Ever since Reserve Bank of India Governor Raghuram Rajan talked about it, “high-quality fiscal adjustment” has become the buzzword for expectations surrounding the contents of this year’s budget. One can’t argue against high-quality fiscal adjustment. It’s like motherhood and apple pie. But it isn’t clear what it means. We know it doesn’t mean meeting the deficit target by squeezing expenditures in the last quarter of the fiscal year; running arrears with oil and fertilizer companies; or getting public sector companies to cough up additional year-end dividends. In the last few years, this has been the sad tale of fiscal consolidation. This year, too, the deficit target will likely be met by using some or all of the above tactics despite a massive respite from the oil price collapse, large ad hoc increases in excise tax on petroleum products, and an all-time-high equity market.
But all this is in the past. More relevant for next year’s budget is what the government makes of the need to make quality fiscal adjustments. If one goes by the exhortations of corporate leaders and analysts, it is essentially increasing capital and lowering social spending (subsidies) as much as possible. Prima facie, the argument sounds fine. Capital (infrastructure) spending is good because it delivers higher and better-quality economic growth. If doing so requires running a higher deficit, it is still not a bad thing because the added expenditure goes into creating productive capacity, rather than being wasted in higher consumption.
No convincing evidenceBut there are a couple of problems with this argument. First, it is very hard to find any convincing evidence, either in India or elsewhere, that an injection of public investment increases medium-term growth. The only discernible effect is that it raises growth in the year the spending occurs, which is exactly the effect that one would expect if the government increased social spending or raised the wages of civil servants.
Does this mean that the government shouldn’t undertake infrastructure projects? Of course not. For a long time now, India has talked about the need for spending a trillion dollars on building infrastructure. The price tag has probably risen quite a bit with the new government adding ambitious river-linking, renewable energy and smart cities projects. The erstwhile Planning Commission, based on the pre-2008 global financial world, had divided the implementation between public and private sectors and how much was to be financed by domestic banks, the corporate bond market, FDI, portfolio inflows, and Central and State budgets. In turn, getting the implementation and funding going would require structural and regulatory reforms, including changes in environmental laws, land acquisition procedures, corporate bond markets, public sector undertaking (PSU) banking operations, FDI and portfolio investment limits.
The world has changed dramatically since then, and it is doubtful whether the pre-2008 calculations would work now. So, to get capital spending right, the government needs to revisit these issues, reformulate the medium-term spending and funding plan, and implement the needed structural and regulatory reforms. That’s the right way to recast public infrastructure spending, and not merely as a way to boost near-term growth, especially when there isn’t any compelling reason to do so. If anything, the global headwinds of the last few years have turned into tailwinds for India. Growth in the G-3 economies is expected to rise, oil prices are forecasted to remain very low, and global financial conditions are expected to remain easy. Under such conditions, it is hard to justify any fiscal boost to growth.
The second problem lies with conflating subsidies with social protection. Subsidies hide the true cost of resources. This leads to inefficiencies. Consider the use of fertilizer: If it weren’t subsidised, farmers would use less of it, instead adopting different and perhaps better farming techniques. So, eliminating subsidies can be a good thing. But the government isn’t planning to do so. Instead, it is aiming to reduce the overall subsidy bill by better targeting through direct cash transfers. This is a welcome step, but it doesn’t improve efficiency much. The government needs to eliminate subsidies while simultaneously expanding targeted and demand-driven social and unemployment protection programmes and untied income transfers, not out of the kindness of its heart, but because such programmes are efficient. They provide fiscal policy the ability to respond quickly to growth booms and slowdowns without going through delays caused by the inevitable lags when government machinery has to identify the need to change policy, decide on the best ways of doing so, and then implement them. Often, by the time the government manages to implement such discretionary changes, the economic conditions alter dramatically.
Four constraintsBut economic growth has stalled in India (notwithstanding recent GDP revisions), and at the centre of this slowdown is languishing corporate investment. There are broadly four binding constraints holding back investment that haven’t changed much in the last few years. In no particular order, India’s environmental laws, land acquisition framework, the structure of public-private partnership (PPP) projects and the high indebtedness of infrastructure companies (the counterpart of which lies in the very high and rising stock of restructured and nonperforming loans among PSU banks) appear to be the constraints. India’s pre-2008 growth miracle was driven largely by corporate investment, not public investment. Unsurprisingly, the growth collapse was also caused by plummeting corporate investment. So, in an obvious way, reigniting corporate investment is the key to getting India back on a sustained high-growth path. Of the four binding constraints, the first two are legislative. But the latter two lie in the purview of the government alone. So, instead of boosting infrastructure spending by a few percentage points, the economy would be much better served if budgetary resources were directed to easing the latter two constraints, either by the government’s taking higher direct stakes in already-approved PPP projects or by increasing PSU bank recapitalisation.
Doing so is likely to get growth going more quickly than the limited sops the government may have planned for corporates and households by way of modest cuts in taxes here and there or a few percentage points of higher public spending that may or may not materialise.
(Jahangir Aziz is Chief Asia Economist, J.P. Morgan.)
