India’s fiscal policy should focus on rebuilding buffers, price stability

The policy recommendations made by the International Monetary Fund (IMF) in its staff report for 2023 Article IV consultation states that the priorities should revolve around replenishing fiscal buffers, securing price stability, maintaining financial stability, accelerating inclusive growth through comprehensive structural reforms while preserving debt sustainability.

The first policy recommendations talks of elevated public debt, which calls for ambitious medium term consolidation while continuing to prioritise capital spending. This should be complemented with a sound medium-term fiscal framework to promote transparency and accountability and align policies with India's developmental goals. It also adds that sovereign debt risks are moderate and are mitigated by the composition of debt.

During Covid-19, India, like other nations, incurred extra expenditure to meet the critical situation, both on the economic front and on health grounds, which resulted in its fiscal deficit reaching highest level of 9.2 % of GDP. However, India was prudent in its fiscal management during the pandemic by focussing on Atmanirbhar Bharat Abhiyan, policy reforms, measures to provide policy support to MSMEs and introduced PLI Scheme for 13 select sectors to attract large investments, among other such timely initiatives. It also released direct benefit cash transfers aimed at the weakest strata of society coupled with supply of food grains to the lower income households.

This resulted in fiscal deficit reaching at 9.2% of GDP as at FY 2021 as against 4.7%of GDP in FY 2020 as the government tax and other collection also suffered with negative growth in economy.

Prior to this we had fiscal deficit of 4.1%, 3.9%, 3 .5%, 3.5%, 3.4% in FY 2015, FY 2016, FY 2017, FY 2018 and FY 2019, respectively.

However, India recovered substantially in terms of economic growth in FY 2022, while also prioritising capital spending, which has a multiplier impact on infrastructure spending on roads, railways, ports, airports and reduced the fiscal deficit to 6.7% of GDP in FY 2022 and 6.4% of GDP as at FY 2023.

For FY 2024, it has kept a fiscal deficit target of 5.9% of GDP, apart from laying down the medium term target of achieving 4.5% by 2025/26.

Against this, the combined fiscal deficit of Sates remains broadly unchanged at 2.8%, below the medium term deficit target of three per cent.

The IMF report states that over the medium term, the fiscal deficit is projected to gradually decline while public debt is expected to remain elevated but risks of sovereign stress are moderate.

Like many other countries, India had to breach the target of 3% of GDP prescribed by Fiscal Responsibility and Budget Management (FRBM) Act 2018, which specifies a target debt to GDP ratio for the Central and State governments of 40 and 20 per cent, respectively, to be achieved by 2024/25, along with a ceiling on the fiscal deficit for the central government of three per cent. As stated in earlier data, even prior to Covid 19, India had to breach fiscal deficit target due to the macro-economic situation at the relevant period. However due to prudent fiscal policies, and focus on enhanced revenue, prioritised allocation and expenditure rationalisation, India has attained control on fiscal deficit which also resulted in consistent improvement in GDP growth.

The general government debt above 66 per cent of GDP is estimated to have a detrimental effect on growth but with current debt levels at around 81 per cent, returning to these debt levels in the near future is not realistic (Pattnaik and others, 2023).

Hence the report suggests what is needed as part of the revamped medium term fiscal framework is a medium term numerical anchor and fiscal strategy that are consistent with India's developmental goals, while rebuilding fiscal buffers at an appropriate pace. It adds that numerical fiscal rules signal the government intentions clearly and increase accountability, while the broader framework can incorporate flexibility in response to shocks.

One more area stressed by the IMF is that fiscal plans should take into consideration long-term risks and challenges such as climate change.

Towards this, the investment needed to reach net zero by 2070 has been estimated to be between four and eight per cent of GDP per year (Ghosh and others 2023).

The IMF further adds that if India were to finance this investment with the current mix of funding sources, this would push debt to over 130 percent of GDP and increase annual financing needs to around 27 per cent.

The Union Ministry of Finance clarified on December 22, 2023 that among the various favourable and unfavorable scenarios projected by the IMF, under one extreme possibility, like once in a century Covid-19, it has been stated that the central government debt could be "100 per cent of debt to GDP ratio" under adverse shocks by FY 2028. It talks only of a worst case scenario and is not fair accompli.

As the IMF report also talks of favourable circumstances, the central government debt to GDP may decline to below 70 per cent in the same period and hence the interpretation that the Central government debt would exceed 100% of GDP in the medium term is misconstrued.

It is a fact that India is figuring better amongst other countries like Japan, Singapore, the USA, France and the UK, whose debt to GDP is above 100 per cent whereas India is at 81%.

However in these periods of uncertainty both geo political, climate shocks, natural disasters, it is necessary to have substantial fiscal buffers and keep a control on reducing fiscal deficit by expanding revenue sources, enhanced tax to GDP ratio, ensuring no leakage or avoidance in both direct and indirect taxes, at the same time put a stricter control on expenditure by rationalisation and proper allocation to productive and capital sectors, reduce the burden of subsidies wherever feasible and the medium term fiscal framework of reaching the desired target of fiscal deficit.

We must continue our efforts to widen the base of alternative renewable energy sources with enhanced investment in additional capacity creation projects and bring in down our over reliance on fossil fuels as we are importing which will have cost implications as well as foreign exchange outflows.

This requires that both government and private sector investments sustain the pace to maintain and enhance the GDP growth. It is therefore imperative to maintain further fiscal tightening to rebuild buffers at a faster pace, safeguarding against shocks. Reducing both central and state government borrowings is also necessary as interest costs has also gone up recently and interest costs account for nearly a fifth of the Centre's total expenditure. Hence enough room for expenditure supporting long term growth like infrastructure, social sectors like education, health and climate change mitigation and adaptation are to be achieved, which are absolutely essential costs of investment.

While appreciating both Central and State Governments prudent fiscal policies, both direct and indirect liabilities like guarantees, as recently suggested by RBI working group paper on state government guarantees, necessary control and proper fiscal plans to keep within prudent limits, are to be undertaken in the period ahead.

(The author is former Chairman & Managing Director of Indian Overseas Bank)