn of more imports across foodgrains next year.