Fiscal policy imperatives

Tuesday, June 09, 2009Dr Ashfaque H KhanAfter successfully reducing macroeconomic imbalances in the current fiscal year, the government appears to have lost patience and decided to pursue an aggressive expansionary fiscal policy in the 2009-10 fiscal year. The National Economic Council (NEC) has already approved the highest-ever Public Sector Development Programme (PSDP) amounting to Rs621 billion for the next fiscal year – up from the revised estimates of Rs363 billion for 2008-09, thus representing a hefty increase of over 71 percent. With massive increase in the PSDP, the budget deficit is likely to be in the range of 5.0 to 5.3 percent of the GDP in the next fiscal year. In rupee term, the budget deficit is expected to be in the range of Rs740-780 billion. It is important to point out that in the current fiscal year the government pursued tight fiscal and monetary policies with a view to reducing macroeconomic imbalances. Such a policy stance was necessary to address the challenges of high budget and current- account deficits. These policies have paid handsome dividend as the fiscal deficit is likely to decline to 4.3 percent of the GDP from 7.4 percent last year and account deficit to around 5.0 percent of the GDP from as high as 8.4 percent. Inflationary pressure has also eased somewhat. These have been the major achievements of the current fiscal year for which the government must be commended. As we move towards the new fiscal year, the government appears to have lost patience and decided to undertake an expansionary fiscal policy. This is not the right time to pursue an expansionary policy because the underlying weaknesses in some key macro aggregates such as fiscal and current-account deficits and inflation still persist. The government should not be complacent about the successes and must avoid taking the expansionary route. This is the message of the SBP's third quarterly report as well.It is well-known that high budget deficit is the "mother of economic problems" as it gives birth to a variety of economic issues. A budget deficit in the range of Rs740 to 780 billion will be construed in the market as the government's becoming a desperate borrower, and as such the market will exploit it. If the bulk of this deficit is financed from external sources it will lead to the accumulation of the external debt and when multiplied by the exchange rate it will add to the public debt which is already growing at a rapid pace. It appears that the government is banking on the pledged sources of external financing to bridge revenue –expenditure gap. Banking on uncertain external inflows to undertake expansionary fiscal policy is a highly risky job. Any shortfall in external financing will have to be met through domestic borrowing. Borrowing from domestic sources (banking and non-banking) to such a large extent will put tremendous pressures on the interest rate, which will prevent the State Bank from even thinking of easing the monetary policy. As such, the high interest rate environment will continue to persist with investment and growth stagnating. If we assume that external sources of financing are fairly certain (on the basis of which the government is increasing expenditure in 2009-10), it will give rise to another type of risk. What will happen if these magnitudes of external resources are not available in the future? Can any government cut down development or other components of spending if external resources are not available in this magnitude going forward? These are valid questions and must be taken into account before enlargement of the base of each component of expenditure. It is presumed that the government has decided to pursue an expansionary fiscal policy to revive economic growth, create employment opportunities and reduce poverty. Is this a viable policy in the face of a current-account deficit of over five percent of GDP? Should we pursue an expansionary fiscal policy in the midst of rising oil prices? Crude prices have already reached a seven-month high at $68 a barrel and the Goldman Sachs has recently predicted the price to touch $85 per barrel by the end of December. An expansionary fiscal policy will increase aggregate demand, which will translate into higher imports, including higher imports of oil. With rising oil prices it will further widen the current-account deficit and will surely enhance macroeconomic imbalances. The purpose of reviving economic activity, creating job opportunities and reducing poverty will certainly be frustrated by the rise in macroeconomic imbalances. It will simply contribute to the widening of the already high current-account deficit and will give rise to macroeconomic instability which will be inimical to economic growth. It will certainly raise the country's debt burden, and most of the budgetary resources will be consumed by interest payments alone. Within the past two years (2007-08 and 2008-09), the interest payment has surged from Rs336 billion to Rs676 billion -- an increase of 101 percent. The interest payment is projected to rise to over Rs750 billion in 2009-10, which will consume 53 percent of the projected FBR's tax revenue. The government should have continued with tight fiscal and monetary policies for one more year. It could have consolidated the gains in 2009-10 before embarking on an expansionary fiscal policy route. Enough resources would have been available for spending in the remaining three budgets of this government. The government appears to have become impatient and the IMF has also forgotten its own lesson of a sound fiscal position, which vital for achieving macroeconomic stability and increasingly recognised as being critical for sustained economic growth and poverty reduction.