This is that time of the year when the corridors of the North Block is buzz with activity and hectic parleys are on from all pressure groups of the economy to showcase their wish-list, in an attempt to corner the maximum benefit out of this mammoth exercise called Union Budget. Although Union Budget is supposed to be just an account statement of the Government of India, it is needless to say that over the years it has presented the government at the helm of affairs an opportunity to outline their economic agenda and hence has become a red-letter day in the financial calendar of our country.

Let us first delve into the economic and political backdrop against which the contours of Union Budget 2008-09 will be drawn up. We are probably in the midst of the strongest growth run in the post-independence India. All the structural factors necessary for a sustained high growth phase seems to be in place but some cyclical headwinds are probably making our journey a little more turbulent than what we would have otherwise liked. Our achievement on growth front over the Tenth Plan period was very close to target and it is no surprise that the Eleventh Plan wants to take us closer to our aspirational target of double digit growth. While the growth process has gathered its own momentum, Union Budget 2008-09 is expected to remove the hurdles towards conquering the next frontier by extending the reforms process to reap long-term gains. In the short run, maybe a little demand fillip will do wonders for an economy where incoming data have been flashing some intermittent signs of growth concerns.

Inflationary concerns dominated the mindset of analysts when the Finance Minister was presenting the Union Budget for 2007-08. At that time he had raised concerns over the inflationary trends but exuded confidence in being capable of moderating those trends. Headline inflation for most part of FY08 has been benign to say the least. This could be a positive outcome of a judicious mix of fiscal and monetary policies and could be highlighted as one of the success stories of last year’s budget. 

The other macroeconomic factor which has dominated economic debates in the last year or so and will be a crucial consideration for this year’s budget, is the deluge of capital flows that the country has received. Finance Minister has himself dubbed them as ‘copious’ and it seems that this process of receiving foreign flows is going to sustain for some time to come. While in FY07 we had a BoP surplus of USD 35bn on the back of around USD 46bn of capital flows, we will not be surprised if both these numbers would double in FY08! Monetary policymakers have been torn between letting the rupee appreciate and intervening in the currency markets to inject more rupee liquidity which could be potentially inflationary in nature. Rupee has been one of the strongest appreciating currencies in the Asian region in 2007 even while RBI has continued its policy of back-to-back intervention and sterilization of the rupee liquidity through issuance of Market Stabilization bonds and CRR hikes.     

It is true that tackling the so called problem of ‘impossible trinity’ (open capital account, fixed exchange rate and independent monetary policy) is the imperative of monetary policymakers, however, the onus of minimizing the collateral damage has often rested on fiscal policy. The suddenness and the magnitude of the exchange rate shock has affected several sectors in the economy which were export dependent with limited import content and did not have enough profit margins. Anecdotal and industry estimates suggest possibility of huge job losses in several industries including textiles and the approach of Finance Minister to address this issue could be one of the highlights of Budget 2008-09.

Most likely this is going to be the last budget of Finance Minister before the general elections. So there will be expectations from him to satisfy a large number of pressure groups who will be the key to electoral success. It will be the Finance Minister’s endeavour to see that the resultant force of these often opposing demands does not lead to a lopsided budget which will be a setback for economic reforms.

The last piece in the backdrop for this year’s budget will be the slowly unfolding global developments. After almost 4 years of unprecedented global growth, there is a possibility that the global economy might enter a phase of moderation in 2008, mainly on the back of a severe slowdown in the US economy.       

What to expect from the Budget?

At a macro level budget policy formulation by the Finance Minister will have to take into account all the above factors. Let us do some crystal ball gazing to see what kind of policies these might turn out to be.

As we had discussed earlier, the recent volatility in industrial production numbers and the steady decline in credit growth from around 30% to 22% now, could be worrying the Finance Minister. He has already mentioned his willingness to see a 50 bps drop in lending rates; however, the banks will rather look for a confirmation from RBI. If the January quarterly review of monetary policy is silent on this account then Budget speech can be used to reinforce the same thought.

The other option in front of the Finance Minister is generating a direct aggregate demand shock which can be orchestrated in two different ways. The first one is trimming the direct tax rates where tax collection has much exceeded expectations and the second one is to increase government spending substantially.

The case for a direct tax rate cut has been based on several arguments. Our marginal tax rates are still somewhat higher than the Asian average and with the improvement in tax compliance being applauded even by the FM, a small tax rate cut will perhaps bring in all the efficiency gains associated with moderating extreme tax rates. However it is not sure whether such a proposal will be completely revenue neutral or not and FM will have to carefully consider the flip side of slipping on the FRBM mandate of predetermined moderation of deficit ratios. The success of VAT would mean that the FM would like to take us closer to a common GST and direct tax collections exceeding the indirect taxes for the first time would imply that our tax system is becoming more and more progressive.

A more straightforward approach of injecting demand will be to pump in additional expenditure. If adhering to a populist framework is the need of the hour then spending on social sector, rural development and non-merit subsidies would be top of the agenda items, maybe even some of the components of the Bharat Nirman dream will get a favourable treatment. A simple number analysis of the last few pre-election budgets makes it amply clear that most of the above mentioned components of the expenditure budget receive out of proportion attention regardless of the controlling power at the Centre. To some extent, these expenditures would further the cause of inclusive growth but one should be aware of the inflationary consequences as well.

Inflation management has been accorded top priority by policymakers across the globe. The conscious policy choice of reducing import duties and banning futures trading in some agri commodities has helped in reining in headline inflation numbers. However, it is not the time to lower our guard against fighting inflation. Global inflation has been on an uptrend in the later half of 2007, riding on crude oil reaching the magical 3 figure mark and food prices forcing inflation to reach multi-year highs in both developed and developing nations. The apparent immunity of Indian inflation to these global developments should not be thought of as resilience. Although a rapidly appreciating rupee has mitigated some of the impact of imported inflation, there is still incomplete pass-through. Some harsh decisions need to be taken as early as possible to align domestic prices with international prices in both the energy and food sectors because increasing off-balance sheet exposure (oil bonds) is making the financial health of the government a little more fragile. Some of these decisions might come before the budget and fiscal proposals could be aimed at neutralizing the second round effects of such price developments.

Some fiscal subsidies in the form of interest rate concessions have already been offered to the exporters being affected by the rising rupee. Budget might bring in a few more such sops to provide much needed respite to the small exporters. It should be noted here that even the burgeoning interest payments on outstanding MSS bonds could be thought of as an implicit subsidy to the exporters. Given the labour market ramifications of the appreciating rupee, we can expect FM to take a sympathetic look at the issue.     

Union Budget 2008-09 is going to be an exercise in balancing the short term populist necessities with the long term goals set out by the Eleventh Plan. The objective will be to further inclusive growth in a stable inflationary environment after neutralizing the impact of an appreciating currency.