The fiscal cynics are wrong; it is growth that will shrink the deficit, not the reverse

If the Mid-Year Economic Analysis by the finance ministry, released last week, is any guide, the government will try and meet the fiscal deficit target of 4.1 percent this year, but might change the goalposts from next year onwards so that space is created for public investments in infrastructure.

This has raised hackles in segments of the financial media, with Mint newspaper advising against this, saying that any “fiscal expansion will defeat the hard-won fight against inflation, the product of tight monetary policy over the years.” I doubt the fight against inflation was won purely by the RBI. Fiscal actions - especially the increase in diesel prices from January 2013 by UPA - and moderation in food support price increases by the NDA were also key.

Business Line says the best way to create space for public investment is to increase public sector disinvestment; the Economic Times, while agreeing that private investment won’t be forthcoming any time soon, says bad politics is the real constraint on growth - and offers the mismanaged electricity sector, with high losses due to pilferage and political patronage, as exhibit A. Both points are valid - but do not controvert the need for a sensible increase in public investments in infrastructure.

The truth is many things need fixing, but nothing can be fixed if growth does not trend upwards. Only growth can create the space for the fiscal deficit to be brought under control in reasonable time. Falling economic growth will make any fiscal contraction a self-defeating exercise.

The fiscal cynics are wrong, for history tells us that deficits cannot be shrunk in a situation of slowing growth. In the 2002-2008 period, when the fiscal deficit was brought down significantly from 5.72 percent of GDP to 2.54 percent, it was growth that did the trick. The growth uptick began with the NDA’s investment in infrastructure, but took off vertically once global growth surged during the Bush years - all the way till the Lehman crash.

Since then, the gross fiscal deficit has been in the 4.5-6.5 percent range as growth tapered off. Clearly, there is need for growth in order to shrink the fiscal deficit. But it must be the right kind of growth driven by the right kind of investment in infrastructure.

For growth to revive, someone has to spend: either the government, or the public, or companies. And banks must be willing to lend. But currently, the government is fiscally challenged with low tax revenues, business is stuck with high debts, and so is the public. Banks are unwilling to lend more without more capital or a reduction in bad loans.

This is what is called a balance-sheet slowdown - where no one can expand his balance-sheet due to the burden of unpaid debt. Companies are unwilling to invest as they are trying to pare down past debts. According to India Ratings , part of the Fitch Ratings group, of the 500 largest borrowers from banks, 82 are in debt trouble, and another 83 are teetering on the brink of trouble. By “trouble” we mean banks have categorised the first 82 loans as bad, or have marked them out for restructuring. The other 83, says India Ratings, have “severely stretched credit metrics.” This means their “operating profitability barely covers the interest required to be serviced.” So forget about investing in growth.

Individuals are also trying to do the same. A Times of India report today (22 December) notes that “between 2002 and 2012, the average amount owed by each family has jumped seven times in cities and more than four times in rural areas.” Little wonder, in April-October 2014, sales of consumer durables plunged 16 percent. The public is in no mood to buy things when old debt is constraining them.

Banks are struggling with bad loans. As at the end of June this year, their portfolio of gross bad loans (non-performing assets) was a staggering Rs 2,27,700 crore.

In contrast, despite a bad fiscal position, it is only the government that has the ability to take on more debt and grow its balance-sheet. As the Mid-Year Economic Analysis points out, “It is worth emphasising that India has a fiscal flow problem but not a stock problem because the ratio of government debt to GDP has declined substantially over the last decade due to a combination of high growth and high inflation. Going forward debt dynamics will continue to work in India’s favour as long as growth remains around 6 percent and the primary deficit (fiscal deficit minus interest payments) remains in the current range of 1 percent of GDP. A case not just for counter-cyclical but counter-structural fiscal policy, motivated by reviving medium-term investment and growth, may need to be actively considered.”

In a nutshell this is the case of increasing public investment in infrastructure: banks cannot lend, corporate cannot afford to borrow to invest, and the ordinary public too is struggling with past debt-based purchases. Only the government is comfortably placed on debt, with its debt-to-GDP ratio actually falling. The fact that the fiscal deficit is still high is thus a short-term problem, not something that says government should not raise more debt.

However, it should be obvious that any attempt to ease the fiscal deficit straitjacket next year should be only for infrastructure investment, and not general spending on subsidies or wasteful projects. That part of spending should be held steady so that as GDP grows, it shrinks.

Higher spending on infrastructure, at a time when global growth is low and there can be no export nirvana, will ensure both growth and jobs, as it will stimulate rural and urban incomes without resorting to NREGA-type expenditures on boondoggles.

The priorities for the next budget should thus be:

#1: Increase spending on rural and urban infrastructure - if needed by creating new public sector entities headed by competent professionals. Roads and railways are obvious choices. As TN Ninan points out in Business Standard , higher public spending will be useful only “if becomes feasible only if the government can find men/women who can deliver well-run projects and companies, like DV Kapur who set up NTPC in the 1970s, V Krishnamurthy and RC Bhargava who set up Maruti, E Sreedharan, who set up DMRC, and Nandan Nilekani of Aadhaar fame. We need to find and empower a dozen like them. That is where the government can and should be doing more.” Quite.

#2: To reduce the revenue and fiscal deficits, the magnitude of public sector disinvestments must be accelerated. All banks should be authorised to automatically raise new capital by reducing government stakes to 52 percent, and, at some point, be encouraged to bring down government holdings to 26 percent. Privatisation of some banks is vital, but if that is anathema, government should issue itself a golden share with 51 percent voting rights that can be exercised in some special circumstances, or to issue broad policy directions.

#3: The fiscal consolidation roadmap must focus on bringing the revenue deficit to zero in five years. The fiscal deficit will automatically follow; it won’t matter much if all of the fiscal deficit is only for funding investments.

#4: No part of the fiscal easing should go towards consumption expenditure or subsidies - unless the consumption expenditures are part of the infra projects themselves (like wage payments for an infra project).

#5: Government must fully disinvest its holdings in SUUTI (said to be worth Rs 55,000-60,000 crore) and also its residual stake in Balco and Hindustan Zinc (said to be worth at least Rs 20,000-25,000 crore).

There is no lack of money if there is imagination. Finding the fiscal space for genuine public investment that will crowd-in private investment can be done, as long as the effort is not sullied by pure populism.