News that GDP growth has slowed considerably to 5.3 per cent in the fourth quarter of 2011-12, as compared with 9.2 per cent in the corresponding quarter of the previous year, could not have come at a worse time for the government. While quarterly GDP estimates tend to be revised substantially, the evidence that the GDP growth rate has been consistently declining over the four quarters of the last financial year and that the fourth quarter rate is the lowest in nine years makes it imperative for the government to respond.
However, other aspects of the emerging economic scenario make the choice of that response difficult. There are three disconcerting aspects of that scenario that are being widely referred to. The first is inflation, which had moderated and the government was hoping would just go away. However, the annual month-on-month rate of inflation as measured by the national Consumer Price Index had risen to 10.4 in April, from 9.4 per cent in March, 8.8 per cent in February and 7.7 per cent in January. Hence, the government may find it difficult to persuade the Reserve Bank of India to announce a substantial reduction in interest rates in order to spur growth. Even if the impact of a reduction of interest rates on growth is not likely to be dramatic, such a move would have served to signal decisive action.
The second is the evidence that lower export growth resulting from the global recession combined with a rising bill on account of both oil and non-oil imports is widening the trade and current account deficits with attendant adverse effects on GDP growth. The deficit in the net exports component of GDP has risen from around Rs 316,000 to Rs. 413,000, and contributes to dampening rather than facilitating growth.
Thirdly, international investors are being less enthusiastic about investing in India, partly because of challenges they are facing elsewhere in the world. That is adversely affecting the rupee that is already weakened by the rising current account deficit, leading to s sharp depreciation of the currency.
These features of the current scenario are hindering the government’s resort to the most obvious countercyclical response to recession -- an increase in spending as at the time of the 2008 recession. If everything else remains the same, an increase in spending would require accommodating a larger fiscal deficit than would have otherwise been the case. This, the fiscal conservatives argue, is unacceptable, because of the already high level of the fiscal deficit, placed at 5.8 per cent of GDP in 2011-12. Moreover, influenced by the misplaced view that a higher fiscal deficit necessarily results in higher inflation, they warn of the dangers of hiking the fiscal deficit in an already inflationary environment. The government, given its own predilections is inclined to agree. It is also concerned that foreign investors would disapprove of a higher deficit, turning investor reticence into investor flight.
So increased spending would be acceptable only if it does not setback the government’s commitment to significantly reduce the fiscal deficit to GDP ratio in the near future -- a task made difficult by the slowdown in GDP growth. In normal circumstances this would mean that the government would have to raise more resources through taxation to finance spending aimed at reviving the economy. But times have not been normal for some time now because of the campaign to freeze and reduce direct taxation. Taxes, argue the rich and the corporate sector, create disincentives to save and invest and must, therefore, be kept to the minimum. The government too seems convinced, possibly with reason, that more taxes on corporate incomes and stock market returns would adversely affect foreign investor sentiment. So talk of mobilising resources through higher taxation is avoided.
This, of course, leaves the problem at hand unresolved. How should the government respond to the downturn that threatens to take the economy into a recession? One answer avoids the question by holding that all would be well if the government is able to continue with reform and even achieve its deficit reduction targets. That argument, if meaningful at all, must be based on the presumptions that growth is slowing because private investment is down, and that investment is falling because the slackening of the pace of reform has discouraged private investors. This is indeed a strange argument because it suggests that while reforms in the past have spurred investment and growth, that reform, even when not reversed, cannot keep investment going. Only a process of never-ending reform can consistently drive investment.
Recognising the problem with such an argument, a completely different package is being put forward by a section of the business community to revive growth without hurting corporate interests. They advocate a step up in public expenditure, especially investment, to revive demand and growth, but hold that such an increase in expenditure should not b financed with borrowing or taxation, but by a reduction in subsidies. The “strength” of that argument lies in the fact (see Chart) that recent increases in the central fiscal deficit to GDP ratio have been accompanied and partly “explained” by increases in the ratio of major subsidies to GDP. So if subsidies can be substantially reduced, it is asserted, it should be possible to step up investment expenditure without increasing the fiscal deficit.
What is being ignored here is the impact of a reduction in subsidies. In 2011-12, subsidies on food and petroleum together accounted for 70 per cent of the outlay on major subsidies (on fertiliser, food, petroleum and interest). These are the subsidies that would have to be reduced if expenditure is to be significantly curtailed. However, neither of these subsidies are easily cut. Reducing food subsidies is near impossible given the government’s commitment to substantially increase the population’s access to subsidised food, with even the diluted Food Security Bill promising to cover 70 per cent of the population. Going back on that commitment when inflation is high and growth slowing would be amount to betrayal of a majority that has been left in malnutrition at the margins of subsistence.
Further, in recent times the increase in the subsidy bill has been more on account of petroleum than food, because of increases in international oil prices. The share of the petroleum subsidies in outlays on major subsidies rose from less then 6 per cent between 2004-05 and 2008-09 to as much as 34 per cent in 2011-12. So curtailing the subsidy bill would require a sharp increase in the prices of petroleum products in the manner done recently with petrol. Being universal intermediates, such an increase in the price of petroleum products would accelerate the current inflation in the prices of necessities. That would not just be politically suicidal but also detrimental to growth.
The implication is clear. The government would have to find ways of financing an increase in expenditure to counter the downturn, while addressing with separate policies any impact this may have on inflation or the balance of payments. But with strong interests working against the choice of such a policy package, there is a real danger that nothing would be actually done. That would take the economy into the recession that it had managed to stall since the onset of the global crisis in 2008.