The global crisis has brought in fiscal stimulus policy across the world with expansionary public spending as a counter-cyclical measure to enhance aggregate demand in the economy, which has been identified as a major solution to revive the economy from the slowdown. Consequently, in India also, three fiscal stimulus
packages have been unveiled since September 2008 to help the economic recovery and to curtail job losses.
These stimulus packages were largely in the form of reduction in taxes and duties and to some extent to export sector and they have had little impact on the demand. Following this, there were high expectations that this Union Budget would unveil some more measures.
As expected, this time around the fiscal measures have concentrated largely on public investment that too in infrastructure project that has emphasis on rural sector. This stimulus measure to cost the exchequer (both Central and State) of Rs 61,000 crores, and is expected to revive the rural demand and help the economy recovery. It may also be noted that this fiscal support would also address the infrastructure bottlenecks particularly faced in the rural sector.
Hence, while in the short run this measure can create additional rural demand, in the medium term it addresses the infrastructure constraint. In addition to this, there are various other measures such as enhancing outlays for long-pending infrastructure projects and various flagship programs such as NREGA that have pushed the Budget deficit to 6.8% of GDP for the year 2009-10, which is substantially higher than 2.5% targeted in 2008-09 Budget.
Although economy is passing through an unusual period, it is necessary to examine how far the expansionary fiscal policies can go and what is the impact of these expansions in short and medium term on the private investments and, hence, on the overall macroeconomic stability. In other words, is there is a limit for fiscal stimulus?
Based on our empirical exercise, we do think that there are limits to fiscal stimulus. At the current circumstance, it is estimated that 5% as the threshold fiscal deficit that Indian economy could afford to have. Any fiscal expansion above this is found to have adverse impact on the private investments, which is identified as the principle growth driver in the recent years. This is also expected to affect the effectiveness of monetary policy.
It may be noted that although RBI has reduced the policy rates sharply, the response from the commercial banks was very less and this benefit was not transmitted to consumers. This is because banks have perceived that the sharp rise in government borrowing could increase yields on government securities and also create liquidity constraints. This perception has already made monetary policy ineffective. (One may note that, although there is a room following negative inflation, RBI is not cutting rates).
To sum up, with further rise in Budget deficit to 6.8%, one might achieve short term objectives. But this could increase medium term growth risk and could prolong the recovery process. We ultimately need to get back to fiscal discipline with a new Act.
Although one may argue it is not the right time for talking fiscal discipline, a road map is very much needs to be in place. Otherwise, there is a risk of downgrading by the international credit rating agencies, which could adversely affect foreign investments. The Economic Survey: 2008-09 talks of zero deficit situation, but the Budget ignores this issue.