Political crisis and pressures severe blow to fiscal consolidation

The political confusion of the last three weeks has been a severe setback to fiscal consolidation that is crucial for economic stability and economic growth. In whatever way the political crisis is resolved political compulsions would drive the country to the brink of a fiscal cliff.

Why fiscal consolidation?

Large fiscal deficits affect every facet of an economy just as high blood sugar of diabetes affects every organ of the body. For these reasons the containment of the fiscal deficit is an essential prerequisite for economic stabilisation and growth. However the recent political gridlock has made fiscal consolidation most unlikely. Populist measures that increase public expenditure are likely to increase the fiscal deficit significantly.

Fiscal consolidation essential

The paramount importance of reducing the fiscal deficit is not generally understood though much of an economy’s stability and performance rests on containing the fiscal deficit.

Containing the fiscal deficit is vital as a large deficit generates inflationary pressures, increases the public debt, distorts public expenditure, reduces export competitiveness and increases the trade deficit. Nevertheless, the fiscal targets for 2018 and 2019 are not likely to be attained in the current political situation when the priority is gaining popularity.

Inflation

The economic consequences of large fiscal deficits are wide-ranging. Fiscal deficits create inflationary pressures that increase the cost of living and causes severe hardships, especially to the lower end of wage earners and pension- ers. This in turn leads to higher wages that in turn increases the costs of production and erodes the country’s competitiveness in international markets.

The depreciation of the Rupee is then necessary to remain competit ive with other countries. Otherwise the lesser export earnings would increase the trade deficit that would be a strain on the balance of payments. Reduced export earnings imply loss of employment and lower incomes.

Production costs

Inflation increases the costs of production and erodes the country’s competitiveness in international markets that necessitates the depreciation of the Rupee to remain competitive with other countries’ lower rates of inflation. Otherwise the lesser export earnings would increase the trade deficit that would be a strain on the balance of payments. Reduced export earnings imply loss of employment and lower incomes to workers in export industries such as garments, rubber goods and ceramics. The solution to the problem is the depreciation of the currency that would ease the competitiveness of exporters. However depreciation would lead to further inflation and increased hardships to people.

Public debt

Large fiscal deficits harm the economy by increasing the public debt. Fiscal deficits lead to borrowing and in turn to huge debt servicing costs.

The large accumulated debt of the country is the result of persistent deficits over the years. Debt servicing costs have risen to mammoth proportions that require the government to borrow to repay debt.

The massive public debt and crippling debt servicing costs distort public expenditure priorities and hamper economic development. The government is starved of funds for investment and social infrastructure development. Consequently economic development is severely hampered.

Unlikely

The recent progress in reducing the fiscal deficit is likely to be reversed. The fiscal deficit that was expected to be brought down to 5.3 percent this year and to 4.8 percent of GDP in 2019 is unlikely to be achieved. The target of achieving a fiscal deficit of 3.5 percent in 2020 is now a dream as no government is likely to take firm steps to enhance revenue and contain expenditure.

Fiscal consolidation

The recent political convulsions have setback the progress in fiscal consolidation in the last two years. The fiscal deficit that ballooned to 7.4 percent of GDP in 2015 was brought down to 5.4 in 2016. It increased slightly to 5.5 percent of GDP in 2017, mainly due to the dip in economic growth to 3.1 percent last year.

The fiscal deficit was on course to be reduced to 4.8 percent of GDP this year with the mid- year fiscal deficit reduced to 2.4 percent compared to last year’s 2.5 percent of GDP. However this year’s deficit would have expanded even without the political crisis owing to increased expenditure on several programs that could increase expenditure in the second half of the year.

Salary increases, increased public service employment and expensive expenditure on popular rural programs could increase expenditure much above expected revenue and increase the fiscal deficit rather than contain it. The political instability has resulted in the government increasing expenditure, on the one hand, and decreasing revenue on the other hand, to placate the voters to ensure its popularity.

Budget 2019

The next budget, whenever and whoever presents it, would have far reaching impacts on the country’s economic stability and development. The fundamental issue is whether the government’s concern would be its popularity in the runup to elections next year or economic stability and long run economic development.

The budget can either ensure that the essential ongoing process of fiscal consolidation is continued by prudent expenditure or destabilise the long term interests of the economy by pandering to the electorate by populist expenditure programs that would increase public expenditure, expand the fiscal deficit and derail the progress in fiscal consolidation.

Populist budget

In the current political context, whoever presents the budget, the budget is likely to be a populist one that proposes a large number of subsidies, populist programs and salary increases. The large expenditure on these populist measures would increase the fiscal deficit unless there are other expenditure controls and new taxation measures. There is also the possibility of some measures of tax relief. These too would expand the fiscal deficit by decreasing revenue. Furthermore, the depreciation of the rupee is increasing the rupee cost of debt servicing that would also impact adversely on the fiscal outturn.

In conclusion

Ensuring that the fiscal deficit is contained is vital for economic stability and growth. The current political crisis and uncertainty is detrimental to the economy at this moment in time. This is particularly so as it comes at a time when the economy is facing several economic challenges from global financial developments and escalating fuel prices.

The fiscal deficit is targeted to be reduced to 3.5 percent of GDP by 2020. Attaining this would be significant for economic stability and development. The paramount issue is whether government expenditure could be contained to reduce the fiscal deficit next year. One can only hope that political stability is restored speedily and the government would be concerned about economic stabilisation and long run economic growth.