Download Summary of Economic Survey 2016-17

Summary of
Economic Survey
2016-17
Chapter 5 & 6
BY Ayussh Sanghi
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Chapter 5 - Fiscal Framework: The World is Changing, Should India Change Too?
Introduction:
 Steady decline in the fiscal deficit from 4.5 percent of GDP in 2013-14 to 4.1 percent, 3.9 percent, and
3.5 percent over the successive three years.
 Since the 2008-09 Global Financial Crisis (GFC), monetary policy has experienced a paradigm shift.
 Near-zero interest rates, quantitative easing in the form of exploding central bank balance sheets and
even to negative interest rates so that economic agents are actually paid to hold money.
 Now that monetary easing has run its course, attention has increasingly turned to the role of fiscal
policy.
 Fiscal policy can legitimately be used for counter-cyclical policy
 The new view of fiscal policy shifts the emphasis from stocks to flows, arguing for greater activism in
flows (deficits) and minimizing concerns about the sustainability of the stocks (debt).
 These flow and stock vulnerabilities are the subject of review under the new FRBM Committee.
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India and the World: Flows
 Like some European countries, India is still afflicted by the twin balance sheet problem, which is
holding back investment and credit growth and hence overall economic activity.
 The need for countercyclical policy cannot therefore be ruled out.
 Two episodes of Indian macro vulnerability in the last 35 years—1991 and 2013—were associated
with, even preceded by, large increases in fiscal deficits.
 In the early 1980s, there was an expansion in spending and deficits in response to accelerating growth.
 The inability to rein in these deficits played a key role in undermining India’s external situation, which
led to the balance of payments crisis of 1991
 The difference between the 1991 and 2013 episodes is that in the former there was a fixed exchange
rate which created a full-blown crisis, whereas in the latter the exchange rate was floating which
attenuated disruptions in other asset prices.
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India and the World: Flows
 India’s fiscal stance has an in-built bias toward higher deficits, because spending rises pro-cyclically
during growth surges, while revenue and spending are deployed counter-cyclically during slowdowns.
 This pattern creates fiscal fragility.
Fiscal commitment
 India is very different from many other emerging markets, especially those in Latin America (and
Russia) which have defaulted on their domestic obligations while India has not defaulted on its domestic
debt either de jure or de facto (through long periods of high inflation).
 In the recent past, India’s highest level of debt has been 83 percent of GDP and it has made sure that
its debt service obligations have been conscientiously met.
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India and the World: Stocks
 India is on a convergence path. Being relatively less developed, its growth rate for the next decade or
two is likely to be substantial.
 The country has grown at just over 6 percent in real terms for 35 years and the scope for continuing
this convergence remains considerable.
 India can grow conservatively at about 7-8 percent for the next 15 years
 Country’s primary deficit, that is the shortfall between its receipts and its non-interest expenditures is
a vulnerability.
 In simple words, India’s government (centre and states combined) is not collecting enough revenue to
cover its running costs, let alone the interest on its debt obligations.
 As a result of running a primary deficit, the government is dependent on growth and favourable
interest rates to contain the debt ratio.
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Conclusion
 It has now been thirteen years since the FRBM was enshrined in law and the basic principles of
prudent fiscal management elaborated.
 Back in 2003, the economy was fairly small and still relatively closed to the outside world, generating
per capita incomes that lagged far behind that of other emerging markets.
 Today, India has become a middle income country. Its economy is large, open, and growing faster
 India’s economy is converging toward the large, open, prosperous economies of the West.
 But its trajectory is different in one fundamental way. While India’s pace of growth has quickened in
the past quarter century, the dynamism of advanced countries has ebbed (declined), particularly since
the Global Financial Crisis.
 Back in 2003 there was common agreement that fiscal policy should be aimed at medium-term
objectives such as reducing the stock of debt rather than shorter-term cyclical considerations.
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Chapter 6 - Fiscal Rules: Lessons from the States
Introduction:
 India like several other countries, embarked in the mid-2000s on an ambitious project of fiscal
consolidation, adopting fiscal rules aimed at curbing fiscal deficits.
 The most well-knoswn and best-studied part of this project was the Fiscal Responsibility and
Budget Management (FRBM) Act, adopted by the centre in 2003. This Act was mirrored by Fiscal
Responsibility Legislation (FRL) adopted in the states.
 Most states achieved and maintained the target fiscal deficit level (3 percent of GSDP) and
eliminated the revenue deficit after the introduction of their Fiscal Responsibility Legislation (FRL).
 The average debt to GSDP ratio accordingly fell by 10 percentage points to a mere 22 percent of
GSDP in 2013.
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Chapter 6 - Fiscal Rules: Lessons from the States
Introduction:
The deficit reduction owes much to favorable exogenous factors:
 An acceleration of nominal GDP growth (of 6 percentage points on average) helped boost state's’
revenues by about 1 percent of GSDP.
 Increased transfers from the centre of about 1 percent of GSDP both because of the 13th Finance
Commission recommendations and the surge in central government revenues.
 Reduced interest payments of about 0.9 percent of GSDP on account of the debt restructuring
package offered by the centre
 Reduced need for spending by the states—estimated at about 1.2 percent of GDP—as the centre
took on a number of major social sector expenditures under the Centrally Sponsored Schemes (CSS)
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Summary of the Fiscal Responsibility Legislation
The deficit reduction owes much to favorable exogenous factors:
 The FRL aimed to impose fiscal discipline through a number of mechanisms
 Fiscal targets were established, which were the same for all states: the overall deficit was not
allowed to exceed 3 percent of GSDP at any point
 The 12th Finance Commission allowed states to borrow directly from the market, in the hope that
investors would also exercise some discipline, by pushing up interest rates on states whose fiscal
position had not improved.
 Broad public discipline was enhanced by introducing new reporting requirements.
 States were required to publish annual Medium-Term Fiscal Policy reports, which would project
deficits over the next three to four years, accounting for growth in big ticket expenditure items like
pension liabilities.
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Summary of the Fiscal Responsibility Legislation
 The 14th Finance Commission (FFC) recommended that fiscal deficit limits were to be relaxed by
0.5 percentage points for states which meet three conditions:
i)
zero revenue deficit in the previous year
ii)
debt to GSDP ratio lower than 25 percent; and
iii)
interest payments to GSDP ratio less than 10 percent of GSDP
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Impact on Deficits
 A decade into the FRL, the average primary deficit was just as large as it was before the law – and
the only reason this slippage hadn’t shown up in the other deficit figures was that interest payments
had fallen sharply, in large part due to the centre’s debt relief.
 There was a statistically significant 0.86 percentage point decrease in revenue deficit that can be
attributed to the FRL in the first two years.
 There is a 0.7 percentage point decrease in the fiscal deficit in the first two years.
 The primary deficit does not exhibit a significant decrease even in the first two years and in fact
rises in later years.
 This is consistent with the hypothesis that the major decreases in the fiscal deficit came from the
reduction in interest payment.
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Off-budget expenditure
 A crucial concern with any fiscal rule is that it would encourage governments to shift spending off
budget.
 These off-budget items are difficult to measure since the instruments may vary by state, are
difficult to quantify and are not centrally compiled and accounted.
 These expenditure channels undermine the power of fiscal rules.
 Prior to the FRL states added guarantees worth on average 0.9 percent of GSDP each year.
 But in the first three years after FRL adoption the flow of explicit guarantees actually turned
negative, meaning that states actually reduced the stock of guarantees outstanding as they allowed
old ones to expire without giving commensurate new ones.
 After three years, states began to add guarantees, at about the same pace as before
 FFC thus recommended the notion of “extended debt”, which includes guarantees to public sector
enterprises.
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Budget Process
 If states were truly committed to their FRL, it is expected that they would try to generate accurate
forecasts of revenues and expenditures, so they would not be forced to make large spending
adjustments at the end of the year to meet their deficit targets.
 In the pre-FRL period budget estimates of own tax revenue are on average 5.9 percent higher
than actual own tax revenue. This means that states were on average very optimistic when
preparing their budgets.
 After the FRL, there is sharp drop in the magnitude of the revenue forecast errors.
 The errors actually turn negative, budget forecasts of own tax revenue, for example, are on
average 0.6 percent lower than the actuals after the FRL. The same caution is seen in estimates of
expenditure
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Budget Process
 There is also a rise in state cash balances.
 As states have become increasingly dependent on central transfers, which can be delayed or
arrive in lumpy amounts far exceeding the immediate requirements, they have tried to smooth their
expenditures by holding large cash balances.
Unspent funds are being converted to intermediate treasury bills (ITBs).
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Assessment
 The contribution of the FRL may really have been much more subtle than the headline deficit
numbers suggests.
 A few years after the FRL, all indicators of fiscal performance—deficits, expenditures, and
especially off-budget activities—started deteriorating.
 Centre has also prevented this deterioration by exercising Article 293 (3) of the Constitution.
 Under this clause, States must take consent of the Centre for additional borrowing since they all
had borrowing outstanding throughout the post-FRL period.
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Lessons for Future Fiscal Rules
 As the fiscal challenges mount for the states going forward because of the Pay Commission
recommendations, slowing growth, and mounting payments from the UDAY bonds, there is need to
review how fiscal performance can be kept on track.
 There may need to be greater reliance on incentivizing good fiscal performance.
 The Fourteenth Finance Commission (FFC) attempted to shift toward incentives by relaxing some
of the FRL limits for better-performing states.
 Greater market-based discipline on state government finances is imperative.
 The chequered fiscal history of India of the last 15 years has been a saga of fiscal prudence on the
part of the states and fiscal profligacy by the center.
 States have alleged that the centre has not only been imprudent but at the same time been the
instrument of forcing prudence upon the states.
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