‘The state of government finances ought to cause far greater concern than it does now’
Record global oil prices are threatening the macro economy in more potent ways than through inflation.
With so much, mostly adverse, news about inflation, it is possible to think that there are no other major economic concerns. The spotlight on the price situation is perhaps inevitable. Every Friday when the inflation numbers are out, the markets, consumers and the political parties react. The Government, represented by the Finance Minister, is always on the defensive.
Especially, last Friday when inflation breached the double digit mark and jumped to 11.05 per cent. It may be tempting to think that once inflation comes down in the foreseeable future all our economic problems will come to an end. Unfortunately this is not true. Rising inflation is a symptom and it has its origins in a number of domestic and global factors. At this juncture there are two other macro economic developments that will have major negative connotations for the economy long after the present bout of inflation is contained.
Slipping on fiscal front
The state of government finances ought to cause far greater concern than it does now. To begin with, it is not at all transparent. Even as the government claims adherence to the Fiscal Responsibility and Budget Management (FRBM) Act, the size of the deficits has been increasing. As is well known the government has been resorting to the bond route, which is really a form of booking major items of expenditure outside the budget.
The latest price hike in the retail prices of petrol and diesel as well as cooking gas may be the most visible component of a package designed to bridge the gap between domestic and international oil prices. But without a generous dose of subsidies — given in the form of additional bonds to the public sector oil companies — mere price rise would have only touched the fringes of the problem. There were of course other measures such as cross subsidy by upstream marketing companies and rationalisation of taxes but the bond route has remained supreme.
According to reports, the government will issue bonds aggregating nearly Rs. 110,000 crore this year to compensate the oil marketing companies. Bonds have also been issued to the Food Corporation of India (by way of food subsidies). Subsidies to fertilizer companies too are in the form of bonds. The government subscribed to the rights issue of State Bank of India by issuing bonds.
The government cannot hold on to the fiction that these items are ‘off-budget’ and hence do not come under fiscal deficit. The sheer size of the amounts involved precludes such a course of action. Realising this, Finance Minister P. Chidambaram had said in his budget speech that the government would refer the entire subject to the Thirteenth Finance commission. But there cannot be any dramatic solution. Some future government will have to face up to the task of redeeming these bonds. Large fiscal deficits have always involved a transfer of the fiscal burden over generations.
The upshot for now, however, is that the government’s credibility in the public finance area has considerably weakened. That is as serious as the worsening financial situation. Not all the buoyancy in personal income taxes and corporate taxes can allay the serious apprehension over the fiscal deterioration. According to estimates, the gross fiscal deficit of the Centre and the States will increase to well over 7 per cent of the GDP in 2008-09 from an estimated 5.7 per cent last year.
Apart from the loss of credibility, there will be other negative consequences. The deficits are caused largely by increased subsidies. The government’s borrowings will go up, pushing up interest rates. Money supply will increase and inflation containment through monetary measures will become more difficult. Funds will not be available for infrastructure investment and for other essential areas. Economic growth will surely slacken.
The UPA Government not only legislated for fiscal rectitude but except for one year kept public finance on course by adhering to the targets. Incredible as it may seem it is seen frittering away all its hard won gains on the fiscal front.
Current account deficit
The external sector has been one area that has been in the pink of health, at least until recently. Even now one can argue that there is no threat to economic stability arising out of the external economy. Reserves continue to be healthy, well above $300 billion. The rupee is trading within a range. Exporters and importers do not apprehend any violent swings. Yet, there are lurking dangers. The current account deficit is widening on the back of a growing merchandiser trade deficit. Both these need not necessarily cause alarms. However, the following development should allay any sense of complacency. Recent data reveal that the trade deficit has widened despite a reasonably impressive export performance.
In April, exports in dollar terms grew by 31.5 per cent over April 2007. Global trade has been slowing down this year and it is going to be a challenge for the exporters to keep up the tempo. More to the point, imports of both oil and non-oil have been growing even faster. During April out of a total oil import bill of $24 billion, oil imports accounted for a third. Both in absolute terms as well as a percentage of imports, oil imports are set to rise. Merchandise trade deficit has widened to nearly $10 billion in April 2008, sharply higher than the $6.8 billion during the same time last year.
Worrisome as the increase is, it the almost near certainty of the trend continuing that should alert policy makers. Software exports and other earnings from invisibles will continue to be healthy but may not be able to reduce the trade deficit as substantially as in the past. The U.S. economic downturn will impact negatively on earnings from software. Hence, the current account deficit too will widen to an estimated 3 to 3.5 per cent by the end of year.
This is a real cause for worry, something that cannot be glossed over especially because capital inflows that have propped up the balance of payments cannot be taken for granted.