Tuesday, July 9, 2024

RBI’s surplus: To spend or not to spend


Indian Express July 4, 2024

With a new government at the Centre, the economic policy discourse has now shifted to speculating about the Union Budget for 2024-25. This year’s budget is especially important for one specific reason. In an unexpected turn of events, the RBI announced last month that it is transferring a sizeable dividend to the government, significantly more than what was anticipated. This has triggered much discussion about how the government can spend this windfall. We need to ask a more fundamental question: Should the government spend it at all?

Fiscal management should be guided by two general principles. First, deficits should be kept at prudent levels. In India, that level should ideally be around three per cent of GDP for the Centre according to the long-standing Fiscal Responsibility and Budget Management (FRBM) Act. Second, governments should spend a bit more than this norm when the economy is doing badly and a bit less when the economy is doing well.

The purpose of varying the deficit, as specified by the second principle, is to stabilise the economy. In bad times, when private sector demand is falling, the government needs to step in and boost demand to prop up the economy. The needs are reversed when the economy starts to recover. As private demand revives, the government needs to curtail its spending lest overall demand races ahead of supply, fostering inflation. A critical aspect of this second principle is that policies must be symmetric. Larger-than-normal deficits need to be followed by smaller-than-normal deficits so that government debt gets stabilised instead of spiralling upwards.

Following these two principles can keep a country out of debt problems while stabilising the ups and downs of growth cycles. That is why these principles are followed in prudent countries all over the world.

But not in India. Here, governments have always struggled to spend within their means, irrespective of whether the economy is slowing or booming. In the 20-year period from 2000-01 to 2019-20, the average fiscal deficit of the Centre was 4.6 per cent of GDP, much higher than the three per cent medium-term target set by the FRBM Act.

During the pandemic, the deficit shot up to 9.2 per cent of GDP in 2020-21, a large increase but a reasonable one, considering the size of the shock to the economy. But curiously even after the economy recovered, the deficit has been slow to come down. In the Interim Budget presented earlier this year, the Finance Minister announced that the government was targeting a deficit of 5.1 per cent for 2024-25. In other words, three years after the pandemic ended, the deficit is still higher than the pre-pandemic levels, and nowhere close to the FRBM norm.

For this reason, a standard way for economists to assess the success of monetary policy is by looking at core inflation. If core (that is, underlying) inflation is close to the target, it suggests that monetary policy is doing its job of controlling demand, notwithstanding any temporary deviations caused by flare ups in food or commodity prices. For instance, in the US, after several quarters of aggressive monetary tightening, headline inflation has cooled down quite a bit. Annual inflation in the US fell to 3.1 per cent in January, compared to 6.4 per cent a year ago. However, core inflation continues to be sticky and has been rising more than expected. Also, wages in the services sector have been persistently high. Both these indicate that demand conditions remain strong, thereby causing the US Fed to delay rate cuts.

Since the Centre has been slow to reduce its deficit, India’s fiscal metrics have deteriorated. The consolidated central and state government deficit is now around 8.5-9 per cent of GDP (compared to the six per cent recommended by the FRBM Act). Total government debt has been more than 80 per cent of GDP over the last few years, compared to an average of 74 per cent in the period from 2010-11 to 2019-20.

It is against this background that the RBI announced last month that it will transfer Rs 2.11 lakh crore to the central government as dividend, double the amount that had been budgeted. The crucial question now is: What should the government do with this unexpected bounty?

According to some commentators, the government should increase its capital expenditure (capex). As per the Interim Budget, the capex growth rate is supposed to slow down in 2024-25. But now with this surplus dividend, the government may be tempted to step up its capex spending. That would be a mistake.

The general sentiment in India seems to be that any spending on capex is great news. This is not correct. Look at China, for example. As part of their infrastructure building spree, they built two to three airports in the same city and are now struggling to repay the debt that was incurred for these projects. What is therefore needed in India is to calculate how much capex is truly needed and of what kind.

Governments spend on capex for two reasons: To stimulate growth and to meet the needs of the economy. Let’s address the second criterion first. Infrastructure in India is definitely a problem that needs to be solved. But not all at once. Since the pandemic, the government’s capex spending has been growing at an average annual rate of 30 per cent. It is not obvious that this pace needs to be increased, or even sustained. On the contrary, recent developments demonstrate that the speed of construction — and focus on new projects, rather than maintenance — has serious downsides.

In addition, not all capex is essential for growth. For example, using Rs 1.6 lakh crore to revitalise telecom MTNL and BSNL is surely not critical, especially when affordable cellphone services are being provided throughout the country by private operators. Likewise, it is not obvious that spending lakhs of crores on bullet trains can be justified in a country whose per capita income is less than $2,500.

Regarding the first criterion, we have to ask the question again: Why does the government need to stimulate an economy that is doing so well? Given the strong economic performance, it should instead use the surplus dividend from the RBI to bring the fiscal deficit down closer to three per cent.

There is, however, a caveat to this discussion. And this relates to the true state of the Indian economy. What if the economy is actually weaker than what the 7-8 per cent growth figures suggest? Then there may be a case for the government to keep spending to support the economy.

There seems to be a lack of consensus on this fundamental point. If the economy is not doing very well, then we should not be surprised if the budget uses the surplusdividend to announce a further increase in infrastructure spending.

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