Non-inflationary growth is the key challenge

Updated: Jul 8 2014, 06:43am hrs
Most of the macro parameters of the Indian economy indicate a significant improvement compared with the situation in mid-2013. However, reviving the economy and pushing GDP growth higher without stoking inflationary pressure is the main challenge before the government. Post the 2008 crisis, the fiscal and monetary stimuli did revive the GDP growth fairly quickly but could not sustain it as it focused more on demand-side management. In 2014, however, the new government will have to address supply-side bottlenecks on priority over the demand-side factors if it wants Indian economy to return to a sustainable high growth path.

No doubt, curbing inflation should be the top-most priority of the new government. This would necessitate a multi-pronged strategy. While RBI is pursuing tight monetary policy to tame inflation, the government will have to formulate a new agricultural policy to address stubborn food inflation. This policy must address the changing food consumption patterns of Indian households and accordingly incentivise the crop mix and its production. Cutting down the intermediaries between the farm gate and the ultimate consumer should be at the centre of this strategy.

Besides controlling inflation, reviving investment at this juncture is critical to stimulate GDP growth. The Cabinet Committee on Investment has laid the foundation for an investment revival by clearing projects worth 4.9% of GDP till April 2014. The government can kick-start the stalled investment cycle by resolving some of the vexed tax issues such as retrospective taxation/tax disputes and establishing better coordination with states.

The new government can also consider some innovative modes of infrastructure financing. It can allow IIFCL, PFC, NHAI and NABARD to issue bonds of 20-year-plus tenor which can qualify under the provision of RBIs statutory liquidity ratio (SLR) norms. This would not only ensure lower cost of borrowing for these lending institutions but also reduce asset-liability mismatch risk due to the longer tenor. While the government is better off providing viability gap funding to smaller projects, large infrastructure projects can benefit more from equity participation, continuous government supervision and accountability. Most infrastructure projects have a long gestation period and need long-term financing. Also, globally, infrastructure is created by the government.

Another area that requires serious attention of the government is the manufacturing sector. Manufacturing growth, besides directly contributing to tax revenue and GDP growth, reduces unemployment and poverty. Reducing infrastructure deficit is critical to accelerate manufacturing growth, but this alone will not be sufficient. The government will have to focus on a number of areas including facilitating FDI, addressing the financial/technological issues confronting micro, small and medium enterprises, providing training to the labour force and creating a common pan-India market by introducing GST to revive manufacturing growth.

One of the first policy statements of the new government would be the presentation of the Budget, scheduled on July 10. Finance minister Arun Jaitley must continue with the process of fiscal correction. Although many developed economies have fiscal deficit/GDP ratio much higher than that of India, due to a smaller revenue base Indias debt/revenue ratio is much higher than that of other Fitch BBB rated economies. This makes Indias public finance highly vulnerable to growth cycles.

In FY14, Indias debt/revenue was 3.1x compared with the BBB rated peer groups median value of 1.5x. Low revenue base and high committed expenditure is the major hindrance in improving Indias public finance. Interest servicing alone accounted for 36.9% of the total revenue receipts of the central government in FY14 (RE). A higher and stubborn inflation hurts even the government finances via rise in borrowing cost. The average WPI inflation in India over FY02-FY08 was 5.0% (CPI: 4.8%) and the average borrowing cost of the government during this period was 7.4%. However, as the average WPI-based inflation increased to 7.4% (CPI: 10.0%) over FY09-FY14, the average borrowing cost of the government increased to 8.0%. As the interest pay out, along with salary and pension expenses, constitutes a committed/sticky component of current expenditure, any increase in it reduces the governments headroom for expenditure reform/reduction.

According to the interim Budget, the total subsidy for FY15 has been pegged at R2.56 trillion, about the same as FY14 (revised estimate). This works out to be 14.5% of the total expenditure and 2.0% of the GDP. Also, there is a carry-over amount of about R1.15 trillion of oil, food and fertiliser subsidies in FY15 from FY14. Perhaps it is time, instead of treating the unpaid subsidy bill as a carry-over, the government incorporates it into expenditure and state the correct fiscal deficit.

To achieve debt/revenue similar to the BBB peer groups median, India will have to at least double its revenue given its debt level. Besides enhancing tax compliance and reducing tax disputes, the best way to augment tax revenue is to implement DTC and GST at the earliest.

Selling government stake in PSUs is often considered to be an important source of non-tax revenue. The clamour for the government to include an ambitious disinvestment target in this years Budget, more so after Sebis communication to the Union government to reduce its shareholding to 75% in PSUs, has increased.

There is a general perception that this is the right time to offload government holding in the market as share market indices are touching record levels. But despite the need and urgency to augment the overall government revenue, P/E (price/earnings) ratio of BSE Sensex and BSE PSU Index indicates this is not the right time to undertake disinvestment in PSUs due to lower valuation. Disinvestment 2-3 years later, if the PSUs performance based on GDP growth trajectory improves, will fetch better returns to the government.

The government might also gain by improving the overall efficiency of the PSUs before disinvesting. This would be particularly helpful with respect to PSU banks which, according to our calculation, would need R6.8 trillion by FY19 to meet the capital adequacy ratio norms of Basel III. Moreover, Sebi is likely to give a three-year time-frame for PSUs to meet the 25% minimum public shareholding norm.

Sunil Kumar Sinha is principal economist and Devendra Kumar Pant is chief economist at India Ratings and Research (Ind-Ra). Views are personal. This column is based on Ind-Ras report Challenges for the New Government