Understanding the FRBM Act

Updated: Dec 6 2004, 05:58am hrs
The Centre has breached the 45% limit of revenue deficit for the first half of the financial year prescribed by the Fiscal Responsibility and Budget Management (FRBM) Rules. As per the Rules, Union finance minister P Chidambaram will have to make a statement in Parliament during the ongoing winter session, explaining the reasons for the breach and the corrective steps proposed. FE takes a closer look at what is the FRBM Act and why it is important.

What is the FRBM Act
The FRBM Act was enacted by Parliament in 2003 to bring in fiscal discipline. It received the Presidents assent in August the same year. The United Progressive Alliance (UPA) government had notified the FRBM Rules in July 2004.

As Parliament is the supreme legislative body, these will bind the present finance minister P Chidambaram, and also future finance ministers and governments.

How will it help in redeeming the fiscal situation
The FRBM Rules impose limits on fiscal and revenue deficit. Hence, it will be the duty of the Union government to stick to the deficit targets.

As per the target, revenue deficit, which is revenue expenditure minus revenue receipts, have to be reduced to nil in five years beginning 2004-05. Each year, the government is required to reduce the revenue deficit by 0.5% of the GDP.

The fiscal deficit is required to be reduced to 3% of the GDP by 2008-09.It would mean reduction of fiscal deficit by 0.3 % of GDP every year.

How are these targets monitored
The Rules have mid-year targets for fiscal and revenue deficits. The Rules required the government to restrict fiscal and revenue deficit to 45% of budget estimates at the end of September (first half of the financial year).

In case of a breach of either of the two limits, the FM will be required to explain to Parliament the reasons for the breach, the corrective steps, as well as the proposals for funding the additional deficit.

What is fiscal deficit
Every government raises resources for funding its expenditure. The major sources for funds are taxes and borrowings. Borrowings could be from the Reserve Bank of India (RBI), from the public by floating bonds, financial institutions, banks and even foreign institutions. These borrowings constitute public debt and fiscal deficit is a measure of borrowings by the government in a financial year.

In budgetary arithmetic, it is total expenditure minus the sum of revenue receipts, recoveries of loans and other receipts such as proceeds from disinvestment.

Do economies need a fiscal deficit
Many economists, including Lord Keynes, had advocated the need for small fiscal deficits to boost an economy, especially in times of crises. What it means is that government should raise public investment by investing borrowed funds. This exercise is also called pump-priming. The basic purpose of the whole exercise is to accelerate the growth of an economy by public intervention. Hence, there is nothing fundamentally wrong with a fiscal deficit, provided the cost of intervention does not exceed the emanating benefits.

The darker side of the story is that the borrowed funds, which always remain on tap, have to be repayed. And pending repayment, these loans have to be serviced.

Ideally, the yield on investment on borrowed funds must be higher than the cost of borrowing.

For example, if the government borrows Rs 100 at 10%, it must earn more than 10% on investment of Rs 100. In that situation, fiscal deficit will not pose any problem.

However, the government spends money on all kinds of projects, including social sector schemes, where it is impossible to calculate the rate of return at least in monetary terms. So, one will never know whether the borrowed funds are being invested wisely.

And how grave is the problem of fiscal deficit
Over the years, public debt has continued to mount and so have interest payments. According to budget figures (revised estimates for 2003-04) the government borrowed Rs 1,32,103 crore. The interest payment during the year was Rs 1,24,555 crore.

What is alarming is that except for a comparatively small sum of about Rs 7,500 crore, more than 94% of borrowed funds are being used to pay interest for past loans. This is what is called the debt trap, where one is compelled to borrow to service past loans.

The other way of looking at the fiscal problem is that more than 66% of government taxes, totalling Rs 1,87,539 crore in 2003-04 were used to pay interest on past borrowings.

Servicing of loans also erodes the governments ability to spend money on critical areas such as health and education and on essential sovereign functions like policing, judiciary and defence.