FRBM : A post mortem

Business Standard, 4 June 2008

In the late 1990s, India was in a grim fiscal crisis. The FRBM and associated efforts were of prime importance in improving the situation. We can now look back and understand strengths and weaknesses of what was done. Now, in the late 2000s, India is once again in a grim fiscal crisis. We need to draw upon these lessons for navigating the next steps on evolving fiscal rules.

Roughly 10 years ago, through a process of public discussion, a multi-pronged response to a grim fiscal crisis was put into place. This comprised the FRBM Act, rules under the FRBM Act, FRAs at the state level based on the 12th finance commission, and a strategy for implementation of the FRBM Act at the Centre. I loosely refer to the sum of these efforts as "the FRBM strategy".

This was a bipartisan effort: it began under the NDA and was carried through by the UPA. These changes were tremendously difficult, and required a massive and coordinated effort to push through. This effort showed India in a flattering light, as a country with a sophisticated policy-making elite that was able to analyse problems and put solutions into place.

The FRBM strategy yielded substantial results. India pulled back from the brink. The central and consolidated deficit dropped sharply. Some improvements in the debt/GDP ratio and in debt dynamics were obtained. FRBM helped encourage long-term thinking on the part of policy makers. By showing the private sector that government operated under rules rather than discretion, it increased confidence on the part of the private sector. The reduction of the consolidated deficit helped to free up resources for private investment which played a key role in accelerating GDP growth.

Now a fresh set of challenges has come up. Subsidies on account of food, fuel and fertilisers have skyrocketed through a combination of a rise in world prices and bad decision making on administered prices. What is worse, these problems have been hidden off balance sheet, which has helped reduce the credibility of Indian public finance data. The 6th pay commission and NREG will lead to large and unpredictable expenses in coming years. A new business cycle vulnerability is now faced with corporation tax being as high as 31% of gross tax revenues: in a downturn, tax revenues will drop. By 2008, the fiscal situation had become much more daunting. The optimism of India smoothly progressing towards fiscal stability has been lost.

What went wrong? It is now time for us to step back, to understand the strengths and weaknesses of the FRBM strategy, to draw lessons from it, to regroup and setup a fiscal strategy for the next decade. Seven flaws of the FRBM strategy can be identified:

  1. The FRBM tolerated off balance sheet items such as borrowings by PSUs. The combination of rules governing fiscal deficits and the lack of rules governing off balance sheet items may have even encouraged placing deficits off balance sheet. This is a loophole that needs to be closed.
  2. The FRBM was silent on the subject of financial repression. Powers amassed in the name of financial regulation are abused to force feed financial firms with government bonds. Force feeding financial firms with government bonds is also a loophole. India's fiscal framework must have all government bonds being voluntarily purchased by well-motivated actors.
  3. The goals of the FRBM were too modest. Even if the FRBM was fully implemented, India would have one of the biggest consolidated fiscal deficits in the world, and would barely qualify for an investment grade rating. A sound fiscal system is one where the debt/GDP ratio goes down in most years, barring a catastrophe such as a war that takes place once in 25 years. The bonds of such a country would be trusted by the private sector.
  4. India has succeeded in putting credible checks on state governments and ensuring that they do not violate FRAs. But there is no penalty for a central government that fails to live within fiscal rules. For fiscal rules to now have credibility, credible sanctions are needed against violations by the Centre.
  5. The FRBM was naive of the business cycle. India now experiences business cycle fluctuations just like other market economies. In good times, tax revenues go up and expenditures on some programs like NREG go down, and vice versa. To try to have rigid rules that work for all years is infeasible; such rules will inevitably be violated and then credibility will be lost. Fiscal rules must take the business cycle into account. The framework should be one where surpluses are run up in good times, which turn into deficits in bad times. In 2006-07, when times were good, the consolidated surplus should have been +3%, so as to make space for a 3 percentage point worsening in a downturn.
  6. Turning to the state level, there is a large heterogeneity in growth rates. Some states are growing at near 10%; others are growing at near 5%. To apply the same fiscal rules to all of them is inappropriate.
  7. The distinction between revenue and fiscal deficits needs to be questioned. The fiscal rules are an `over determined system' in specifying too much about the process of fiscal consolidation with rules for both the revenue and the fiscal deficit. Most core public goods such as law and order or judiciary do not require capital expenditures. From the viewpoint of fiscal stability, it is only the debt/GDP ratio that matters; whether government spends on salaries or steel is irrelevant. Hence, fiscal rules need to focus only on the fiscal deficit and stop caring about the revenue deficit.

The FRBM strategy was a valuable one; it helped in pulling India back from the brink. While it yielded results for some years, fiscal stability is now once again in question. To move forward, progress needs to be made in addressing the seven flaws of the FRBM strategy: closing the loophole of off-balance sheet items, closing the loophole of financial repression, setting more ambitious goals so that India can be well into an investment grade rating, having credible sanctions against a non-compliant central government, bringing in business cycle sophistication, recognising differences between high-growth and low-growth states, and focusing only on the fiscal deficit.

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