Behind the scenes of an optimistic survey

The economic survey 2021-22 tabled in Parliament today has highlighted the following: (a) that economic growth is projected  at 8-8.5 per cent for  fiscal 2022-23, (b) both in terms of supply side and demand side growth, the Indian economy has moved to more than the pre-pandemic growth level,(c)fiscal space has been created during the period April-November 2021 due to higher revenue augmentation, leading to a lower fiscal deficit and this trend will continue for the whole of fiscal 2021-22, (d) such fiscal space will  help in enhancing further allocation of capital expenditure in the Union Budget 2022-23, (e) inflation remains at elevated levels and (f) the external sector is resilient with a high build up of forex reserves.

Penciling in further higher revenue growth will be detrimental to good fiscal arithmetic and will question the credibility of budget making

This presents an optimistic picture of the Indian economy. But given the persistence of the inflation rate at more than the target (average 4 per cent) mandated in Flexible Inflation Targeting (FIT) coupled with an ambitious economic growth projection, when private sector investment is weak, what could be the fiscal and monetary policy mix as the Budget 2022-23 comes up on Tuesday (Feb.01) and the monetary policy stance is decided on February 07-09, 2022?

Fiscal policy currently is rule-based and is guided by the legislative mandate of the fiscal deficit at 3 per cent of the GDP and debt to the GDP ratio at 40 percent. Going by the reported revenue augmentation in the April–November 2021 period, the fiscal deficit to GDP ratio for the revised estimates for 2021-22 will be lower than the budget estimates of 6.8 per cent. At a conservative estimate, it could be around 6.5 per cent. One important question in this context is: should the Union Budget 2022-23 start fiscal correction and consolidation? The budget will attempt a fiscal correction with a medium-term projection. However, fiscal consolidation with sharper a correction looks difficult as projections of revenue, particularly tax revenue, cannot continue to grow for the second year running in the current circumstances. In this light, penciling in further higher revenue growth will be detrimental to good fiscal arithmetic and will question the credibility of budget making.

Another important aspect is financing of the fiscal deficit and interest rate impact. In a rough estimate, if the fiscal deficit is reduced by a 0.5 per centage point during 2022-23 to 6 per cent of GDP and a major portion is financed by market borrowings (dated securities and treasury bills) as has been the trend, there will be an adverse impact on the interest rate. It may be noted that already the interest rate has moved to a higher trajectory. For example, the interest rate on a 10-year government bond has increased to 6.63 per cent as on January 21, 2022, from 5.95 per cent a year ago.

In the context of the projection of the growth rate of 8-8.5 per cent, we may mention that the higher allocation of capital expenditure is a necessary condition. The sufficient condition is augmenting savings to GDP ratio in the economy. The persistence of the revenue deficit which operationally implies dis-savings of the government continues to drag the savings potential of the economy. Given the downward rigidity in the revenue expenditure to address the reduction of the revenue deficit, what is important is fiscal empowerment (maximising revenue to the budget). This requires moving to a higher tax buoyancy by increasing tax compliance and broadening the tax base.  This is again unlikely to be achieved in the short term.

We may focus on the capital expenditure allocation in the budget. There are two issues which need to be addressed. The budget making process is longer in the sense it takes nearly two years to complete. For example, the time taken for budget estimates to be translated to revised estimates is one year and a further one year is required to make revised estimates accounts or actual figures for public dissemination.  As the evidence suggests, there is a tendency to overestimate capital expenditure in the budget estimate and subsequently reduce it in the revised estimates and actuals.  Second, the higher allocation of capital expenditure does not necessarily reflect the growth enhancing aspect of capital expenditure. What needs to be addressed is the return on capital in relation to borrowing cost to finance it.

Given the higher inflation in US and many other emerging market economies, there is a potential threat of imported inflation in India

The analysis of growth data as released by the NSO reveals that growth has mostly been contributed by consumption expenditure by the government and also by the private sector. This trend is not sustainable, given its inflationary potential. In this context, what is important is potential output and output gap (deviation of actual output from the potential) in a medium-term perspective. The Indian economy has been operating below its potential with a negative output gap. Conceptually, the supply side measures are important to address this issue. One important element in this regard is incremental capital output ratio (ICOR) which states how many units of capital are required in an economy to produce one unit of growth.  Operationally, it means augmentation of efficiency and productivity in the economy, thereby reducing the input cost. These are again long-term measures and cannot materialise in the short term.

Policy intervention is in many ways the art of managing contradictions even at the best of times

During the pandemic, globally and also in India, monetary policy was frontloaded as there was not adequate fiscal space due to the high fiscal deficit and debt relative to GDP. Accommodative stance became the guiding principle coupled with unconventional monetary policy measures. However, the transmission of the monetary policy remained weak as the movement to the credit channel from the interest rate channel has not been encouraging both in terms of cost of credit and delivery of credit. Given the higher inflation in US and many other emerging market economies, there is a potential threat of imported inflation in India. In this context, should the monetary policy (in the ensuing MPC resolution dated February 07-09, 2022) reconsider the continuation of the accommodative stance? It is beneficial for growth to continue with the accommodative monetary stance with no change in the policy repo rate. This is because any increase in the policy repo rate to address inflation will reduce growth rate as the economy will move in a dis-inflation glide path.

In the end, there are tradeoffs to growth and inflation and also tradeoffs in fiscal consolidation and fiscal stimulus. Policy intervention is in many ways the art of managing contradictions even at the best of times. In the current times of a pandemic, it becomes even more challenging.

(The writer is a former central banker and a faculty member at SPJIMR. Views are personal)