The economic policy of the United Progressive Alliance, or UPA, was marked by missed opportunities because of its failure to carry forward economic and administrative reforms.
The legacy it leaves behind is the largest-ever combined fiscal deficit (a measure of the resource gap between the government’s expenditure and revenue, which is met through borrowing) in India’s history at close to 12% of gross domestic product, or GDP, which would leave the next government with hardly any fiscal space to spend on its priorities.
Signs of the fiscal deficit slipping out of control have begun to hurt India’s sovereign rating, which would eventually increase the cost of overseas borrowing for companies. “The management of fiscal policy has been myopic. It has been characterized by a lack of concern and preparedness for the medium-term,” said D.K. Srivastava, director, Madras School of Economics.
A fallout of the UPA government’s five-year approach to fiscal policy is that when economic growth is slowing down, the government’s fiscal stimulus revolves around tax, which has a weaker impact.
India’s integration into the global economy came without domestic reforms to cushion the economy from global volatility. When US investment bank Lehman Brothers Holdings Inc. collapsed in September, Indian companies, whose timely payment of taxes is critical for running the government’s rural programmes, found themselves hit hard.
In the next two months, tax collections began to contract and the government’s antidote to the problem has left its balance sheet in tatters and begun to blunt monetary policy tools at the Reserve Bank of India’s (RBI) disposal.
Two areas where the UPA needed to carry out sweeping reforms to capitalize on the near 9% growth during its first four years were the financial sector and administrative reforms such as creating a mechanism for better targeting of subsidies.
UPA, like its predecessor, National Democratic Alliance (NDA), functioned within the constraints of a coalition. The difference was that UPA survived on the legislative support extended by the Left, opponents of market-oriented reforms.
Opposition from the Left thwarted some of UPA’s showpiece legislation to reform the financial sector. Bills aiming to increase foreign investment in insurance, align voting rights in private banks to shareholding and introduce pension reforms did not receive the Left’s backing in Parliament.
Some economists, however, feel the Left played a positive role. “In March 2006, Prime Minister Manmohan Singh said that the country is ready for full capital account convertibility. In hindsight, it would have been a disaster had the government gone ahead with the proposal. It is the Left’s support, which helped the government and the country save its face even during the global financial crisis,” said Praveen Jha, professor, Jawaharlal Nehru University.
UPA’s inning saw record capital flows in its first four years, which helped companies raise resources through equity and overseas debt to fuel investment. The net capital inflows increased from $27.8 billion (Rs1.43 trillion) in 2004-05 to $98.6 billion in 2007-08. Investment became the primary driver of growth in the past few years.
According to Economic Survey 2008-09, the most important contribution to demand growth during the 10th Five-Year Plan (2002-07) has come from investment demand.
The sheer volume of capital inflows, which at $98.6 billion reached about 9% of GDP in 2008-09, blindsided UPA on the importance of domestic financial sector reforms. “The global capital flows in a way sidestep the problem of intermediation,” Arvind Virmani, the finance ministry’s chief economic adviser, had told Mint in a recent interview.
The government also came under attack for failing to do enough to create an institutional framework to develop a viable bond market and the mechanism to bring about the bond-currency-derivative nexus. It was not that UPA was unaware of the gaps in India’s financial sector. Two comprehensive reports (Percy Mistry Committee report and Raghuram Rajan Committee report) took a bird’s-eye view of the financial sector and suggested steps to improve it.
Finally, when the developed world’s financial crisis hit Indian companies, the Indian banking system had to bear the entire load of resource requirement. According to RBI, between 1 April and 2 January, flow of non-banking resources to the commercial sector shrank 30% to Rs1.91 trillion from a year earlier. During the same period, banks’ stepped up their lending to the commercial sector by 30% to Rs2.93 trillion.
A salient feature of UPA’s expenditure priorities is the transfer of resources to the social sector. According to the Comptroller and Auditor General’s audit of the government’s accounts for 2007-08, the social sector spending that year was Rs63,246 crore, about 1.34% of GDP. UPA pushed up the social sector spending from a shade below 1% of GDP at a time when nominal GDP was growing around 14%.
Supporting the prioritizing of government expenditure towards social and rural projects was the growth in taxes, particularly direct taxes such as corporate tax and income tax. Tax revenue increased to 12.58% of GDP in 2007-08 from 9.23% of GDP in 2003-04. In 2008-09, the budget estimates put the tax to GDP ratio at 11.54% on account of the slowdown.
One of the early moves of UPA was to operationalize the Fiscal Responsibility and Budget Management (FRBM) Act, which sought to cap the fiscal deficit at fixed proportion of GDP within a specified time frame.
The primary problem with the fiscal deficit in India has been its size and its composition. A huge stock of outstanding debt tends to pre-empt a large part of revenue into paying interest. Between 1992 and 2008, interest payments have generally eaten up a quarter of revenue expenditure, which is a measure of the government’s current expenditure and includes employment generation projects. This has happened despite interest rate reforms initiated by NDA bringing down the average yield on government debt from 8.28% in 2003-04 to an average rate of 7.93% over the next four years.
Early improvement in fiscal deficit measures in the UPA regime came primarily on the back of buoyant tax revenues. UPA found itself unable to move ahead on serious reforms on expenditure. Therefore, despite unprecedented tax collections, by 28 February 2008, then finance minister P. Chidambaram told the Parliament, during his budget speech, that FRBM would be violated (the legislation was designed with escape clauses) on the revenue deficit measure (it represents the extent of dis-saving to finance current expenditure) on account of UPA’s social sector spending priorities. He had planned to meet the 2009 FRBM target of restricting the fiscal deficit to 3% of GDP. However, the fallout of the economic slowdown has pushed the fiscal deficit in 2008-09 to 6% (budget estimates). The 13th Finance Commission, which is currently operational, has been asked to come up with a new road map.
From showing early progress on the fiscal deficit front, the game has unravelled so fast for the government that it had resorted to roundabout way of monetizing deficit, a practice that was abandoned a few years ago.
Earlier, RBI, while trying to neutralize the impact of a surge in capital inflows, issued bonds under the market stabilization scheme (MSS) to suck liquidity out of the market. Once the money was sucked out of the market to contain the inflationary pressure of capital inflows, it was sequestered by RBI to ensure it would be used only to redeem MSS bonds and not be a part of regular government expenditure. As the government borrowing in 2008-09 was close to twice its original estimate, last week it had to amend its agreement with RBI and pull out MSS proceeds to meet its regular expenditure.
Sanjiv Shankaran and Asit Ranjan Mishra