variable inflation (Figure 8). Anchoring fiat money to the basket of goods in the consumer
price index is now seen to be the right solution for achieving a nominal anchor, one that
stabilises the domestic economy.
Just as the FRBM constrained fiscal policy, new legislation is required, which con-
strains monetary policy to deliver an inflation target in an environment of transparency,
accountability and independence. This requires divesting all functions other than setting
the short-term interest rate from the central bank. Largely speaking, this is well understood
territory, where dozens of countries have implemented such reforms. An Indian effort in
monetary policy reform would need to adapt this broad understanding to local conditions.
3.2.2 Fiscal policy
As emphasised above, placing Indian public finance on a sound footing involves passing
three tests: (a) Sound measurement of deficits and debts, (b) A debt/GDP ratio that de-
clines in all years except for rare calamities and (c) Government bonds that are voluntarily
purchased by well motivated actors. The approach of the FRBM Act, has been to place a
limit of 0 upon the revenue deficit and a limit of 3% of GDP for the fiscal deficit. There
is a broad consensus in India that this was an appropriate strategy to bring about a fiscal
consolidation.
However, looking forward, a fiscal strategy where the government tries to rigidly hold
the revenue deficit and the fiscal deficit near these two values of 0% and 3% is neither
feasible nor optimal.
The first issue is that of feasibility. In a business cycle downturn, tax revenues will
inevitably be hurt. This is particularly owing to the importance of corporation tax and
income tax, which are vulnerable to business cycle fluctuations. Expenditures on programs
such as NREG will inevitably go up in a downturn. When a budget is crafted in February
2008, data about the economy is only known upto December 2007. Hence, little is known
about business cycle conditions that will prevail from April 2008 to March 2009. Hence,
‘fiscal marksmanship’ will inevitably be poor.
At the same time, an enlargement of the deficit in a downturn constitutes a stabilising
response on the part of fiscal policy. From the viewpoint of stabilisation, it is healthy and
appropriate to have a higher fiscal deficit in a downturn. Yet, the very credibility of fiscal
rules will be adversely affected if, for sound reasons of a business cycle downturn, the limits
are frequently violated. Financial markets will not trust Indian public finance if claimed
fiscal rules are violated.
In addition, the present fiscal responsibility framework involves limits for the centre
and states which add up to capping the consolidated fiscal deficit of centre and states at
6% of GDP. This is one of the biggest fiscal deficits of the world. As Table 5 shows, in
the class of countries with a long-term foreign currency sovereign rating which was at the
lowest possible investment grade (S&P’s BBB), only Hungary had a fiscal deficit of 6.8%.
It will be difficult for India to maintain an investment grade rating while running such a
large deficit; public finance will often be teetering on the edge of difficulty.
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