New issues in Indian macro policy.



a major role.

The UPA has now embarked on an ambitious array of welfare programs. The early
evidence suggests that these have not led to a sharp rise in the expenditure/GDP
ratio. However, in coming years, this could shape up differently. Some of these pro-
grams could build up a significant administrative capability. Pressures for enlarging
budgetary allocations on a given program could emerge when an array of contrac-
tors and political parties learn how to tap into the spending opportunities presented
by the program. Finally, the expenditures of some of these programs, such as the
NREG, could go up in a business cycle downturn. Hence, these programs represent
a source of fiscal risk that is larger than is presently visible.

• Rethinking fiscal rules Roughly speaking, India now has fiscal rules which cap the
central fiscal deficit at 3% of GDP and the fiscal deficit of the states at another 3%
of GDP. A consolidated fiscal deficit of 6% of GDP would be one of the biggest fiscal
deficits in the world. There are many combinations of GDP growth rates and interest
rates for which this would yield an increasing debt/GDP ratio. In particular, interest
rates in the future are likely to be higher in the future when compared with those
present today, if monetary policy reforms take place.
12

Hence, the legislative framework for fiscal responsibility needs to be amended so as
to shift towards greater fiscal prudence.

In summary, while India has made remarkable progress on the fiscal problem, the next
few years are a critical time in achieving a sound outcome, in addressing the five areas of
concern articulated above. These factors suggest that the first task of macro policy in India
remains that of battling the fiscal crisis. The destination involves three key litmus tests:
Sound measurement of deficits and debts, a declining debt/GDP ratio in all years except
for rare calamities, and purely voluntary purchase of government bonds by well motivated
actors. While India’s fiscal situation has progressed dramatically, with important legislative
and institutional changes, India is not yet at a point where these three tests are satisfied,
or will be satisfied with a high probability in the forseeable future.

3.2 Stabilisation

In past decades, India did not have a ‘conventional business cycle’ in the mainstream sense
of the term. All that was found was a sequence of short-lived agricultural shocks. Now,
the emergence of a large corporate sector, coupled with flexibility of decision making in
the hands of this corporate sector, has - for the first time - given a business cycle rooted

12With a pegged exchange rate, a period of capital inflow is associated with loose monetary policy and
accelerating inflation. This is an effective characterisation of India’s monetary policy from 2002 onwards.
If monetary policy reform comes about, giving a cessation of exchange rate pegging, then monetary policy
would be concerned about issues such as inflation and the domestic business cycle. In this case, interest
rates on a business cycle upturn would be higher than those seen in 2007.

18



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