25/02/2015 2:47 PM IST | Updated 15/07/2016 8:25 AM IST

Why Raghuram Rajan Will Be Watching The Budget Very Closely

The Reserve Bank will cut the repo rate only when the government manages to allay its fears and present the path for a sustained and a high quality fiscal consolidation. And that is why Rajan will be watching Jaitley's budget very closely.

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NEW DELHI, INDIA - FEBRUARY 19: Union Finance Minister Arun Jaitley during the launch of Central Services on eBiz Portal at National Media Centre on February 19, 2015 in New Delhi, India. eBiz portal is a government to business portal on which 11 central government services are available for the ease of doing business in the country by providing one-stop clearance platform for investment proposals. (Photo by Sonu Mehta/Hindustan Times via Getty Images)

After the India-Pakistan match in the cricket World Cup, the Modi government's second budget may be the most keenly watched event this month. Other than corporates and individual tax payers, the Reserve Bank of India (RBI) governor Raghuram Rajan will also watch the budget to be presented on February 28, very closely.

The finance minister Arun Jaitley had said in his budget speech in July 2014 that: "My Road map for fiscal consolidation is a fiscal deficit of 3.6 per cent for 2015-16 and 3 per cent for 2016-17." Fiscal deficit is the difference between what a government earns and what it spends.

Rajan will be watching very closely if Jaitley stands by this promise. There has been great pressure on Jaitley in the recent past to abandon the fiscal deficit target for the next financial year and expand public expenditure to get the investment cycle going again.

A survey of capital investment plans of 192 listed, private and public sector companies, carried out by CRISIL Research threw up a very interesting result. 90% of the companies surveyed expected a pick up in overall capital investments in 2015-2016. But "their own capital investment plans actually indicate a 4 per cent decline!" So, companies are clearly not putting their money where their mouth is.

This despite the fact that the corporate mood has improved significantly. "A year back, about 80 per cent of the companies CRISIL Research surveyed saw the investment cycle worsening. Today, that number has dropped to 3 per cent."

Given this likely fall in private capital investments in the next financial year, the government will have to step in, CRISIL suggests: "It's clear that till such time there is better demand visibility, the private sector will prefer to wait and watch than intrepidly commit more skin. In such a scenario, the ability of the government to kickstart investments through fiscal crucial."

Arvind Subramanian, the Chief Economic Adviser to the ministry of finance had also made a similar suggestion in the Mid Year Economic Analysis released in December 2014. As he wrote: "Over-indebtedness in the corporate sector with median debt-equity ratios at 70 percent is amongst the highest in the world. The ripples from the corporate sector have extended to the banking sector where restructured assets are estimated at about 11-12 percent of total assets."

Given this high level of bad loans, banks aren't interested in lending. Hence, Subramanian suggested that: "it seems imperative to consider the case for reviving public investment as one of the key engines of growth going forward, not to replace private investment but to revive and complement it."

If Jaitley goes with these suggestions of the government acting as a catalyst to revive investment, chances are the fiscal deficit of the government will shoot up. The government finances the fiscal deficit through borrowing. If the fiscal deficit goes up, the government borrowing also goes up, leading to what economists call the "crowding out" of the private sector.

The government borrowing more leaves a lower amount of money for others to borrow and in turn pushes up interest rates. Further, increased government expenditure is also likely to lead to higher inflation, with more money chasing the same number of goods and services. Given this, Rajan will be closely watching the fiscal deficit number to decide whether he should cut the repo rate further. Repo rate is the interest rate at which the RBI lends to banks and acts as a sort of a benchmark to the interest rates at which banks carry out their lending business. In a surprise move, the RBI had cut the repo rate in January this year by 25 basis points (one basis point is one hundredth of a percentage) to 7.75%.

This was widely followed by the expectations that banks will reduce the base rate (the minimum rate at which a bank lends to consumers). However, only three banks reduced their lending rates. Banks are essentially waiting to see if the RBI will continue cutting the repo rate, before they make a definite decision regarding cutting their base respective base rates.

After the surprise rate cut in January, Rajan had said that further cuts in the repo rate would depend on "sustained high quality fiscal consolidation." Whether this "sustained high quality fiscal consolidation" is happening will get clear only once Jaitley presents his second budget.

So being true to its form, RBI will cut the repo rate only when the government manages to allay its fears and present the path for a sustained and a high quality fiscal consolidation. And that is why Rajan will be watching Jaitley's budget very closely.