Budget: Focus on the quality of expenditure
India judiciously refrained from a large demand-side fiscal stimulus even during the pandemic by focusing on more public capex to build the supply side. It is important to continue with that theme in the FY24 budget
For some people, budget-making is an accounting exercise, whereas, for others, it is the policy road map of the government, which has to be set in the context of the current macro and political backdrop. If you believe in the latter, this year’s budget will likely be torn between two diametrically opposite themes. Should the finance minister opt for an expansionary pre-election budget, or should she focus on getting the fiscal house in order by compressing the fiscal deficit? It makes economic sense to attempt a larger fiscal deficit reduction at this juncture rather than keeping the fiscal tap on to generate immediate political dividends.
To start with, high-frequency growth indicators are doing reasonably well. Our combined index from these indicators, called Growth Activity Tracker for India (GATI), shows that even after a slight moderation in the last couple of months, the growth momentum is now close to the pre-pandemic average. An obvious implication is that growth needs less fiscal support now, but there seems to be a disconnect between this data and the narrative about future growth. Expected spill overs from a possible global slowdown, the delayed impact of domestic monetary tightening, and the absence of pent-up demand and excess savings (since people couldn’t spend during the pandemic) are making analysts worry about a sharp stalling of growth. While we share some of the concerns, in our view, it is too early for monetary and fiscal policy to react. Clearly, there would be enough scope during the year for a course correction if the negative growth shock becomes large enough to warrant policy intervention. On the other hand, the budget needs to be realistic in its assessment that the nominal tax revenue growth in FY24 would adjust to the decline in nominal Gross Domestic Product (GDP) growth, leaving less resources for additional spending.
Preserving macro stability is the other facet of any fiscal exercise. Two indicators of macro stability — headline inflation and current account deficit — are both likely to improve during FY24. While this may be comforting, the government will be mindful that core inflation is still elevated and sticky. In the past (particularly after the global financial crisis), continuing the fiscal stimulus for an extended period resulted in persistent inflation. A repeat of that in a pre-election year could be politically unacceptable. Widening the current account deficit should be avoided in a year when its financing could be more difficult in a challenging global liquidity environment. Lowering commodity prices offers some immediate relief on this front but a more structural solution can be crafted only by reducing the fiscal deficit and avoiding the twin-deficit problem. India’s external financing needs are still elevated, and any macro stability concerns could intensify these funding pressures.
Another problem of running a high fiscal deficit is the risk of crowding out of private investment. With the government’s borrowing more than doubling after the pandemic, it has to pay a premium (higher interest rate) over the overnight rate to sell its bonds, called the term premium on risk-free government bond yields. Even as the policy rate is likely approaching its peak in the current cycle, the term premium has not been corrected in line with the historical trend. In many earlier cycles, the term premium has come close to zero but in this cycle, it remains around 100 basis points on the 10-year government bond. This has not allowed the lending rates for corporate firms to come down as much as would have otherwise happened because they remain a function of the risk-free government bond yield.
One option for funding the deficit is encouraging foreign savings to buy Indian government bonds. The inclusion of India in different global bond indices could help attract passive flows but until that process is complete, reducing the fiscal deficit becomes imperative to avoid crowding out.
Deficit leads to debt. Public debt likely fell from a Covid-peak of ~90% of GDP in FY21 to ~81-82% of GDP in FY23, led by double-digit nominal GDP growth (15-18%YY) in consecutive years. However, as nominal growth rates normalise toward 10-11%, the pace of decline in the public debt ratio is will be modest. Even if nominal GDP growth sustains at 11%, the fiscal deficit must fall below 5% of GDP for the debt-to-GDP ratio to be even on a declining path. Over the last six months, all three rating agencies have retained India’s investment grade rating and kept the outlook at “stable”. While this is encouraging, India’s debt-to-GDP ratio is higher than other countries in the same rating group and could be a hindrance for any future rating improvement. Also, the debt-to-GDP ratio remains much higher than pre-pandemic levels and reduces fiscal flexibility on spending as interest expenses on that debt have already reached 37-38% of total revenues.
There is no good year for fiscal compression and hence the one-off savings on subsidy (because of lower commodity prices and the rejig of the food subsidy scheme) of approximately 0.7% of GDP should not be wasted. It is a political call on how much of this subsidy savings will be used for fiscal consolidation. The government has set a target of achieving 4.5% of GDP fiscal deficit by FY26. If there is no meaningful fiscal pruning in the FY24 budget, then the asking rate for the next two years to meet the target could be challenging.
India judiciously refrained from a large demand-side fiscal stimulus even during the pandemic by focusing on more public capex to build the supply side. It is important to continue with that theme in the FY24 budget and focus more on the quality of expenditure. Macro stability warrants limiting the fiscal space. We need to make the best of whatever is left.
Samiran Chakraborty is chief economist, Citibank
The views expressed are personal