Is India ready to face another bout of global recession? World Bank report explains all

What if the world economy were to go into another bout of recession? How prepared is India to face it? Does it have the elbow room to again go in for an expansionary fiscal policy similar to 2008-09? If it doesn’t, it needs to create some. That is the message coming out of the World Bank’s Global Economic Prospects released today. Only countries with adequate fiscal space can take steps to counter the effects of a recession, the report argues, and advises countries whose fiscal space has narrowed as a result of stimulus measures taken in the light of the Great Recession of 2008-09 to return their fiscal positions to more sustainable levels. The report defines fiscal space as simply having enough budgetary resources to take counter-cyclical or other measures without jeopardizing the government’s coffers or the economy itself. It points out that countries with “more ample fiscal space” used stimulus measures more extensively during the recession than those with tight fiscal space. What’s more, wider fiscal space also makes the stimulus measures more effective, the report argues. One measure of the effectiveness of fiscal policy, it notes, is the fiscal multiplier, or the effect of a unit of government spending on gross domestic product (GDP). Based on a modelling exercise, the report found that fiscal multipliers hovered around zero when the fiscal space was narrow but could be as high as 1.8 over a long time horizon when fiscal space is wide. “Fiscal space would help ensure that fiscal policy remains available as a countercyclical policy tool. A wider fiscal space would not only increase the likelihood that fiscal stimulus is a feasible policy option, but would also improve its effectiveness.” The report suggests three ways in which fiscal space can be strengthened – drawing up of fiscal rules (setting ceilings on debt, deficits, expenditures), stabilization funds (setting aside funds saved during favourable times to cushion against shocks) and medium term expenditure frameworks (setting out a credible plan for expenditure over a certain number of years). [caption id=“attachment_1635749” align=“alignleft” width=“380”] Reuters[/caption] In more concrete terms, Kaushik Basu, senior vice-president and chief economist at the World Bank, believes it is time developing countries started to seriously address the issue of fiscal deficits. He suggests that oil-importing countries should lower or even eliminate fuel subsidies and “rebuild the fiscal space needed to carry out future stimulus efforts”. India seems to have done just the opposite, squandering fiscal space when it should have been building it up. Remember that in the mid-2000s, the country was on track to meeting the Fiscal Responsibility and Budget Management (FRBM) Act’s target of reducing the fiscal deficit to 3 percent of GDP by 2008 and eliminating the revenue deficit. But the United Progressive Alliance (UPA) government threw fiscal caution to the winds. Even as the FRBM rules were notified, then finance minister P. Chidambaram, in his first budget, moved an amendment to relax the target for eliminating the revenue deficit by one year. In his second budget, he pressed the pause button on FRBM targets. Instead of shoring up government revenues during the boom period, the government  went on a spending spree on programmes like NREGA and a Rs 60,000 crore farm loan waiver, among other things. That both of these adversely affected the economy in other ways is a separate issue. Then came the Great Recession and Pranab Mukherjee, who was then the finance minister, announced a series of stimulus measures totalling 3.5 percent of GDP, which sent the fiscal deficit soaring to 6 percent of GDP. Nobody grudged the stimulus package, but this was not accompanied by steps to save somewhere else. Besides, the phasing out of the stimulus package was delayed. Chidambaram, who returned to the finance ministry when Mukherjee became President, had said publicly that the withdrawal should have started a year before it actually did. Would the economy have fared better if India had a larger fiscal space than it did in 2008? The World Bank report suggests that it would; the stimulus measures would also have been more effective. What now for Chidambaram’s successor, Arun Jaitley? How does he go around reclaiming the fiscal space and creating a buffer for the next recession, whenever that happens? The Mid-Year Economic Analysis has suggested stepping up public expenditure to perk up the economy and this could lead to a narrowing of the fiscal space, which means a very thin cushion against any external shock. But the Global Economic Prospects report does not recommend a cookie-cutter approach; it acknowledges that fiscal multipliers will depend on the unique conditions of each country and its economy. Basu suggests a way out, noting that the quality of the fiscal deficit is as important as the size. “Emerging market economies would do well to invest in infrastructure and support social schemes vital to poverty reduction. Such policies can raise future productivity and reduce the fiscal deficit in the long run,” he suggests. Clearly, then, it will make sense for Jaitley and his team to focus on capital expenditure on physical infrastructure, which will have a huge multiplier effect on the economy. Though Basu talks of spending on social sector schemes, this need not mean a continuation of untargeted subsidies and poorly designed schemes like NREGA and the National Food Security Act. As chief economic advisor to the government during the UPA regime, Basu had constantly recommended a reform of the subsidy and welfare programmes in order to bring down the subsidy bill. Jaitley and his chief economic advisor Arvind Subramaniam need to ensure that a slightly expansionary policy to revive the economy does not cut too much into the fiscal space that the economy will need, given the turmoil the world economy appears to be heading for. It’s a precarious tight-rope walk, but one that will have to be attempted. As Ayhan Kose, director of development prospects at the Bank, warns, “the need for additional fiscal buffers is more pronounced now in an environment of uncertain growth prospects, limited policy options and likely tighter global financial conditions.” Hopefully North Block will pay heed.