The fiscal retrenchment—through a 1.2 percentage point reduction in the fiscal deficit—rebuilds sovereign credibility, severely damaged when fiscal rules were violated in a populist splurge. This is achieved by extending last year’s flexible policies. If counter-cyclical responses demanded loosening strings, despite an already strained financial position, the case for a contraction with an upswing in the cycle was equally strong. Anything less than a retreat, however modest, would have been interpreted as the bad old habit of extravagance.

Openness demands policy restraint; profligacy becomes costlier than before. The past year singularly demonstrates how these costs are impinging upon policies.

Markets—now deeper and globally integrated—have reinforced the adverse impact of large fiscal deficits. Bond market vigilantes—fortunately only local (things would have been much worse if public debt was significantly foreign-held, as is the case in Greece, or was the case in Hungary and Indonesia at the end of 2008)— pushed long-term bond yields from a low of 5.37 per cent in December 2008 to above 7.8 per cent in February 2010. Consequently, the interest cost on government debt has risen from an average of 6.2 per cent in 2008-09 to 7.1 per cent in 2009-10. With public debt levels at 80 per cent of the gross domestic product (GDP), the increasing costs of debt-financing have virtually forced the deficit-interest rate trade-off to settle for the former.

Rating overseers, fed upon debt indicators and market signals, were equally punishing. They reacted quickly, as Standard and Poor’s did, by lowering India’s outlook to negative in February 2009. Being assigned the lowest investment grade—also the lowest among the BRIC (Brazil, Russia, India and China) countries—is not merely an embarrassment, but has real economic costs when a country is financially integrated. The cost of foreign capital, which now meets nearly one-third of the funding requirements of Indian companies, is determined by these risk ratings. In the last year, borrowers have faced high interest rates domestically and high risk premium abroad, reflecting fiscal vulnerability, among other risks. The pressure for fiscal policy to be reworked in order to enable private investments has therefore doubled.

Rating agencies also demand orderly policies on the external account. A negative confidence shift triggered by a downgrade can result in an outflow of foreign capital, now integral in financing the savings-investment gap. The threat of disrupting trade financing (inching towards normalcy) and deterring foreign investments through further downgrades, at a time when raising investment levels is central to economic policy, has advanced efforts to repair public finances. The Indian Treasury will endeavor to do this by accepting the 13th Finance Commission’s recommendation to bring down the national debt-GDP ratio to 48 per cent by 2014-15. The promise of fiscal rectitude is backed by intent—reduction and reorientation of subsidies, taxation reforms, and so on—and supplemented with honesty, by bringing on board off-budget liabilities.

Finally, the pressure of a liberalised capital account is imposing policy discipline. In the current macroeconomic environment—upswing in the business cycle, inflation and a positive capital flow outlook—were policymakers not to opt for a fiscal restraint-looser monetary policy combination, the deficit-induced pressure on interest rates would further add to the existing bias toward monetary tightening. The complications arising from a widening domestic-foreign interest rate gap—attracting disproportionate volumes of arbitrage capital (often carry-trade related), which encourages investors to take short positions in anticipation of an appreciating domestic currency—are a real threat to stability. A taste was offered in 2007 of the negative spillovers of managing a capital inflow boom—exchange rate appreciation, monetary expansion, sterilisation, and so on. The destabilisation threat from volatile capital movements has now been factored into policymaking. In responding correctly to the macroeconomic situation, India’s 2010 Budget sends out a mature message of responsible policymaking.

An unintended but welcome consequence of liberalisation, the trend towards responsive and disciplined policies will likely become the future norm with deepening economic integration. This implies two things. First, as reinforced by market responses to the post-crisis fiscal expansion, the federal government will have to create fiscal room to enable expansion in order to combat adverse shocks or a downswing. Second, it follows that a contractionary stance in an upswing should lead to savings. Markets will assess sovereign credibility based on improvement in public finances and whether surpluses are utilised for payouts in a downswing in the future.

India loosened its monetary and fiscal policies in synchronisation with the world to counter the global financial crisis. Ironically, the synchronisation has also brought domestic macro policies into greater international focus. Emerging from the crisis to become the second fastest growing economy in the world has placed the Indian economy at the centre of international attention. You learn to behave yourself when playing in the big league.

An earlier version of this article first appeared here at LiveMint.com

Renu Kohli is a New Delhi-based economist who was until recently with the International Monetary Fund.