As Finance Minister Pranab Mukherjee gently articulated the big picture and finer details of Budget 2010, the market couldn’t make up its mind on what to make of it. And then, suddenly, it did. When Mukherjee threw a number that basically meant the government would do quite a bit to stop the economy from living beyond its means, while maintaining its new-found momentum in growth, the market gave a vote of approval. When he said the fiscal deficit—the defining measure of how much an economy is living beyond its means—would drop from 6.9% to 5.5% of GDP, the BSE Sensex rose 2.5%.

A few hours later, another market, the bond market, gave its verdict. It shared the stock market’s appraisal of the FM’s intentions, but it was more circumspect in its response. It said that it liked the cards the FM had laid out. But much as it wanted to believe him, that they would fall the way he wanted them to, it couldn’t believe him. Not fully. Not just yet. The yield on 10-year government securities increased by 0.07 percentage points to close at 7.87%, signalling a rise in the cost of borrowing when Mukherjee’s script required it to fall.

If one leaves aside the risks for a while, Mukherjee has nailed the script. The task before him was clear. He had to place the economy on the 8-10% high-growth path once again, and pass the baton to the private sector. He had to start the long process of mending the government’s finances. And even as he went about balancing growth and control, he had to find the ways and means to continue his government’s stated agenda of inclusive growth.

His script gives him a realistic shot at achieving all three—simultaneously. He’s begun a calibrated withdrawal of the stimulus package that was introduced in tranches beginning December 2008; and he’s made it abundantly clear that the government has to shape up. Despite the loss of that artificial support, the economy is projected to grow 8-8.5% in 2010-11, up from 7.2% in 2009-10. And despite the tightening of finances, the outlay for social spending has increased by 35%. Mukherjee has managed to balance the books, and interests, nicely.

The Backdrop

In order to appreciate this artful exercise, one needs to go back. To December 2008, when Mukherjee took over what is, arguably, the second most important job in the country. Mukherjee was stepping into the big shoes of P Chidambaram, a poster boy for reforms, who could defend new taxes and quote Saint Tiruvalluvar with equal ease. And he was taking over at a time when India was facing its worst economic crisis since 1991. There was no cash. There was no growth. There was little hope of a quick or easy reversal.

Mukherjee wasn’t suave, but he was solid. He spent and spent to get the wheels of the economy moving again. He cut taxes to get people to spend more. Excise duty on goods was halved to 8%. Service tax was lowered from 12% to 10%. Between March 2008 and March 2010, the government’s total expenditure galloped at a compounded growth rate of 20%. At the same time, tax collections—at about 60%, its main source of revenues—declined at a compounded rate of -3.2%. To balance its books, it borrowed and borrowed from the domestic market.

The contribution of private-sector investment to GDP growth went from 50% to minus 30%. Mukherjee wants it to return to the heady days.

By the time it became clear that the economy was back on track, around August 2009, the government’s finances were in a mess. The fiscal deficit—revenues minus expenditure and interest payments—had jumped from an acceptable 2.7% in 2007-08 to an alarming 6.9% in 2009-10. In the current financial year, the government has borrowed Rs 4,51,000 crore—nearly four times what it borrowed three years back.

Down that road, the government was heading for a debt trap. And because it was borrowing so much, it was crowding out the private sector from raising money, making it difficult for companies to raise funds to expand. It also had the effect of increasing the cost of borrowing.

This had to be reversed, everyone agreed. The tax cuts had to be withdrawn, the government had to spend and borrow less. The question was: should it be in one go or in tranches? Do it too fast and the economy might slip into a funk again. Do it too slow and the mountain of debt grows.

The Revenue Side

The Thirteenth Finance Commission, which came out with its assessment of India’s fiscal situation a day before Budget 2010, recommended a gradual withdrawal. It’s exactly what Mukherjee has done. He’s hiked excise duty—the main giveaway in the stimulus package—from 8% to 10%. He’s restored import and excise duties on petroleum products, and brought more services into the service-tax net. All this will add Rs 46,000 crore to tax collections, which are anyway likely to be good, given the 8-8.5% GDP growth projection for 2010-11. That means more revenues.

Mukherjee also has two new sources of revenues—and abundant ones at that—that his UPA predecessor, even Mukherjee last year, did not have: disinvestment and 3G spectrum auction. Some might say he got lucky. Mukherjee might say he created his own luck.

The 3G auction, which is expected to fetch the government Rs 35,000 crore in 2010-11, has been on the drawing board for almost three years now. Once it became the field of a shadow war between companies in the telecom sector, it got caught in a maze of bureaucracy. It was shunted between ministries, even within ministries. It was only when Mukherjee intervened and said that the auction has to be done before March 31, 2010, did the issue start getting untangled. Mukherjee will still narrowly miss his deadline—the auction is fixed for April 9—but he will definitely have that kitty next year.

Even while balancing growth and control, he has found ways and means to continue to expand his agenda of inclusive growth.

Even with disinvestment, though Mukherjee has benefited from not having the Left parties threatening to bring down the government, he has moved with speed and purpose in the political space given to him on the issue. In the early days of his second term, he set the agenda for disinvestment: minority stake sales in all public sector undertakings (PSUs) with a three-year profit record. He’s stuck to it. He expects to close 2009-10 with Rs 25,000 crore. Next year, he wants to move up a gear or two, and raise about Rs 40,000 crore.

It may materialise, it may not. “The government has said it won’t sell a strategic stake in PSUs, it will only sell a minority stake,” says Suresh Tendulkar, former Chairman of the Prime Minister’s Economic Advisory Council. “Minority stake sales depend heavily on investor sentiment and market conditions.” The last two PSU public issues, from NTPC and REC, met with a poor response from retail investors; institutional investors had to step in and bail out the issues.

Mukherjee is looking to mop up Rs 75,000 crore from 3G and disinvestment. That’s about 10% of the government’s revenues for 2010-11, and gives him the bandwidth to continue with the spending-based stimulus for some more time without sending the fiscal deficit awry again.

The Expenditure Side

On the expenditure side, Mukherjee did get lucky. There are no one-time events with shock value. There’s no populist farm-loan waiver scheme, which cost the exchequer Rs 60,000 crore spread over three years. There are no Pay Commission salary arrears to drain out Rs 47,000 crore.

Total expenditure is slated to grow at a slower pace in 2010-11—8.5% versus 15.6% in 2009-10. More importantly, in the way he’s made the allocations, Mukherjee is trying to spend the money better. So, he’s increased ‘plan expenditure’—spending that creates assets and income—by 18.4% (14.5% in 2009-10). By comparison, he’s increased ‘non-plan expenditure’—outgoes like subsidies and interest payment that don’t create assets or income—by only 4.1% (16% in 2009-10).

The net effect of these revenue and expenditure alignments is that Mukherjee hopes to reduce the fiscal deficit from 6.9% of GDP in 2009-10 to 5.5% in 2010-11. And furthermore in the following years. The Thirteenth Finance Commission wants the Centre’s fiscal deficit to drop to 3% by March 2014. It has also asked the Centre to reduce its debt from the current 53.9% to 47.5% by March 2014.

The government is tacitly saying that its role in driving the country’s growth is nearing its end for now, and that it would like to vacate the space for the private sector. “With development and economic reforms, the focus of economic activity has shifted towards the non-governmental actors, bringing into sharper focus the role of government as an enabler,” Mukherjee said in his speech.

He’s countered the partial withdrawal of the spending stimulus by giving people more money so that they keep buying goods.

The private sector holds the key to growth in the economy. Although the government spends Rs 11,00,000 crore in a year, its share in India’s GDP is only 10%. Private consumption accounts for about 60% of the GDP and the remaining 30% comes from investments made by the private sector.

With the stimulus, the government was essentially feeding the 60% set (private consumption). By altering the tax slabs and reducing their tax burden by Rs 26,000 crore, Mukherjee is also feeding that set. “It will boost consumption and offset any reduction in demand because of the excise duty hike,” says DK Joshi, Chief Economist, Crisil. Mukherjee would much rather do that because a rupee spent by private consumption (both individuals and companies) makes a far greater contribution to the economy than a rupee spent by the government.

The Investment Side

Mukherjee is now targeting the 30% set (private-sector investment). This set accounted for about 50% of India’s GDP growth when the economy grew at 9% or more in the three years till 2007-08. In 2008-09, as businesses held back investments, it made a negative contribution to growth, of -30%. Part of Mukherjee’s plan is to have the government borrow less so that there are sufficient savings available for the private sector to pick up.

In the Indian context, one can broadly divide the economy into three parts: government, corporate and households. Only households are net savers—they have a surplus to lend out. In the current fiscal, household saving will be about Rs 6,90,000 crore, which has to be shared between the Centre, states and the corporate sector.

The Centre, with its extravagant fiscal deficit to fund, will borrow Rs 4,50,000 crore (or 65% of household savings). The states will borrow Rs 1,50,000 crore (22% of household savings). In other words, the entire private sector has a pool of only Rs 90,000 crore (13% of household savings). In 2007-08, the corporate sector tapped 70% of household savings.

Higher borrowing by the Centre wasn’t so much of a problem last year because of subdued demand from the corporate sector. But in the coming fiscal, the private sector is expected to expand capacity and will be looking to borrow more. “We need to keep in mind that investment outlook is improving,” says Tendulkar. “Thus, fiscal stability is important for long-term growth.”

The higher the money available for corporates, the lower the pressure on interest rates. Lower borrowings by the state also translates to stable interest rates, as the yield on 10-year G-sec is the benchmark for other borrowing rates in the economy.

The Doubts

There’s a lot riding on the government sticking to its promise to reduce its fiscal deficit. “It (fiscal consolidation) has come too late in the day,” says Golaka C Nath, Senior Vice-President (Economic Research), Clearing Corporation of India. “The government has to walk the talk.”

There’s not much faith in the government’s ability to do that. It’s constantly blown targets. In 2008-09, Chidambaram promised to bring down the fiscal deficit to 3%, but the government decided to waive the requirement citing “unusual” circumstances. Those “unusual” circumstances were farm-loan waiver and Pay Commission award. “All this talk of fiscal consolidation has to materialise to have an impact on G-sec yields,” says Indranil Pan, Chief Economist of Kotak Mahindra Bank.

Mukherjee will also need a little luck to come his way. For instance, he will cross his fingers and hope that crude stays below $75—the threshold beyond which the government’s subsidy bill goes out of control. Mukherjee has allocated just Rs 3,100 crore to oil subsidies in Budget 2010—nearly Rs 12,000 crore less than what was spent in the current fiscal. Fertiliser subsidies are also projected to come down. He’s banking on decontrol of prices in both oil (to be announced) and fertiliser (announced) sectors. Forget the opposition, even Mukherjee’s allies are opposed.

In the quest for growth, Mukherjee is prepared to risk higher inflation. One of the arguments given against the withdrawal of the stimulus is that it would be inflationary. As it is, Wholesale Price Index (WPI), the headline inflation rate, stood at 8.6% in January, compared to 7.3% in December 2009. Food inflation was the worst, at 15%. “The excise duty increase will increase prices by 0.5%,” says Satya Poddar, Partner with Ernst and Young, a global accounting and advisory firm.

Crisil’s Joshi feels food inflation is due to supply-side shortages brought on by a poor monsoon. “Food inflation should ease in the coming months,” adds Pan. “This could offset any inflationary pressure from increase in excise duty and petroleum prices.”

The Misses

While Mukherjee has done commendably in creating conditions to push growth while going back to fiscal prudence, he could have done more to push reforms in the economy. “I’m unhappy with the pace of reforms at least in the case of disinvestment and deregulation of oil prices,” says Tendulkar. There are small reformist strokes: the intent to usher in the direct tax code and the goods & service tax by April 2011, bidding for coal mines, cash transfer of fertiliser subsidies, a super-regulator in financial services, the push to the New Pension System (NPS).

But he’s dodged the big ones. If one goes by the world-weary logic that bold economic decisions can only be taken when the political stakes are low, this is the maximum clear room he could have hoped to get. The UPA government is in the first year of its five-year term and no major state elections are due this year. In contrast, a year on, the political calendar is packed. If and when Mukherjee does rise to present Budget 2011, it will be in the backdrop of assembly elections in the heavyweight states in three of the four regions of India: Uttar Pradesh (north), West Bengal (east) and Tamil Nadu (south). Maybe, he will still, outside the budget. He better, or else he might be left with no choice but to leave it for another day.

There’s a lot in the government’s inbox, including some long-pending reforms like a hike in foreign direct investment (FDI) limits in retail, insurance and banking. There’s deregulation of petroleum prices, which Mukherjee has left for Murli Deora, Minister for Petroleum & Gas. There’s an urgent need to help infrastructure building graduate from potential to performance.

Robert Prior-Wandesforde, Senior Asian Economist, HSBC, warns of the dangers of ignoring reforms when the economy is doing well. “Over the next year or two, public finances will benefit from the economic recovery,” he wrote in a post-budget report.

“But what happens when this cyclical support is removed?” Mukherjee’s predecessor in North Block, M Chidambaram, confronted this situation, and he got exposed. If he stays true to his word on fiscal prudence, Mukherjee might script a different fate for himself. One that both the stock market and the bond market approve of.