July 6 (Bloomberg) -- India's new government has given a strong hint that its annual budget on Thursday may turn out to be the country's much-awaited first step on the long, arduous -- and ultimately rewarding -- road to fiscal prudence.
On Friday, the finance ministry vowed to cut the budget deficit by 0.3 percent of gross domestic product annually. The pledge has been included in a law, the Fiscal Responsibility and Budget Management Act, which came into force yesterday.
There's more. If by mid-year, the deficit is more than 45 percent of the annual target, the government will be required to take corrective action, and make a statement in parliament. From April 1, 2006, the government can't borrow from the central bank.
For investors, who have driven down the Sensex stock index by 17 percent this year, and caused 10-year bond yields to rise as much as two-thirds of a percentage point, it's the first good news since a communist-supported alliance came to power in May, raising concerns of higher public spending, bigger budget gaps, lower sovereign ratings, and costlier capital for companies.
Standard & Poor's made it clear as early as May 31 that the government had no choice. ``The 2004 budget,'' the rating company said, ``will be the litmus test of either fiscal consolidation or the continuation of India's parlous fiscal record.''
Why are investors and credit rating companies making such a big deal of the deficit when the Indian economy grew 8.2 percent in the first quarter of this year, a rate second only to China's 9.8 percent among the world's top 20 economies?
Deficit Poses Risks
For an appreciation of the risks, recall India's 1991 balance-of-payment crisis, when the country's foreign currency reserves were almost depleted.
In the year to March 31, 1991, the combined budget deficit of India's federal and provincial governments was 9.4 percent of GDP. Today's situation is no different. The total deficit for the year ended March 2004 is expected to have been 9.1 percent. Meanwhile, the government's indebtedness has risen: Public debt now equals 77 percent of GDP, versus 62 percent in 1991.
What may be preventing another crisis is that unlike in the mid-1980s, when India started running large current account deficits possibly as a result of high budget deficits, the country now has the comfort of a record current account surplus, thanks, largely to booming software exports. India now has foreign exchange reserves that can pay for 19 months of imports.
Many economists say that a developing country like India should run a small current account deficit, and finance it by foreign capital. A current account surplus and rising foreign currency reserves are signs an undervalued domestic currency may be curbing private consumption and investment.
Drag on Rupee
However, for the authorities to allow the rupee to appreciate, the budget deficit must narrow. Else, we could again see a crisis of confidence among investors. There's already some nervousness that a part of the unprecedented $22.7 billion of capital inflows into India last year may reverse once the U.S. Federal Reserve raises interest rates further.
Thus, by adopting the Fiscal Responsibility law days before the budget, Finance Minister P. Chidambaram may be seeking to lessen investor concerns, and at the same time laying the foundation for higher economic growth.
The promise is ``likely to reassure jittery investors,'' says Rajeev Malik, an economist at J.P. Morgan Chase & Co. in Singapore. The federal government's deficit in the year to March 31, 2005, will be brought down to 4.2 percent of GDP, from 4.5 percent in the previous 12 months, Malik estimates.
Investors' attention will shift to the mechanics of how Chidambaram will meet his goal. Will he focus on the numerator of the deficit ratio, or take refuge in the denominator? In other words, will the government's debt sales reduce? Or will economic growth coupled with quickening inflation increase the nominal GDP, so that the deficit ratio falls even with higher borrowings?
Bond Market
The difference will matter to the bond market.
``A modest rise in the borrowing program has already been discounted,'' S.P. Prabhu, head of fixed-income research at IDBI Capital Market Services Ltd., a primary dealer in Mumbai, said on Saturday. ``However, if the rise in the borrowing program is large, concerns of oversupply of paper will dominate the sentiment,'' Prabhu said in a research note to clients.
If the finance minister is serious about keeping a tight rein on borrowings, the only option before him is to raise tax revenue. A surcharge on personal and corporate income taxes to finance education is widely expected, as is a plan to raise the tax rate on banking, railway, insurance and other services.
It'll be interesting to see how Chidambaram proposes to increase -- in the eight remaining months of the current fiscal year -- revenue from services, which account for more than half of GDP and yield just 3 percent of the government's total taxes.
The finance minister has set himself a tough target. If he fails, ``it will be a loss of credibility for him,'' says Saumitra Chaudhuri, economic adviser at New Delhi-based credit rating company ICRA Ltd. ``It would be difficult to explain why the targets can't be met in the first year itself.''
No comments:
Post a Comment