Three Steps to Steer The Budget Out Of The Fiscal Storm

Finance minister Arun Jaitley’s third budget signals the mid-point of this government’s tenure. At the best of times, the honeymoon period would have ended by now. But it is unfortunate that the finance minister has to face a perfect storm of snowballing fiscal liabilities in public sector banks, drought-induced low agricultural productivity, international economic headwinds, the additional cost of securing India in an increasingly insecure world and the consequences of populism (primarily the wholly unnecessary increase of 23 percent in government pay and pensions and the outcome of delayed reforms in subsidy). In comparison, the government’s budget kitty is woefully inadequate even without meeting the long-standing demand for spending more on health and education, developing infrastructure, boosting rural incomes, extending the patchy system of social protection and enhancing the long-neglected defence preparedness. The total annual capital budget of the central government last year was just Rs 2.4 lakh crore (just 1.7 percent of GDP). State governments spend a similar amount. But public investment of just 3.4 percent of GDP does not compare well with the thumb rule of at least 8 percent of GDP for developing countries, especially when just the central government is running a fiscal deficit of 4 percent. More worryingly, even this meagre public investment may not actually be possible if the fiscal mess emanating from public sector banks is to managed. Loans worth Rs 3.5 lakh crore in government-owned banks are acknowledged as non performing. Some provisioning for writing off these non-performing assets (NPAs) has been done but not enough. The real risk is that a whopping Rs 2.7 lakh crore of loans have been dressed up by “restructuring” them. In essence, rolling over these loans so that they exit the NPA classification. But whether the favoured borrowers can support future repayments is unclear. The RBI has come down heavily on such practices and directed banks to start provisioning against all stressed assets. Hence the spate of losses recorded by public sector banks in the quarter ending December 2015. Another worry is that government banks will need an additional Rs 1.8 lakh crore of equity infusion to comply with the Basel III capital adequacy norms. This takes the total capital requirement of these banks to Rs 6 lakh crores - just under 4.5 percent of GDP. Even if the entire capital budget of the government is diverted for re-capitalizing government banks, it will still take two to three years before they get a healthy balance sheet. And what is there to stop the cycle of irresponsible lending from being repeated? After all, these NPAs were built up over the past several years. But none of the top honchos of these banks — present or past — have been called to account for this colossal deception.

Poor credibility of corporate governance

Today, government bank equity is deeply discounted. The credibility of corporate governance in these banks has been dented. Worse, there is no clear path for restoring stability. The government has preferred to retain the current governance architecture, with notional changes to enhance bank autonomy. Privatisation of select banks - a sure mood lifter for the domestic and international investor community - has never been a preferred policy option. Government ownership has benefits. For one, it notionally reassures depositors that their money is safe. Possibly this is why there is no run on deposits in government banks. Depositors and bond holders view public sector banks through the filter of sovereign credit. It helps that India has an impeccable record on meeting all its financial commitments. But one trigger which could escalate the financial risk sharply could be the firming up of oil prices subsequent to the production freezing agreements between Saudi Arabia, Russia and other top oil producers. This will stoke inflation in India, keep domestic interest rates high, thereby impacting investment and worsening the current account deficit. Additionally, sharply reduced public investment - a consequence of possible diversion of capital to clean the balance sheets of public sector banks - will also impact growth, jobs and incomes.

The poisoned chalice of trade offs

Government has a poisoned chalice it needs to sip from. If it brushes deep bank restructuring under the carpet, it can postpone the day of reckoning - but only at significant medium term economic cost. A broken government banking system, which caters to 70 percent of banking needs, cannot sustain rapid private sector growth. One option for maintaining fiscal stability is for the government to access multilateral support from the International Monetary Fund (IMF) for restructuring government banks. IMF support reassures investors because it comes with a programme of structural and governance reform, including broad-basing the shareholding of banks to non-government investors, professionalising their boards and embedding oversight mechanisms to insulate them from succumbing to politically motivated loan melas or dodgy private projects.

Government should shed its muscular stance

The downside is that going cap-in-hand to the IMF does not fit the muscular India story, which is the leitmotif of this government. The BJP will worry that it will have negative political consequences in various state elections that are due. This is true. But none of these states, barring Uttar Pradesh, offer credible political gains for the BJP in any case. The muscular approach can be abandoned without much grief. Its marginal utility is diminishing and reduced dividends are already visible. One hopes that the government’s brand managers are reading the tea leaves correctly. This is not the time for soaring rhetoric or proclaiming achievements loudly. Far better to adopt a humble posture, point to the depressing state of the world and outline an agenda for dealing with adverse circumstances.

Three big steps out of the fiscal mess

First, Jaitley must guard against 2016 becoming India’s 2008 “Lehman Brothers” moment. That sparked off a domino effect which exposed deep financial irregularities across the banking sector. It also triggered the Occupy Wall Street movement. At the best of times, Indians are suspicious of big business and are quick to come out on the streets in protest. This is not the time to risk an Occupy Dalal Street movement. Government must regain credibility by coming out strongly against all those who have connived to build up this huge quantum of non- performing loans — bank managers who were in decision-making roles, large corporate borrowers and those within the political establishment who may have turned a blind eye to such maladministration. Jaitley must also share publicly how deep is the rot and what steps the government proposes to manage the fall out. Second, the government should take this opportunity and opt for only a “holding budget” for 2016-17 — an accounting exercise to rationalize and consolidate past initiatives. The bottom line is to insulate income support for the poor and allocations for agricultural production from the fiscal mayhem. Health, drinking water and sanitation and education allocations should be held at 2014-15 levels relative to projected GDP. Finally, the government must increase gross tax collections over the next two years from the low of 10 percent of GDP in 2014-15 to 12 percent (last achieved in 2007-08). The GDP growth projections of 7.5 percent lack credibility when triangulated with the ground realities. Lower growth will impact tax revenues negatively. Services tax is a progressive tax, which primarily affects the well off. Raising the rate by 2 percentage points could generate an additional Rs 30,000 crore. Taxing capital gains from the sale of equity and the receipt of dividend beyond a threshold level is another option for reducing income inequality and plugging a big hole in the tax net. The government already spends more than it earns on revenue expenditure – the revenue deficit is nearly 3 percent of GDP, which we fund by taking loans, increasing the burden of interest payment. Trade-offs will have to be made if the unwise commitment - amounting to Rs 100,000 crore - on the Seventh Pay Commission recommendation is implemented. So are we in the eye of the storm? And could we be on the cusp of a potential financial emergency? We should act before a flash point triggers this eventuality. A modest budget for 2016-17, enhancing tax collection by selectively increasing the effective tax rates and sharply focused allocations for value enhancing public expenditure is the only way out of this mess.