``The overarching theme, intent, and orientation of the Union Budget 2010 will be fiscal consolidation. Because of the extraordinary turn of events last year, starting with the Lehman fall, policymakers across the world have adopted expansionary economic policies of varying degrees and nature. Monetary stimulus was essentially tendered by   pruning policy rates rather aggressively, accompanied by quantitative easing measures to ensure liquidity,`` said Jay Shankar, chief economist- vice president, Religare Capital Markets.

Fiscal measures involved tax-cuts and one-time rebates along with propulsion in government expenditure. The aim was to boost private consumption and investment demand. The impact of these fiscal measures on economic activity and growth, as measured by the fiscal multiplier, was reflected in India`s improving economic health but increasing deficit levels. Reining in these deficit levels through fiscal consolidation thus stands high on the agenda of Union Budget 2010.     

India`s consolidated fiscal deficit is likely to cross 11.5% of GDP: 7-7.2 % for the central government and ~ 4.5% for the states. Fiscal deficit for financial year 2010 has been pegged at 6.8% of GDP - a 16-year high. Such high levels of fiscal deficit, in our opinion, find their origin in 2008-09 when government spending soared due to the sixth pay commission, higher subsidy burden arising from a spur in crude prices, and the debt waiver scheme. The stimulus measures only added to the deficit, but much later.

Unfortunately, the deficit figure could move up further if the budgeted revenue assumptions go wrong. Clearly, such towering fiscal deficit levels are not sustainable in the longer-term as the government will have to resort to higher borrowing, and thus may risk crowding out private investment. Higher demand for funds may lead to upward movement in interest rates; higher cost of capital may stunt investment and economic growth. At a macro level, this may as well fuel inflation and thus making growth unsustainable. Consistent increase in borrowing levels may swell the interest burden that would eat into a significant portion of government revenues. This may also lead to sovereign downgrades by international rating agencies and may hamper capital flows.

Fiscal consolidation thus appears to be the only way out.  Reining in the fiscal deficit - a revenue side exercise. Technically, fiscal deficit can be tamed in two ways; by raising revenues or trimming expenditure. Given the nature of political economic realities, fiscal consolidation in India takes place mostly through the first route. The former, as empirical evidence suggests, is also bolstered by strong economic growth, besides reforms. Moreover, besides tax and non-tax revenues, some one-off items like 3G license fees and divestment proceeds have gained prominence as fiscal saviours off-late.

With the 3G auction not likely to conclude in FY10, the aggressive allocation of ~ Rs 350 billion will only spiral the fiscal deficit. However, the proceeds from divestment may exceed the modest budgeted amount of Rs 11.2 billion by several folds. Also, better-than-expected growth may lead to higher tax recoveries. This, along with tighter expenditure, may throw up some pleasant surprises as far as the current year`s fiscal deficit is concerned. Roll back of the cut in excise duty and service tax may also provide some respite. The government may thus project a 5-5.5% deficit number for FY11.

On the tax reform front, the GST and Direct Tax Code (DTC) would go a long way in providing a kind of perennial fiscal stimulus by boosting demand. This is also in conjunction with our broad theme that consumption will be in the driver`s seat for the next economic cycle. These tax reforms are likely to promote a consumption-driven society, even at the cost of a decline in the savings rate.

Some sectors that have responded well to the policy stimulus have rebounded with enough momentum to cross the `escape velocity`. These sectors have certainly `taken-off` in the sense that they can sustain most of this growth beyond the stimulus withdrawal. It is also true that the economy can not be kept on artificial booster doses for long.

However, the government will have to be careful and selective in calibrating the stimulus exit. While it may be prudent to retain some stimuli especially for sectors with strong linkages, there is certainly a case for withdrawing benefits from sectors that have not responded well. Sectors such as auto and real estate have done well. Both these sectors carry a lot of weightage in terms of sentiment - general consumer confidence and demand across industries. They also have strong backward and forward linkages, in terms of employment creation as well as demand for other sectors like steel, auto-ancillary and components, tire, and cement.

As the economy gets stronger by the day, the government`s focus has now shifted from addressing the demand slump to exiting smoothly from the stimulus packages introduced last year. For sustainability of the ongoing recovery, the real issue is whether private consumption can replace public spending and to what extent. The showstopper for Union Budget 2010 will be the way the government manages a smooth exit, while minimizing the adverse impact of withdrawal. Its going to be one of the most difficult tightrope walk in the last two decades.