'Tighter fiscal policy would allow the central bank to cut rates more aggressively in response to a slowdown,' said a report by Goldman Sachs, the legendary investment bank that was turned into a retail bank recently as a fall out of the US financial crisis.
The Reserve Bank recently infused Rs 1 lakh crore (Rs 1,000 billion) into the system by cutting mandatory deposit requirements for banks, CRR, by 2.5 percentage points, besides taking other steps.
The RBI is scheduled to announce its mid-term review on October 24.
However, the loose fiscal policy may have the unintended consequence of imparting a stimulus to slowing consumption and domestic demand, it said.
'We think, however, that the fiscal loosening, whether by design or default constitutes a key macro risk,' Goldman Sachs said, adding the combined Centre and states fiscal deficit may jump from 6.2 of GDP in 2007-08 to 8.4 per cent in the current fiscal. It may further rise to 8.5 per cent of the GDP in the financial year 2009-10, the US bank said.
'There is considerable uncertainty as how high the deficit may go, and its macro implications,' the report stated.
It further added that the deficit is not rising due to tax cuts but because of the increase in spending, which is of permanent nature and is unlikely to reverse when the business cycle turns upwards.
'We believe government borrowing will crowd out private sector credit, squeeze liquidity further, and add to the already high government debt, thereby worsening sovereign risk,' it said. It further added that a higher spending-induced deficit would reduce overall savings in the economy and worsen the current account deficit.