Rethinking fiscal benchmarks

The main thrust of discourse around the imminent budget focuses on increasing expenditure. Against the acute spending prudence in the outstanding shock of a once-in-a-century pandemic, the advocacy is that the government should now open fiscal spigots to trigger a virtuous cycle. Yet, the consciousness of unsettling market confidence lurks beneath. The fear hasn’t disappeared for the imminent budget’s formulation is still governed by the FRBM Act. The government has not jettisoned this, even though its boundaries were stretched to limits even before Covid-19 and battered beyond recognition thereafter. The absence of consideration of the legal structure in relation to the approaching budget is puzzling because this is fundamental for fiscal policy choices in the next two-three years or the medium-term.

At the heart of budget-setting in any year, including this, are the FRBM rules and medium-term strategy structured around these. These are legally binding, no matter that FY22 budget must respond to a contingency not even remotely contemplated therein; the severest shocks considered in the FRBM Act do not foresee an accident, or act of god if you will, causing output loss of magnitudes as those inflicted by the Covid-19 crisis. The maximum legal break is an extra 0.5% of GDP, used up last year to overcome revenue losses from structural reforms. There is no other allowance beyond this and certainly not for battling pandemics with short-lived as well as enduring damages.

The operational framework continues to serve as a departure point for drawing budget FY22 because the government has never said, at any point, that it is abandoned. But, neither has it ever said anything about revisiting, on which there is total silence. Therefore, commentators view large-scale disinvestments and asset sales to fund larger deficits, repay future debts. However, these are too uncertain a source for financing emergency expenditures, and therefore, can increase doubts about future growth. Rethinking the legal framework from the standpoint of addressing the current crisis remains undiscussed.

As the budget cannot be set without a medium-term macroeconomic strategy, the views or choice of the debt dynamics, inflation and growth in the present exceptional context need a clear articulation to match expenditure commitments. Since the FRBM Act itself is broken and un-rectified but valid, what kind of modification is required? Could it be the inclusion of such an event as an escape clause for, well, a legal break? What would be the additional space required or necessary for its accommodation that can then be budgeted? Or is a pause, i.e., putting the FRBM framework on hold for two years or so, a better option? Should the present debt-GDP caps hold? Or should these be revised up to house Covid-19’s impact?

Either way, there is a careful choice of debt dynamics to allow countercyclical fiscal response required now, and perhaps, another two years, which is sufficient to recoup output losses and return to a stable growth path, with retrenchment thereafter. Fair deliberation and reasoned choices are important for this.

Consider fiscal rules and how these may apply in the present context. Do these constrain or matter from an intellectual standpoint globally where these are not the guiding lights for addressing the pandemic shock? Would India, as an emerging economy, be held to fiscal standards relevant for normal times as opposed to extraordinary ones? Even with a clearly articulated medium-term strategy that specifies post-pandemic retrenchment? The global consensus, including IMF advice, is to spend more/freely now with redemption afterwards as not doing so risks a prolonged recovery that would worsen the forward debt dynamics.

Debt sustainability is a critical question. It is commonly expected India’s debt-GDP ratio will be in the 80% plus region in FY21 against the existing 60% ceiling for general government. There are three choices here: if debt-GDP is to be brought down steadily in the immediate years following; or to be held constant at March 2021 levels for say, next two years; or allowed to rise for the same period before moderating down.

This, of course, is linked to growth and inflation, and the respective medium-term evolutions. Growth calculations, thus, involve acknowledging output losses from Covid-19 shock, and the expected time horizon for the closure of the output gap. How does the faster-than-expected rebound in the second half of FY21 fit in here? Does it imply no permanent effect, ie, trend decline in post-pandemic growth? Then, Covid-19 has overshadowed the fact that pre-Covid growth itself dropped to 4.2% in successive worsening for the third year. How does that accord with current and post-pandemic growth assessment? The answers remain speculated and unknown because debt sustainability continues to rest upon FRBM targets, which are so distant from achievement so as to become irrelevant.

Inflation is by far the most important variable in this equation. How is domestic inflation foreseen when global inflation anticipated remaining low, notwithstanding temporary surprise, outbursts on pandemic-specific factors? The inflation view is crucial for visualising debt dynamics ahead: if the global and domestic output gaps are unusually large as may be, wherefrom are the inflation risks seen? The consensus view abroad, where debt levels have reached vulnerable proportions in advanced countries too, is that debt is sustainable because interest rates are far lower than future growth rates achievable through larger fiscal expansion in the current period. Does this hold for India? Because if it does, the government can be flexible. In any case, these are issues for debate.

It is evident that the overarching question here is if our domestic macroeconomic planning should be restricted by the standard, normal-time concerns, viz crowding-out effects upon the private sector, creation of inflation, etc, and hold down growth when the context is extraordinary and demands a different response. The world, including international agencies, are thinking and acting very differently to accommodate the bizarre settings imposed by Covid-19. Would an approach that serves well for tranquil or normal cycles be as relevant or correct for a pandemic situation? Or could it prove counterproductive?

After all, the whole point of fiscal-inflation rules of the FRBM Act and inflation targeting frameworks is to impart macroeconomic certainty and assure investors of such risks. In the context that defines Covid-19, it is debatable that subscription or adherence to fiscal and inflation certainties could instead lead to demand uncertainties. There is a need to debate around these fundamental norms, and if some notions need rethinking or setting aside for a while. Even if the eventual choices were to stick to these principles because that is what markets and investors will assess emerging economies like India through, the legal, fiscal structure would require modification and change.

In this fundamental sense, the approaching budget is indeed one like ‘never before’. That in itself suggests that expenditure increases—above past levels and in proportion to GDP—could mean a revision or pause of the FRBM Act. The government went into the pandemic in a highly conservative mode. Now, if it wants to spend more, it will have to refer to the legal framework. But it has the choice to think boldly, out-of-the-box, and shall we say, like ‘never before’?

The author is New Delhi based macroeconomist
Views are personal