Budget FY19: Time to reboot

Despite a fairly positive global economic environment, India’s economic growth declined in 2017. Without excessively high interest rates, demonetisation, and a badly structured goods and services tax (GST), growth could have been at least 1-1.5 per cent higher. But two bold moves by the government – recapitalisation of banks and an ambitious road program – a ratings upgrade, and improvements in ease of business rankings have changed the mood. There are now nascent signs of recovery but how strong they are and whether the global environment will remain benign is unclear.

Some say the government has done enough in three years and in the FY19 Budget must consolidate ongoing reforms. But the recovery, if there is one, is weak and the Budget, therefore, presents an opportunity to not only repair but reboot the economy.

While the rest of the world kept monetary policy loose in 2017 to nurture their economic recovery, the Reserve Bank of India (RBI) inexplicably kept interest rates too high. The real repo rate (the difference between the repo rate and headline consumer price index (CPI) inflation), which averaged around 2.5 per cent in 2014 and 2015, and fell to 1.5 per cent in 2016 – about the right level for India – has jumped to 2.9 per cent in the first 10 months of 2017. A period of benign inflation, when interest rates could have been cut by at least another 140 basis points, was missed. The new Monetary Policy Committee (MPC) has turned out to be more hawkish and less informative. It is not serving us well and needs an independent expert review.

As a result, the change in real credit growth as a share of gross domestic product (GDP) has fallen to 2.28 per cent in the first nine months of 2017 — the lowest level since 1993. High real interest rates not only damage the economy by keeping up the cost of capital, but they also reduce demand and draw in short-term capital, which in turn, leads to an appreciated real exchange rate.

The RBI has struggled to contain the appreciation through reserve accumulation to an extent that it has even drawn a notation from the US Treasury. But despite its best efforts, the rupee has appreciated and hurt India’s competitiveness. As a result, despite better global market conditions India’s exports have not increased as much as others; imports have surged and domestic producers have suffered.

Demonetisation-related supply disruptions have also hurt exports and led to higher imports.

The GST mistakes have been corrected to some extent, although more could be done by immediately fixing the refund problem for exporters. For the coming Budget, the government must press ahead by bringing the exempt items – petrol, liquor, and real estate – into the GST ambit, which will allow further rationalisation to three-four tax rates. Over the next few years, India must also try and raise direct taxes from currently under 6 per cent of GDP to around 10 per cent. This will require widening the tax base and reducing evasion. This process should begin in the FY19 Budget.

With the US intending to reduce the corporate tax rate to around 20 per cent and the average corporate tax at 23 per cent for advanced countries and many emerging economies, it is time we reduced our rate to at least the 25 per cent announced earlier. The concern that the government will lose revenues is misplaced as a tax reform that removes exemptions, reduces rates, and remains fiscally neutral in the short run is achievable. Over time, as the tax cuts enhances economic activity, revenues may even rise, as has been experienced in several emerging economies such as Turkey and advanced economies such as New Zealand, Slovakia, and Sweden. Global evidence also shows increases in entrepreneurship (more and larger start-ups) with lower corporate taxes.

The bank recapitalisation scheme is another big move which will contribute to recovery in 2018, if it is handled well. It sent a signal that the government is serious about tackling the banking mess it inherited and led to the Moody’s much delayed upgrade. The resources allotted to it – some ~2.11 lakh crore ($32 billion) – are not enough to address the entire problem (around $200 billion), but is nevertheless a significant move. Without recap funds resolution and reform become a meaningless exercise and drag on delaying recovery. A smartly executed reform-recap will be the best booster for the economy. This would include reducing the number of state banks from 19 to single digits, and prioritising recap of the better performing banks first so that the credit cycle can begin.

The ambitious road scheme of about ~6.9 lakh crore over five years and port-led development schemes are also a welcome boost, but will need resource mobilisation on a massive scale. Monetising existing infrastructure assets and more aggressive privatisation of PSUs will be needed to raise resources to finance road and other infrastructure needs. The government could signal its intent by promising to raise $250 billion over 10 years from privatisation of PSUs for the National Investment and Infrastructure Fund and revamp the public-private partnership (PPP) by announcing the creation of the 3Pi — a central institution to facilitate PPPs, as suggested by the Kelkar committee.

Further reforms to boost farm incomes are also needed, including APMC liberalisation so farmers can get better returns and not clamour for loan waivers. Expanding direct benefit transfer (DBT) into food production, will benefit small farmers, reduce fiscal subsidy by plugging leakages and help us in our negotiations at the WTO.

The PMs “Make in India” idea is being hammered by cheap imports and struggling exports. Improving our score on the ease of doing business further is very welcome. But we need something more ambitious and one which deals with real business needs — not just paper reforms. A new trade and industrial policy, which addresses India’s competitiveness — excessive and unpredictable regulation, review of harmful free trade deals, better export incentives and links to global supply chains, and a more competitive exchange rate policy is needed to accompany the Budget.

The temptation to tread water is high but the underlying global currents are unpredictable and if India wants to restore growth to the 7-8 per cent range a bolder, more reformist Budget is needed now. The time to tread water will come next year in the run-up to 2019 elections.