India’s recent budget prepared by incumbent bureaucrats, not incoming politicians. It represented continuity—which surprisingly was endorsed by much of the post-budget commentary—when the need of the hour was change. The following analysis focuses on macroeconomic rather than real sector policies. Modi’s vision deserves the highest of grades but the substance and the policy actions were not equal to the goal.
In fairness, the new government has had limited time to put personnel in place and prepare politically for the implementation of its policies to restore confidence and generate growth. That may yet happen. For now, observers and critics should be forthright in their assessment of the 2014 budget. But they should also give this government the benefit of doubt and time to translate its laudable vision into recognizable reality.
The budget is about more than headline deficit numbers. But fiscal policy is hugely important, and when correctly measured, this budget will either entail no fiscal adjustment or even some fiscal relaxation.
Such a relaxation would not normally be a source of concern and might even be warranted. But these are not normal macroeconomic times for India. These are unusually fragile times. Inflation is running at 8.5 percent, a rate that is among the highest in the emerging markets. Fiscal deficits are at 7 percent of GDP, and the current account deficit is at 2 percent of GDP, kept in check only by a growth collapse and controls on the imports of gold. A terrible monsoon is about to produce lower growth, higher inflation, and increased expenditures. Oil prices could soar because of global trends, and above all, asset prices, especially the stock market, have bubbled to such high levels that a small trigger could lead to capital outflows and a sharp, disruptive correction in asset prices. This budget needed to anticipate these contingencies by creating a cushion to withstand possible shocks.
More broadly, a basic misunderstanding is driving complacency in fiscal policy. The budget and its analysts alike have focused on the medium term path of fiscal adjustment. This path is important but not critical. On fiscal policy, India has a flow problem, not a stock problem.
India’s debt-to-GDP ratio is not critically high and has in fact been going down because of high inflation, which has boosted nominal GDP. Inflation has been bad for consumers and savers but great for debtors and a bonanza for the biggest debtor of all, namely the government. On the other hand, the flow problem stems from high fiscal deficits keeping inflation high and the current account under pressure.
This distinction leads to different conclusions for fiscal adjustment. The stock perspective argues for modest and steady improvements in the deficit. But a flow perspective argues for greater and faster adjustment because of the fragile state of the macroeconomy described above.
Accordingly, the budget should at least have started reducing the aggregate fiscal deficit by 0.3 to 0.5 percentage points. Instead, the fiscal deficit might deteriorate further, moving in the opposite direction in light of India’s fragile situation.