Budget attracts hawks of inflation

But India makes some smart moves

By all accounts, India’s fiscal policy and Budget 2010 can be termed bold, innovative and futuristic, although spiralling prices will invite hawks of inflation, creating political and social disgruntlement.

Managing a country of 1.3 billion people with diversity of income and expectations and a $US 1.2 trillion economy is a formidable task.

Instead of tinkering with hems, Finance Minister Pranab Mukherjee has gone for the whole nine-yards, addressing a number of critical issues, the most important of which was to cut the budget deficit to 5.5% of the Gross Domestic Product (GDP) this year and to 4.8% during fiscal year 2011-2012.

But given the need to maintain the tempo in the economy on the face of global economic meltdown, the Government may not be able to curtail its ‘stimulus spending,’ especially since Foreign Direct Investment (FDI) may not flow as per forecast this year.

Indian Newslink analysis of the Indian Budget would place the deficit at 6.5% of the GDP for the current fiscal year, somewhat in the range expected in the Government’s earlier Policy Statement and Economic Survey.

Unenviable Position

Mr Mukherjee has proposed that public spending would peak to about Rs 11.08 trillion (about $US 280 billion), accounting for a rise of 8% over the past year.

Government borrowing has been set at a whopping Rs 4.57 trillion ($US 100 billion), although almost all borrowings would be in the domestic market, through bills, bonds and redeemable debentures.

India is in an unenviable position. Set to foster economic growth, which has been among the highest in the world over the past two years, the Government faces a series of challenges, including managing political and social unrest in the wake of a hike in fuel prices included in the Budget.

Worst of all, the economy would be battling inflationary pressure, which would certainly prompt the Reserve Bank of India to raise the Official Cash Rate. The current interest of 5.75% may not be sustainable, given the pressure building in various segments of the economy.

A number of private banks have already put up their lending rates for home and car loans, signalling increases in other areas of loans and advances in the near future.

Mr Mukherjee has committed his country’s economic growth at 9% for the current financial year, a task that could be daunting; for, with the private sector remaining somewhat lukewarm to the Government’s programmes and policies, much of the burden would be shifted to the public sector. This in itself may be ironical, for India is committed to a ‘tactical balance’ between public and private sector involvement in infrastructure development, manufacturing and services.

Economic growth at 9% could be sustainable, provided the Government makes available appropriate incentives to local and foreign investors. Many large public sector contracts are now being awarded on the condition that foreign contractors and suppliers invest a third of the value of the contracts in India, producing components or providing services and employing Indian labour. Companies such as Boeing have agreed to such a condition, creating a win-win situation.

Inflationary bites

The economy has been witnessing runaway growth in inflation, placed at 8.56% in January 2010. “We expect inflation to touch around 10% by next month and remain in double digits for few months.” 

Wholesale food prices rose by 17.58% (for the week ended February 13), almost all of which were passed on to consumers.

The Government has raised the price of petrol by 6% and diesel by 8%. The move to levy an excise duty of one rupee (less than two US cents) per litre on petrol and diesel has already led to a hike in fuel prices.

There is an inherent risk in such spiral, for high prices of essential commodities tend to erode personal savings, lower business confidence and impact the investment climate.

Inflationary pressures would also come from higher disposal income, especially among the middle-income group, orchestrated by tax relief (see chart).

Economists in India expect inflation to rise to 10% this month and remain in double digits for a few months.

Tax cuts

One of the most interesting aspects of Indian budgets in recent years is the sincere attempt by successive Governments to lower the rate of taxation and lift the threshold so that an increasing number of people can remain outside the taxation system.

It was in reinforcement of this objective that Mr Mukherjee raised the income threshold in this year’s budget to Rs 160,000 ($US3520), reduced the tax rate of people earning up to Rs 500,000 ($US11, 000) to 10%. The rate of income tax has been capped at 30% for income from Rs 800,000 ($US 17,600) and above.

It is no surprise that tax reforms have divided public opinion. While one school of thought believes that lower taxes lead to reduced costs and increased productivity, another would say that reduced revenue would constrain the Treasury to cut public utility services. This argument has been active in New Zealand as well.

Mr Mukherjee has not yet specified how he would achieve the objective in the Indian context. What should be borne in mind is that the level of tax evasion continues to be high (unlike New Zealand) with a thriving “Parallel economy” of hoarders, evaders and perpetrators of other economic offences.

Creeping into this scenario is the complexity of levies, duties and taxes of the State Governments to boost their own income. Prices of most commodities including petrol, diesel, fruits and vegetable vary between States.

Mr Mukherjee told the Indian Parliament that the symptoms of economic recovery were more widespread now.

“The improvement of the economy encourages a course of fiscal correction. India should become the world’s fastest-growing economy within four years, surpassing China,” he said.

But in an interview with Financial Times of London, he admitted that there were problems in implementing a number of structural reforms.

“The Congress Party lacks majority in Parliament. This is an obstacle to raising the cap on foreign investment in the pension and insurance sectors and in improving governance. But we hope to achieve 10% annual growth because of the steps that we have taken in recent years,” he said.

The Annual Economic Survey released by the Government on the eve of the annual budget was one of the finest documents that clearly spell out the objectives and the challenges faced in achieving them.

Business Consultant Gaurav Bhalla said India had opted for “inclusive economic growth, with increased spending on infrastructure and social and agricultural sectors.

“Most of the stimulus measures remain intact as the Government targets about 10% growth over the medium term. The roadmap for fiscal consolidation, direct tax measures and lower-than-expected borrowings are other key positives,” he said.

His analysis accounts for rallying markets in most parts of the economy, except fast-moving consumer goods. The increase in infrastructure spending, re-capitalisation of public sector banks and other measures towards inclusive development are likely to boost corporate earnings, he said.

“Markets which had initially rallied on better-than-expected fiscal deficit projections, reversed gains towards close of day on concerns about possible deficit overruns and the limited room for RBI. We expect the long end of the curve to remain under pressures, while short rates will depend on RBI’s actions,” he said.

The above analysis is Indian Newslink copyright, prepared with the assistance of our New Delhi based reader K Prashant.

Read our editorial, The imbalance of handling deficits in this section