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Fiscal Policy Response in India to Global Financial Crises

Article · June 2011

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Fiscal Policy Response in India to Global Financial Crises

Dr Mohd Saeed Khan

Department of Economics
AMU Aligarh
Email: msk2313@[Link]
Mobile: (+91) 9760017326

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 Fiscal Policy Response in India to Global Financial Crises

Abstract

Global Financial Crises (GFC) was basically monetary phenomenon but the consequent
recession with almost world wide spread demanded a multi pronged public policy response.
Fiscal policy has the capability not only to combat recession but to compliment the monetary
policy in its endeavor to fight the same. It was believed that Indian economy would remain
insulated from the GFC for two reasons, one; the economy was not integrated with the world
economy to the extent the other economies were and two; the regulatory mechanism was well in
place in India which was not the case with other economies e.g. US economy. But the reality
turned out to be otherwise.
Since India is a federal country fiscal policy is conducted at Centre and State level
(though there are the local governments as well but for this matter they are relatively
insignificant). Constitution of India provides for assignments of revenue sources and the
responsibilities to be discharged as well as the fiscal institutional arrangements for the working
of federation. So for the conduct of fiscal policy and its response to any crises like situation, like
the one under reference, federal fiscal arrangements assume significance as the conduct of fiscal
policy depends a great deal on such arrangements.
The paper evaluates the response of India’s fiscal policy and makes out as to what extent
its fiscal federal arrangements contributed to the effective public policy intervention and also to
find if such arrangements themselves were affected in any manner.

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 Fiscal Policy Response in India to Global Financial Crises

Introduction

Recent financial crises once again revived the debate over the role of the
government in regulating the affairs of the economy. Historically there have been two
approaches with regard to the role of the government in matters of economic
management. One is neo-classical approach that believes in the self equilibrating
capability of the market forces and therefore advocates minimal government as its
intervention in the economy would bring in distortions. Another one is the Keynesian
approach that sees much greater role for the government and its fiscal policy. None of the
two approaches are without logic and have guided public policy to steer the economy
through crises. The main point of difference between these competing approaches is the
public expenditure and its fiscal policy.

Drawing parallel between government budget and family budget Adam Smith in
18th Century AD advocated for fiscal prudence by favoring public expenditure to be kept
within the confines of revenue. Governments would do well to borrow in emergency
situations only and return to balance budget as soon as situation returns to normal. This
logic implicitly does not recognize fiscal arrangements to be the effective tools of public
policy. It was Keynes who saw a clear cut role for fiscal policy for the stabilization of
economy and raising the level of economic activities that would result in higher
employment and income levels. He took a line that government should go in for extra
spending as it would raise the ‘aggregate demand’ and eventually the employment. The
deficits so occurred should be financed through borrowing. Thus for the first time
theoretical legitimacy was accorded to deficits financing.

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 Keynesian logic proved to be effective in guiding the economies out of the crises
the world over during the ‘great depression’ of 1930s. The glut in the market then could
not have been overcome through the natural course of market initiatives as entrepreneurs
would shy away from investment resulting in further decline of aggregate demand. A
downward spiral of economic activities was inevitably the logical outcome. In such
situation the attention of the capitalist world was turned to the Keynesian logic (which
remained neglected all through) which was successfully put to practice. The autonomous
investment and other public expenditure (which are not qualified to be called investment)
generated aggregate demand and economies were eventually put on rail. Keynesian
approach continued to be guiding force as in the wake of world war and the post war
recovery there could have hardly been any dispute to the increased government spending.
It was in the 1970s that the capitalist world was struck by the twin problems of stagnation
and inflation that Keynesian wisdom began to be questioned. Faith was revived in the
neo-classical approach which began to guide the public policy and became favored policy
instrument for multilateral financial institutions. The revived faith in neo-classical
wisdom continued to overshadow Keynesianism till the eruption of recent crises in 2008.
Once again Keynes is back in contention.

The recent financial crises were the worst the world has seen since the great
depression of 1930s. The genesis of the economic crises was the emergence of what has
been termed as shadow banking system in United States where each lending institution
was treating each other’s debt as asset in the capital base for lending, resulting eventually
in the circular credit interdependence (Bhaduri 2009). The absence of effective
regulations in US economic governance could therefore be held responsible for current
financial crises. In the era of financial globalization other economies could not have
remained insulated. The crises spread to other economies closely integrated with it.
Indian economy which was considered to be insulated because of well regulated financial
sector also found itself inflicted by the global financial meltdown. Its difficulties arose on
account of the shrinkage of demand for its export and slackening of capital inflows from

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these economies on which India’s economic growth, during last one and a half decade,
came to be critically dependent.

The crises assumed global coverage in August-September 2008 and demanded

fiscal solution as the task was not only to inject extra liquidity into the economy but also
to generate demand for it. Therefore most of the countries responded to the crises by
offering stimulus packages. This paper attempts to evaluate the trail of fiscal intervention
in India.

Impact on the Economy of Global Financial Crises

When financial crisis began to surface in U.S and Europe in August, 2007 it was
believed India would remain largely unaffected because of its ‘strong fundamentals’ and
well-regulated banking system. But the deceleration in the growth of economy was very
much in evidence in 2007-08 when it registered a growth of 9.2 percent as compared 9.7
percent in 2006-07. This small deceleration is significant as it occurred despite significant
acceleration in agricultural output. Further, in view of the economic growth sustained by
the economy over the last many years despite agriculture’s less than satisfactory
performance the small deceleration discussed above is significant.

In order to understand the contagion of the global meltdown for Indian economy
the genesis of the economic boom in India that preceded the current downturn needs to be
understood. Such boom could be attributed to India’s global integration in three ways;
one, increased dependence on capital inflows especially of the short-term variety, two,
greater reliance on exports particularly of services, and three, the role these played in
domestic credit-induced consumption and investment demand. The question whether
economic slowdown observed in 2007-08 was on account of the global crises contagion
or the domestic factors1 is not relevant (for this paper), what is significant here is that the
economy’s growth in the last many years was contributed a great deal by external sector

1
Mihir Rakshit (2009) believes India began to slow down even before the emergence of the global crises.

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which generated sufficient aggregate demand. With the crises in external market Indian
economy was bound to suffer.

Foreign Capital Flows

The major part of the capital inflows consisted of foreign institutional

investment (FII) which dried up as the crises deepened. The withdrawal of FII in
substantial magnitude (table-1) caused decline in Indian companies’ access to foreign
capital, reduced domestic liquidity and led to a downslide in the stock market. Rate of
interest shot up compressing investment further and building inflationary pressure
resulting ultimately in shrinkage of aggregate demand.

Table-1
Net Capital Flows
April-March 2007-2008 2008-2009 (P)
(PR)
Items 2007-2008 2008-2009 Apr- Jul- Oct- Jan-
(PR) (P) Jan-Mar Jun Sep. Dec. Mar

FDI 15.4 17.5 8.5 9.0 4.9 0.4 3.2

Inward FDI 34.2 35.0 14.2 11.9 8.8 6.3 8.0

Outward FDI 18.8 17.5 5.7 2.9 3.9 5.9 4.8

FIIs 20.3 -15.0 -4.1 -5.2 -1.4 -5.8 -2.6

Net Capital 108.0 9.1 26.0 11.1 7.6 -4.3 -5.3

Flow

US$ billion

P: Preliminary, PR: Partially Revised.

Source: External Economy July 27, 2009, RBI Publication III

Why Fiscal Policy?

For long since the economic crises of 1930s, discretionary fiscal policy with a
combination of increased public expenditure or the tax concessions was actively used for
the purpose of macroeconomic corrections if the economy exhibited recessionary trend.

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However by the early 1980s, it lost favor on account of some of its long term fallouts.
Consequently it revived the neo-classical wisdom which believes in the self equilibrating
capabilities of the market. For the purpose of dealing with the downswings of the
business cycle Monetary Policy began to be favored as it induces the desired change
through the function of the market. Further, since multilateral financial agencies too were
obsessed with neo-liberal market policies they bitterly opposed expansionary fiscal
policies involving public debt on account of its distortions it produces in the economy
especially the crowding out of private investment. However expansionary fiscal policy
has been justified in case of sustained and long term decline in aggregate demand
(Feldstein, 2002). For the fast deteriorating economy fiscal stimulus are expected to arrest
such downturn quicker than the monetary measures.

With the outbreak of present crises fiscal policy swung back to contention again.
The proper design of the fiscal policy, it is suggested, should have following properties; it
should be ‘timely’ given the urgency for the action, ‘properly’ targeted for maximum
impact and should be ‘temporary’ so as not to breach the sustainability conditions for
long.

India’s fiscal Policy Stance

Among the public policy options Fiscal Policy occupies a prominent position in
India. Though it has begun to gradually move away from the regime of social controls to
the market economy but it did so in a cautious manner. In view of the large poor
population it has to provide wide array of goods efficient provision of which cannot be
ensured by the market (merit goods). Environmental issue also makes the government
intervention inevitable as market does not exist for environmental goods. Therefore the
tax and expenditure (that include subsidies) measures along with public debt continued to
be the effective means for the socially desirable allocation of resources.

Since the onset of economic reforms in 1991 India’s fiscal policy has been
consistent with the objective of reducing fiscal deficit with occasional deviation from the

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path for social sector spending as well as for the reason of political expediency. The
experience of the decade preceding reforms, when fairly higher growth rate failed to
reduce economy’s dependence on public expenditure for ‘aggregate demand, made us
obsessed with fiscal deficit as public debt reached to unsustainable level (Seshan 1987).
Therefore managing fiscal deficit remained very high on any agenda of fiscal reforms.

As there was little coordination between the fiscal actions of the Centre and States,
despite former having initiated the reforms, fiscal deficit had reached, towards the close
of the century, to a level comparable with the pre reform period. The problem became so
prominent that Centre had to introduce, in 2000, ‘Fiscal Responsibility and Budget
Management Bill’ to its eventual enactment in 2003 albeit in a bit diluted form. In the
meantime political conditions in the economy paved the way for the Eightieth
Amendment to the Constitution making all the Central taxes (except cess and surcharge)
sharable.

India’s Federal Institutions and Response to the Current Crises

As has been discussed earlier in the paper that by August 2008 crises assumed
global dimensions affecting economies in all the corners of globe. By this time Indian
economy started showing the signs of deceleration. This was in despite the massive
public expenditure during 2008-09 on account of certain social security obligations like
National Rural Employment Guarantee Act (2005) and the payment of part of arrears to
the Central government employees following the acceptance the recommendations of
Sixth Central Pay Commission. The finances of the Central and State Governments
deteriorated considerably in 2008-09 as a result of global economic slowdown which
impacted Indian economy and fiscal stimulus measures consisted of indirect tax cuts and
additional expenditures. The fiscal implications of the same were tremendous and the
fiscal consolidation that was achieved by 2007-08 was lost the very next year. But the net
result of such fiscal expansion was that economy’s growth momentum, though
decelerated a bit, was still impressive if viewed in comparison to the other economies of

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the world. But such growth could be achieved through fiscal expansion (as in the 1980s).
Extra spending by the Central government continued into 2008-09 as well. One single
item of non regular public expenditure again was the disbursement of the remaining 40
per cent of pay revision arrears of Government employees. But significant thing in this
financial year 2010-11 as well as in the preceding one has been that it was not financed
by the tax increase or subsidies rollback but through debt finance which would not have
been possible in the absence of crises for the government guided by fiscal conservatism.
Thus the government could exploit domestic compulsions for fiscal expansion to its
advantage.

Another response to the crises was the Centre allowing State governments, in
2008-09 and 2009-10, to spend beyond the Fiscal Responsibility and Budget
Management Act (FRBM) stipulations temporarily restoring the fiscal space earlier taken
away from them. It was because of the fiscal correction measures undertaken by the
States to fulfill the obligations under FRBM, and meet the requirements of the debt-write
off that States could achieve considerable improvement in their finances up to 2007-08,
reflected in the revenue surplus of States reaching 0.9 per cent of GDP and gross fiscal
deficit (GFD) declining to 1.5 per cent of GDP in 2007-08. Such fiscal consolidation
enabled the States for fiscal expansions as demanded by the current crises.

Table-2

Composition of Revenue Expenditures of State Governments (2000 to 2010)

(Per cent on GDP)

Item 2000-05 2005-10

Development Expenditure 7.3 7.2
Social Services 4.4 4.4
Economic Services 2.9 2.8
Non-Development Expenditure 5.8 4.9
Interest payments and Debt
2.8 2.2
servicing

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 Pensions 1.2 1.2
Total Revenue Expenditure 13.3 12.4
Source: Reserve Bank of India, State Finances: A Study of Budgets of 2009-10

Considering the combined share of the States in the aggregate spending of the
economy (table-2) and their fiscal obligations towards the local government the States
should have been provided a little more fiscal space while what happened was just
contrary to it. The net result of such developments is that the States seem to be unwilling
to concede the same space to the local governments (aspect not discussed in this paper). It
also resulted in the failure of various social security measures especially the employment
programs to create social and economic infrastructure and as a result continued to remain
perpetually dependent on budgetary support rather than being put on self sustained path.
The observation of table-2 suggests that in relation to GDP States’ revenue expenditure
was roughly the same or a little less as it was in the five year period preceding it. Such
revenue expenditure would not have been possible had the States not been allowed to
breach the fiscal limits they were subjected to as per the requirements of FRBM Acts, a
concession that stands withdrawn in the Union Budget 2010-11 as the states have now
been asked to go back to the fiscal correction path by 2011-12.
Thus the developments over the last few years have created a situation where
States’ fiscal priorities were not being determined by the States themselves but by the
Central Government. .

Conclusion

The analysis of the fiscal policy pursued in India during the crises suggests that the
constitutional as well as institutional framework of it is well crafted as it provides
tremendous amount of flexibilities to adjust itself to such economic challenges. India’s
federal fiscal system facilitated whatever was required to meet the challenges of the
current economic crises. Despite States having larger share in total expenditure they were
utilized in limited manner. Major fiscal concessions to maintain the aggregate demand
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came from Central government. The States could not have maintained their expenditure
levels (though they did it through fiscal profligacy) during the crises had they not
achieved the fiscal correction in the last few years.

Furthermore, the FRBM induced fiscal discipline has reduced the fiscal space to
the States reducing their options to effectively intervene if the circumstances so demand,
as in the present case they could do only when Centre had allowed them to. Considering
the assignments of responsibilities to the States they should have been devolved some
more fiscal power as fiscal devolutions on which States are greatly dependent offer only
revenue but keep them deprived of the fiscal instruments. In nutshell it can be said that
though India’s response to the crises was appropriate but it was largely the federal
government’s initiative. Sub-national governments could have been made to play greater
proactive role but to realize this institutional constraints would have to be eased off.

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