Core sector growth slows down to 1.8% in November
EGoM on spectrum to meet on 3 Jan

Economy Jan 1, 2013

India’s fiscal cliff: Why Chidu may be praying for inflation

By R Jagannathan

You know things are not okay if, on a New Year's Day, The Economic Times front page has negative news. This pink worthy runs on the belief system that optimism is good for the economy and the markets (and thus its own advertisers). It goes out of its way to tell people the good news, and buries the bad on the inside pages.

But today was different. "New Year starts with a number of reasons to worry", said the lead story in Mumbai. Not to be outdone, Business Standard, which usually steers clear of trying to artificially uplift the mood, started the year with a downer: "Red flags on the economy...." The contrarian was a white business paper, BusinessLine, which painted cheery hues with its "India Inc upbeat on 2013 prospects."

Both cliffs lead to a sheer drop into the abyss of slowdown and financial crisis. AFP

So what forced ET and BS to lower the boom on 1 January?

The answer is not the fiscal cliff the US has been trying to avoid (which it appears to have done), but the emergence of our own twin fiscal cliffs as bigger threats than previously imagined. Finance Minister P Chidambaram is right there, dangling dangerously from the two cliffs-the current account deficit (CAD), which is the difference between what the country earns and spends abroad, and the fiscal deficit, the gap between what the government spends and earns back home.

Both cliffs lead to a sheer drop into the abyss of slowdown and financial crisis. Which is why Chidambaram may prefer inflation to CAD for the July-September quarter, figures for which were available yesterday, is at an unsustainable 5.4 percent of GDP-an all-time high. (For April-September, the figure is 4.6 percent). This means the excess of our import/external payments over incomes is 4.6 percent as big as our annual GDP. We are simply consuming more foreign goods than we can afford to pay for with our export and remittance incomes.

We have to ultimately pay for such excess consumption by either earning more abroad, or by tightening our own belts, both at the government level and elsewhere. Currently, we are managing to pay our import bills by borrowing more...exactly the kind that got Greece and Club Med (Spain, Italy, etc) into trouble. We are allowing foreigners to invest more in Indian debt and equity (net foreign inflows were Rs 1,74,386 crore in equity and debt in 2012, or nearly $32 billion), and also borrowing more from banks abroad, to pay for oil and gold, which continue to be our big imports.

That's the first fiscal cliff we have to negotiate in 2013.

The second one relates to our own government's overspending. Chidambaram revised the fiscal deficit target for 2012-13 upwards to 5.3 percent of GDP, and there is a chance that he will be able to get somewhere there in view of the sharp cutbacks in important government expenditures.

But this cliff is deceptive. The latest numbers show that the deficit in April-November was Rs 4.13 lakh crore, which is 80 percent of the whole year's target. This means in eight months (two-thirds of the year) the government has consumed four-fifths of its outlays-not exactly the best way to stay within budget.

But, Business Standard assures us, since Chidambaram has changed the goalposts (he has raised the deficit target to 5.3 percent from 5.1 percent of GDP), on the revised target the fiscal deficit works out to only 77 percent. Not a spectacular save, but a little less gloomy.

However, the real reason why the deficit situation could ultimately be a bit better is unrelated to the government's efforts. It may depend on inflation. The fiscal deficit figure is calculated on a 14 percent GDP growth figure (real growth plus inflation), and a lot would depend on how the two figures add up. If real GDP growth is, say, 5.6-5.8 percent, and inflation is, say, 7 percent, we get a money GDP growth figure of 12.6-12.8 percent.

In short, if the money GDP figure grows slower than the assumed 14 percent, the fiscal deficit will look worse in percentage terms.

Chidambaram will thus be praying that inflation remains high so that the fiscal deficit remains at 5.3 percent.

However, serious expenditure compression may be happening for unstated reasons. An earlier Business Standard report said that a quarter of over 100 spending departments had not spent even a third of the money allocated to them for 2012-13 till October. And since ministries are allowed to spend only 33 percent of a year's total outlay in the last three months, these ministries will not end up spending their full allocations this year. That will save Chidambaram some blushes.

His ability to meet the fiscal deficit target thus depends on two variables-inflation, which he will be hoping will be higher, and spending, which he will be hoping will be much lower, with ministries unable to spend their outlays.

Clearly, India is dangling between the CAD and fiscal deficit cliffs-and the remedy for both is to spend less, both at home and abroad. At 5.4 percent (CAD) and 5.3 percent (fiscal deficit), the cliffs look equally dangerous, and the answer to one means dealing with the other as well. Both spell slowdown and/or higher inflation in the short run.

Spending less at home means following deflationary policies, which could include the following:

One, increasing energy prices, especially diesel, so that demand will cool off. As demand cools, oil imports will come down and bring down the fiscal deficit, even as subsidy expenses are brought down in the budget. But this will push inflation up via the cost route.

Two, raising interest rates-or holding them at the current level for longer. But Chidambaram has been shouting from the rooftops about the need to bring down rates. If the RBI finally succumbs to this pressure, Chidambaram will end up fanning the same fires that he has to douse-a rising CAD, and rising inflation spurred by cheaper money. If higher growth spurs a further rise in CAD, the rupee will take a toss, and accelerate inflation.

Three, drastically cutting government expenses, which will have the short-term effect of reducing domestic demand, and hence accentuating the slowdown. A further slowdown will reduce revenues and hence inflate the fiscal deficit. But it will cut down the CAD.

With his political bosses breathing down his neck with elections round the corner, Chidambaram may thus opt for high inflation as the lesser of many evils. But that will leave the fiscal cliffs where they are, as the rating agencies and international investors fret about where this will all lead.

by R Jagannathan

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