The latest review of interest rates of banks announced by the Reserve Bank of India on May 3 included an increase in short-term lending rate by 50 basis points to 7.5 per cent and short-term borrowing rate by 50 basis points to 6.25 per cent. The RBI Governor, D. Subbarao, has justified this as necessary to moderate inflation even if it means a slowing down of growth in the short run. The gross domestic product (GDP) expectation for 2011-12 has been lowered to 8 per cent. The RBI Governor has warned that high and persistent inflation undermines growth by creating uncertainty for investors and driving up inflation expectations. He has called for an increase in prices of petrol and diesel.
It seems the initial reaction was to treat inflation as a supply bottleneck problem. Later, spurt in demand was considered as the main trigger. Over the last 12 months, the RBI has increased bank rates eight times but the latest one is the steepest. The perception is that these are too late and too little. It is, however, necessary to understand the predicament of the RBI. Monetary policy and tools are not the sole devices to promote economic growth. Fiscal policy is a vital ingredient. These should work in tandem. Any disconnect will lead to unacceptable economic slowdown. The persistent fiscal deficits in government budgets lead to government borrowings which increase the money supply and liquidity in the economy. This is what has been happening in India. The increasing fiscal deficits of the Central and State governments over the last few years have placed the RBI in a difficult position to control liquidity and moderate inflation.
The fiscal problems and issues to be tackled by the government go beyond budgetary deficits. How the revenues are raised and how the public money is spent raise the important role of good governance especially in implementation. Investor confidence in the future is not a quantifiable concept but will be encouraged only by visible proof of good governance. For an immediate and ready example corruption is a virus which is eating into the vitals of the economic system. It pervades the whole gamut of raising and spending public money.
The proposal to set up an apex body to deal with this canker has been in limbo for the last so many years and has been revived only now with the Lok Pal bill and that too by public outcry and protest: the bill is only in the drafting stage and the start has been mired by unnecessary controversy. Black money is a huge drain on the country's wealth and revenues. The action taken so far has not made any dent. The Supreme Court has expressed its displeasure with the non-action in tracking black money. The only response it has got from the government is the proposal to set up a committee to study the problem revealed by the Finance Minister when he presented the central budget in February this year.
The control of fiscal deficit also presents a poor track record. The Fiscal Responsibility and Budget Management (FRBM) Act 2003 has not helped in tackling the root of the problem. There has been obsession with showing compliance with quantitative deficit targets .This has been based on revenue buoyancy and one-time receipts like spectrum auctions. The resulting complacency has sidetracked major fiscal issues and problems. The so called medium-term road map for achieving fiscal consolidation is not based on any time-bound action to identify and reform these problems. The list is substantial covering revenue and expenditure.
These have been covered in detail in these columns in the past. Broadly the problems are fundamental review of government functions, activities and schemes, addressing the policy and implementation issues to reduce subsidies, prioritisation of expenditure, dependency of public sector enterprises on government budget, sick and loss making enterprises due for closure, transparency in budget and accounts, accountability, use of output and outcome budget as a management tool and critical examination of tax revenue forgone which was nearly Rs.5-lakh crore in 2009-10.
Even the computation of fiscal deficit ignores quasi fiscal deficits like those of Central Public Sector Enterprises and Special Purpose Vehicles (SPV). These are relevant in addressing the overall liquidity position which the RBI has to tackle through monetary measures.
Another crucial point in deficit control is the State government deficits and the borrowings which again affect the liquidity in the economy. The Central Government can make the States follow the fiscal path through leveraging funds transferred to them annually as central assistance. But they can do this only if they set their house in order and adopt a reform-based medium-term road map.
The current inflation in food prices deserves a special mention. This seems to be a supply-side problem. The aspects needing consideration and action are modern methods in farming, supply of improved seeds, useful extension service, proper storage for grains, rural loans and improved irrigation and water supply to reduce dependence on rain fed crops. Output and outcome budgeting can be useful in ensuring proper use of irrigation dams and reservoirs to improve efficiency in water use and evolving suitable crop pattern. As a medium-term agenda the Central Government can take action to amend the constitution to make agriculture, water and irrigation a concurrent subject instead of a purely state subject. Interlinking of rivers and canals can also be a long-term project.
In conclusion, what is needed is urgent and time-bound action plan to reform all these issues and not mere promises and studies. For better coordination of fiscal and monetary policies a parliamentary committee can call the Finance Secretary and the Governor of RBI for a joint hearing.