In the shadow of the deficit

Indian Express, 26th February 2013

Finance minister must strike a balance between poll pressures and imperatives of reform

When Finance Minister P. Chidambaram stands up to present Budget 2013 later this week, he will have to walk a tightrope between a budget that makes investors optimistic about India and one that satisfies his party, especially those in the Congress who want welfare programmes and subsidies. In Chidambaram's earlier stint as finance minister, walking this tightrope was not as difficult as it is today because the economy was growing fast, the fiscal deficit was under control and the current account deficit was much smaller than it is today.

The forthcoming budget is expected to be the last one this government can present. Next year, there might be a vote on account, in view of the elections that will follow soon after. That makes this budget the last chance for the UPA to fulfil all the election promises it made. If Congress MPs feel that they are not going to win the next elections, the desperation to expand welfare programmes will only increase. This could involve a stepping up of expenditure, which the government can ill afford at the moment.

Introducing new programmes like the food security bill, or continuing old programmes and increasing expenditure on them, needs money. With a slowing economy, tax revenue growth is unlikely to be buoyant. Even if the finance minister tries to come up with proposals to tax the rich more, it is unlikely that he will raise much revenue from them. Further, even if he is able to introduce the GST, revenues might not go up in the first year. Infrastructure issues, compensation to states for Central sales tax cuts, and the costs of implementing the new system will mean that he cannot depend on higher tax revenues in the coming year.

So will Chidambaram project a higher budget deficit? No, because that would be a problem with domestic and foreign investors. Consequences of the fiscal deficit, such as higher inflation, private investment being crowded out by large government borrowing and the spillover to the external sector, remain concerns, as in the past. What is new, perhaps, is how close we are to a credit downgrade. If credit rating agencies believe that our fiscal deficit is going to be higher in the coming year, India could get a downgrade. That would push up the interest rate Indian companies have to pay when they borrow abroad.

The domestic banking sector, with its rising number of non-performing assets and loan restructuring, has seen its balance sheets weaken. External loans remain an important source of borrowing for large corporations. Domestic interest rates are also unlikely to come down very much unless inflation goes down, of which there are few signs so far. Unlike in previous years, when the size of the fiscal deficit was an academic debate rather than something that bites the corporate sector, it is different this time.

If Chidambaram is under pressure to increase expenditure in some areas, as his party desires, he has to cut expenditure in others. The freeing up of diesel prices has been an important development in curtailing expenditure. First, it has indicated Chidambaram's commitment to containing expenditure on oil subsidies. Second, the price hike passed relatively peacefully, without creating a political storm, as most people might have expected. This bodes well for the finance minister's plans. He can make projections of not just the oil subsidy going away in the coming year but also of other subsidies going down to provide, for example, for an increase in food subsidy.

The second major concern of business is the investment environment. While Chidambaram set up the Cabinet Committee on Investment a few months ago to speed up stalled projects, investors have not seen any action on that front. It has not inspired confidence and encouraged investment again. With no change in the legal framework, few believe that a government committee could solve the problems. However, many were willing to give Chidambaram the benefit of doubt, and to wait and watch. Here again, we run into trouble with politicians in the party who might want to say they stand for tribal rights, environment and land rights, much more than they would have when not faced with an upcoming election. If legal changes are proposed this year, they may not be in keeping with the kind of balance that India needs to strike between development and the protection of various affected groups. If they are not proposed, investors will continue to have low confidence.

A major concern of the minister would be to keep foreign capital coming in to fund India's large and growing current account deficit. One small mistake in the couple of hours when Chidambaram makes his speech could cause a loss of confidence, months of flight of foreign capital and a depreciation of the rupee. It could be new foreigner unfriendly taxes, such as the GAAR of last year. It could be a capital gains tax, since in India, taxes are not residence based and foreigners are taxed. Or the budget speech could talk about renegotiating the Mauritius double taxation treaty. Or it could be something else that the zealous tax department thinks of in its attempt to reduce the budget deficit. Any tax on capital inflows, at a time when the country needs to finance its current account deficit by attracting them, would not be pragmatic.

Not only does Chidambaram need to be careful about taxing foreigners, Part A of the budget speech, which is the government's reform agenda, has to be persuasive, investor-friendly and inspire confidence. Part B of the speech, which includes his tax and expenditure proposals, has to keep the deficit under control and his party colleagues happy.

With a non-performing government, a party seeking to buy votes, a declining economy, an uncertain global environment, persistent inflation, a large deficit and colleagues wanting an election-friendly budget, Chidambaram clearly has a tough job ahead.