Over the last year, the Indian economy has been rocked by two forceful government policy moves: the sudden cancellation of 86% of outstanding currency notes last November and the implementation of a national goods and services tax this past July.
Each was a blow to growth and the resulting slowdown has prompted widespread calls for fiscal stimulus. In response, the government announced on Oct. 24 that 6.9 trillion rupees ($106 billion) will be spent over the next five years to develop 83,677km of roads. Officials gave little detail on how this initiative will be financed, beyond indicating that both public and private investment will be involved.
In fact, the government's war chest is too small to support this plan. Instead, the authorities should draw on the nation's foreign currency reserves to finance much-needed infrastructure investment.
The GST will eventually prove positive for India. Some disruption is to be expected when major tax reforms are implemented, and the impact in this case has been exacerbated by inadequate planning and preparation.
Largely as a consequence and despite a pickup in global growth, gross domestic product expanded just 5.7% in the April-June quarter from a year earlier, the slowest rate seen in 17 quarters. The last time India experienced such a slowdown was in the aftermath of the global financial crisis.
As the economy struggles, the clamor for stimulus has reached a crescendo. But the government does not have adequate fiscal headroom to pump prime the economy out of trouble. New Delhi also needs to remember that the initial success of the fiscal stimulus delivered after the global financial crisis dissipated quickly and was undermined by persistent double-digit inflation.
Public expenditure is already propping up the economy in the face of anemic private investment and sluggish consumption. Year-on-year GDP growth averaged 5.9% over the last two quarters, but nongovernment growth averaged just 4.1% and has been growing at an average of 1.5 percentage points below headline growth for five quarters.
Higher government spending has been financed by a large oil-related dividend produced by drastic rises in excise taxes on gasoline and diesel at a time oil prices were falling. Between April 2014, the month before Indian Prime Minister Narendra Modi came to power, and March 2017, federal excise taxes increased more than 380% on diesel fuel and more than 120% on gasoline. As a result, excise tax revenues from petroleum products more than trebled to 2.43 trillion rupees. Federal revenues from non-oil excise taxes grew at a much more modest rate of 14.5%.
That was then. Excise revenues on oil products are expected to keep growing but at a much more modest pace. With inflation showing signs of rising and elections looming in some states, the federal government has already announced that it will reduce fuel taxes.
Tax revenues will also be affected by lower-than-expected economic activity. The government has projected nominal GDP growth for the year to March 2018 of 11.75% year-on-year, but Societe Generale expects the rate will actually be 10%. Non-tax revenue will be dented by a cut of more than 50% in the Reserve Bank of India's dividend payment as a result of the cost of demonetization.
All this will keep the general government deficit close to 7% of GDP, above the government's target of 6.5%. Rather than pump priming, the government may be forced to reduce capital expenditures to keep the budget deficit in check.
The quality of public expenditure is also deteriorating. Although overall government expenditure has increased sharply in the current fiscal year, the share devoted to capital spending has fallen as officials find it easier to cut such allocations than subsidies and other programs.
It is also likely that a sharp increase in the deficit would be inflationary, given that inflation and the current-account deficit are both rising in spite of weakening economic activity.
While further details are awaited, the recently proposed road-building plan will lead to either of two unappealing outcomes: the fiscal deficit will rise or existing capex plans will have to be cut down.
But there is an alternative. Given India's desperate need for infrastructure investment, the government could set up a dedicated fund using part of its foreign exchange reserves, which stood at $400 billion at the end of September. Some of that cash could be set aside for infrastructure without much risk. Infrastructure spending would not be inflationary in the short term; in the long run it would help to improve productivity and keep inflation in check.
While such a fund might draw criticism amid partisan polarization in New Delhi, proper safeguards should help. It should be professionally managed, set up with specific objectives and free from government intervention, as difficult as that may be. Such a fund would not resolve all the challenges facing Indian infrastructure development. Issues such as land acquisition and environmental concerns that have stymied past attempts to improve infrastructure need separate attention, with better coordination between governmental agencies and stakeholders.
India is in a position to use its large foreign exchange reserves for meaningful infrastructure improvements while also providing a much-needed impetus to the economy. As a rule of thumb, governments should maintain foreign exchange reserves at a level equal to the value of six months' worth of imports. India's are now equivalent to more than 10 months' worth.
Some economists think even less is required for safety. According to Cornell University economics professor Kaushik Basu, foreign exchange reserves are required only to finance current-account deficits, rather than imports as a whole. On both these counts, India compares quite favorably with most of its emerging-market peers.
At the end of March, India had $133 billion of foreign exchange reserves parked with various central banks, overseas branches of commercial banks, the Bank for International Settlements and the International Monetary Fund, much of which was earning very low returns. Assuming that the Reserve Bank of India would give its required assent, these funds would be a good starting point for creating a dedicated infrastructure fund.
Kunal Kumar Kundu is India economist for Societe Generale.