Fiscal favors

I came across this article in the Telegraph a couple of days back, and I was enlightened with some understanding of the economic forces in the present globalized world.

The Indian economy is no longer immune to the world economic changes. The recent fears of economic slowdown in the US has tumbled the stock markets, with foreign investors taking away their pie before its too late. And this has affected domestic growth rate as well.

India has moved on from a fixed exchange rate regime to a flexible rate, thereby allowing INR to fluctuate with the demand and supply in the forex market. In addition, the existence of capital account convertibility (which allows freer movement of capital in and out of the economy) gives India the capability to compete in the world.

The author opines that the existence of the above (capital account convertibility and flexible currency rate regime) renders the fiscal policy ineffective.

A chain of events occur due to the favorable (or unfavorable) fiscal policy. Higher revenue spending on growth will lead to greater outputs and higher incomes. This will translate to higher demand for commodities, and subsequently higher demand for loanable funds and resulting in higher commodity prices.

Rising prices imply higher inflation. Now this inflation hurts the poor and benefits the rich. This is because of higher incomes of the rich, or because the rich are the commodity suppliers. The poor, on the other hand cannot demand higher income, but are faced with inflationary pressures.

To keep inflation in check, the government raises the interest rates. In the presence of CAC, there is a higher capital inflow in the domestic economy, leading to accentuating stock markets. The demand for domestic currency also rises because of flexible currency. This makes foreign items cheaper for the domestic market and domestic commodities more expensive to foreigners. The demand for locally made products takes a hit, and so does exports.

The recent fall in the bellwether index is a fallout of expectations: FIIs expected a reduction in the interest rates in India after US economy reduced theirs. But the RBI governor has not shown any intention to reduce the rates. So, foreign investors are expected to be back soon.

But what does government intend to do? They will have to keep an eye on the forthcoming elections. The recent hike in fuel prices, thought long awaited has already seen sections railing against the government for the pragmatic move.

The author expects the larger populace to be pleased with “fiscal favors”, and issues like exchange rates and CAC will take a back seat.