3% fiscal deficit no holy grail, raise capex to mitigate pain

Just as Indian industry shrugged off the disruptions of demonetisation, things fizzled out again. We are off to a wobbly start in the second quarter. Industrial production declined by 0.1% on an annual basis in June after 2.8% growth in May. This is the first contraction in four years, and it was primarily due to production cuts to reduce inventory ahead of GST implemen-tation. This impact is expected to spill over to July as well. Moreover, export growth continued to moderate for the fourth consec-utive month. The annual export volume growth contracted in July. Of course, this is in line with other nations in the region.

The GST-related issues also resulted in a sharp fall in July manufacturing PMI. It was the steepest fall since the 2008 financial crisis, plumbing to its lowest in more than eight years. PMI, or the Purchasing Mana-gers’ Index, is an economic indicator based on monthly surveys of private sector companies. In tandem with the manufacturing sector, the services PMI also contracted.

The press release stated, “Firms expressed a lack of knowledge regarding the GST and expect more clarity in the near term to lead to activity growth”. This is the second dip in economic activities after the demonetisation surprise. However, the silver lining in the PMI survey is the rise in the future activity index – both in manufacturing and services – indicating that firms expect this GST impact to be transitory, with some rebound in the coming months.

On the positive side, consumption remained on a firm footing. Although overall import growth moderated, consumption goods imports (such as electronics), reflecting domestic demand, stayed strong. Two-wheeler sales growth, indicating discretionary consumption, continued to remain robust.

It is investment, particularly private investment, that has failed to pick up. Private investment had contracted in the quarter ending March 2017. The latest data does not evoke any confidence on the revival of investment. The July data for imports shows that investment goods imports (like machinery and project goods) have continued to stay weak.

Against this backdrop, the central government needs to increase public expenditure. However, it is constrained by its fiscal deficit target. Capital expenditure by state governments has been squeezed by the Seventh Pay Commission recommendations and farm loan waivers.

On the other hand, Foreign Direct Investment (FDI) flows into India are blazing high, registering a growth of a whopping 37% during the April-June 2017 quarter. It has been empirically proven for India that there is a causality between FDI and GDP — a stable GDP growth in India attracts FDI inflows which, in turn, boosts domestic investments. So, FDI inflows can complem-ent domestic investments in the long run.

The various reforms, including GST, will be unsettling in the short-term. But these will bring about long-term structural benefits. These measures will improve transparency, increase the tax base, channelise more savings into the formal banking system, and help expand public finances over time. However, to avail these long-term benefits, the government needs to cushion the economy from immediate pain.

Loss of traditional jobs

The GDP growth, though respectable from a global perspective, is not enough for our economy. Growing below potential for consecutive quarters has risks — the foremost one being employment. Digitisation, technology improvements have resulted in the loss of traditional jobs.

Even GST implementation has led to the closure of many border checkpoints which has improved logistics but resulted in job losses at these points. These employment losses have led to greater dissatisfaction. The growth estimates fail to capture the large informal part of the economy and are way out of sync with ground realities. It is absolutely essential for the central government to increase public capital spending to mitigate these short-term disruptions.

In the budget, the government had announced a target of fiscal deficit (FD) at 3.2% of GDP this year and expects to bring it down to 3% in the next three years as per the new Fiscal Responsibility and Budget Management (FRBM) Act.

The monthly fiscal numbers show that maintaining deficit target might be difficult considering the shortfall in non-tax revenues. The expected windfall in tax revenues from GST might be just enough to offset the shortfall. Although many believe that the government should maintain fiscal discipline and its hard-earned credibility, this is definitely not the time to cut down on capital expenditure.

For an emerging economy like India, to borrow to build capital assets should be considered a positive. The real focus should be revenue deficit (RD), which needs to be reduced to zero. Increased public capital expenditure will reverse the falling investment cycle. This will lead to capacity creation, reduce infrastructure constraints, increase productivity and hence potential growth and finally crowd in private investment.

We know that the RBI keeps underlining the importance of maintaining the fiscal deficit target in order to control inflation. It is true that large fiscal slippages in the 2008 budget, just prior to the global financial crisis, and the government’s inability to bring it down in subsequent years led to double-digit inflation. But the entire slippage in deficit during that time was for boosting final consumption and not creating capital assets. So, there should be a distinction between good and bad deficit.

As we move into the second half of the year, it is imperative to increase capital expenditure. The avenues for these expenditures can range from highways, ports, modernisation of railway stations and safety facilities, low-cost housing, dredging of riverbeds, etc. This will revive economic activity, create low and semi-skilled jobs and also boost several sectors like cement, steel, etc.

It is possible for the government to even issue special infrastructure bonds to meet these expenditures. Under the present conditions, as the economy is losing some steam, we need to understand that 3% fiscal deficit is not the holy grail.

(The writer is a research scholar at IIFT and adviser at Policy Monks. Views are personal)