The Non Operating Income Trap

Writing in Business Standard (March 11, 2010), the reputed economist, Shankar Acharya has reiterated a basic flaw in the government’s approach to fiscal consolidation. The 1.4 % reduction in the fiscal deficit in the coming year will rely heavily on a few items: an additional Rs 15,000 crore of PSU disinvestment proceeds, Rs 35,000 crore of the much-postponed 3G telecom auction proceeds, about Rs 20,000 crore saved on account of no Pay Commission arrears, about Rs 15,000 crore saved on account of no loan waiver payments and Rs 10,000 crore saved on account of no oil/fertiliser bonds. Together, these five items add up to Rs 95,000 crore or 1.4 per cent of fiscal deficit ratio improvement claimed by the Finance Minister!

But many of these items are one-off in nature. And in corporate language they would be called non operating income. In other words, the worry is how will further deficit cuts be achieved?

The bond market is usually a powerful judge of government policies. In the second week of March, the 10-year benchmark interest rate crossed 8 per cent, reflecting the concerns of that market. The hardening of yields is also a sign that markets are anticipating higher inflation.

Meanwhile, the government has sought to assure industry that there will be no crowding out effect due to government borrowing. But Acharya mentions that unlike last year, excess liquidity may not remain as the RBI will most likely continue its exit from its expansionary policy introduced at the peak of the global meltdown in 2008. At the same time, commercial banks are already holding almost 30 per cent of their assets in the form of government bonds. They may have little appetite for more such assets, especially when there is a risk of capital losses due to higher interest rates. So, the only way to offload government paper may be to offer higher interest rates. This will drive up interest expenses for the government adding up to the structural deficit. More importantly, by increasing the cost of funds, investment and growth may also be affected.

In other words, the budget has painted a far more optimistic scenario than would be justified if we take into account the ground realities.