Vignettes from RBI Annual Report 2010-11

RBI is worried about fiscal consolidation at the Centre, or the lack of it. They do not mince too many words on it. The need to balance consumption and investment is stressed. Government fiscal multiplier is higher for capital expenditure than for government consumption expenditure. Not surprising. India’s inflation threshold is around 4% to 6%. RBI hopes for global growth slowdown but not a crisis. It hopes for a sustained correction in commodities. Otherwise, it is concerned about monetary accommodation in advanced economies. It comes out batting for financial globalisation. Does not fret much about loss of monetary policy freedom. Declining agricultural yields over time and low yields compared to the rest of the world. The Central Bank wants to invoke a raise in the household savings rate which has not gone up since the early years of the Millennium. But, how? Savings are a function of income and employment. So, more jobs and more income needed. So, more and better education and better health too. Presto, the entire gamut of government policy action is required to raise the household savings rate.

The Central Bank is quietly confident of managing the Current Account Deficit. It is taciturn on foreign exchange reserves and is mostly silent on China’s exchange rate.

The Incremental Capital-Output Ratio (ICOR) in the XI Plan Period was 4.5 while the target was 4.1. I doubt if this would be bettered in XII Plan. So, to get to 9% growth, the savings rate has to go up to 38%. Around 33% now. Assume current account deficit of 2%, we need the savings rate to go up by another 3% at least. I think if India achieves 8% real GDP growth in the XII Plan Period, that would be a good achievement. Real GDP would double in nine years and nominal in five years, assuming 6% GDP deflator.

Extension of the ban on mining in Karnataka to two more districts appears, on the face of it, to swing things to the other extreme. Livelihoods are affected either way. Posturings can be at the extremes. Solutions are always in the middle. These kinds of things won’t help India achieve the economic growth rate it needs, to generate employment. Coal, Iron ore, Steel and Power – they are the pillars of a modern economy that wants to grow at 10% and wants to double the contribution of its manufacturing sector to the national economic output.

I present below select paragraphs from the RBI Annual Report on different topics. This post deals with fiscal consolidation. The full annual report is here. Pl. note that RBI fiscal year runs from July to June.

Recent superficial fiscal consolidation and challenges ahead

I.14 Fiscal deficit ratios in 2010-11 turned out to be better than envisaged in the Union budget. Centre’s gross fiscal deficit (GFD) was 4.7 per cent of GDP against 5.5 per cent budgeted. Compared with a GFD of 6.4 per cent of GDP in 2009-10, this was a huge swing.

I.15 A qualitative assessment of fiscal correction during 2010-11, however, raises concerns. Not only did the correction in revenue account reflect more than-anticipated non-tax revenues from spectrum auctions, there has been a spillover of subsidy expenditure from the last quarter of 2010-11 to the current fiscal year. Although the share of capital expenditure in total expenditure increased in 2010-11 from 2009-10, it was marginally lower than the budget estimates. In particular, capital outlay-GDP ratio fell short of the budgeted ratio in 2010-11 and is still significantly lower than that achieved during pre-crisis period. Consequently, in outstanding terms, the Central government’s capital outlay (as ratio to GDP) as at end-March 2011 was lower at 12.9 per cent than 13.8 per cent a year ago.

I.16 Improved fiscal position had a large temporary component arising from a business cycle upswing and one-off revenue gains. This resulted in the improvement in headline deficit numbers. Not counting for the revenue proceeds of two main one-off items – spectrum auction and the disinvestment – the GFD/GDP ratio works out to be 6.3 per cent of GDP during 2010-11. Also, revenue buoyancy was supported by a cyclical upswing that led to above trend growth. So the one-off gains and higher growth in nominal GDP of 20 per cent against the budgeted 12.5 per cent contributed largely to lower deficits, while the permanent component of fiscal consolidation was rather weak.

I.17 Clearly, a more enduring fiscal consolidation strategy that focuses on expenditure compression by restraining subsidies as well as revenue enhancement by implementing Direct Taxes Code (DTC) and Goods and Services Tax (GST) needs to be put into place without any further delay.

I.39 In the context of weakening global economy and the likelihood of some spillovers to the domestic economy during 2011-12, the twin deficits require close monitoring. If the global crisis deepens and domestic economy slows down beyond what is currently anticipated, the fiscal slippage could turn out to be an issue of concern. It could potentially erode the fiscal consolidation achieved in the previous year.  On current assessment, the fiscal deficit in 2011-12 is likely to overshoot the budgeted projections. If the economy slows down beyond what is currently anticipated, the resultant revenue erosion could magnify the slippage. At the same time, the fiscal space to support any counter-cyclical policies is more limited than what existed at the time of the global crisis of 2008.

II.5.7 Expenditure growth remained higher than budgeted for 2010-11, thereby maintaining pressures on aggregate demand. The revised estimates of total expenditure on subsidies (mainly on food, fertiliser and petroleum) remained higher than the budget estimates reflecting the impact of higher international prices of these commodities. Capital expenditure, both plan and non-plan, remained higher than the budgeted levels in 2010-11. On the whole, expenditure growth not only turned out to be higher than that was budgeted for 2010-11 but also accelerated as compared with that of 2009-10.

II.5.17 While restraint on revenue expenditure growth not only ensures that the fiscal consolidation process is sustainable, it also creates a fiscal space for undertaking additional capital outlay, which is essential for infrastructure financing and to provide an enabling environment for sustained economic growth. Nonetheless, going forward, there are certain concerns with regard to fiscal consolidation. First, the ratio of revenue deficit to gross fiscal deficit, which is an important benchmark for assessment of the quality of fiscal consolidation, is expected to remain significantly higher at 74.4 percent in 2011-12 (BE) than 41.4 per cent in 2007-08. This indicates that a large portion of borrowings is used to finance the revenue deficit, thereby reducing the availability of resources to undertake capital outlays, which could have implications for potential growth. With the GFD-GDP ratio budgeted to be lower in 2011-12, higher RD-GFD ratio reflects that fiscal adjustment envisaged during 2011-12 will be mainly through compression in capital outlay. Accordingly, the quality of fiscal adjustment may have long-term implications for growth as fiscal multiplier is generally found to be higher in the case of capital expenditure (Box II.14).

From Box II.14: Fiscal Multiplier higher for capital expenditure

Based on quarterly data for 1996-97 to 2009-10, it was found that government consumption positively impacts GDP growth (both in real and nominal terms) in the short-term. Government consumption multiplier peaks within first three quarters (ranging between 0.11 and 0.20 under alternative specifications), after which the impact is found to peter out. Focusing on impact of Central government’s investment as reflected in annual capital outlays (in real terms), the cumulative multiplier works out to around 1.5 when the multiplier peaks. Thus, cross-country findings as well as the results for India show that government consumption leads to crowding out with size of multiplier being significantly lower than one while investment multiplier, working over the long-run, has crowding-in impact with its size more than unity. This calls for improving quality of public expenditure management by increasingly rationalising outlays towards investment as the Central and State governments revert to the rule-based fiscal consolidation path.

This post originally appeared at The Gold Standard and is reproduced here with permission.