Markets are fixated on this week’s Budget presentation, where continuity i.e. keep to the fiscal consolidation path or change i.e. overshoot in the deficit target (beyond the seemingly sacrosanct — 3.5 percent of GDP), is being weighed.
The government returned for a second term after a decisive win in the May elections and Friday’s Budget will mark the first under new finance minister Nirmala Sitharaman.
Set against the backdrop of a global and domestic slowdown, expectations are running high for a pro-consumption push, extended emphasis on the welfare framework, and efforts to sustain the broader investment push.
How could the math stack up: We expect the interim FY20 Budget target of -3.4 percent of GDP to be maintained, even as worries over a small overshoot continue to linger. Concern over slippage in the FY20 target surfaced after the FY19 breakdown saw actuals diverge significantly from revised estimates — a 1 percent of GDP shortfall in tax collections was accommodated by a cut in total expenditure, particularly revenue outlays.
This potentially sets the budgeted estimate (BE) FY20 laid out in the interim budget to an ambitious start. Hence, we expect few changes in the math – which could include a reduction in tax revenue estimates (income tax and GST), while the burden of revenue generation shifts to non-tax revenues, translating into a higher contribution expected from divestment receipts and larger share of RBI dividend contribution to the exchequer, anticipating a favourable outcome from the economic capital framework panel. Firmer nominal GDP assumption and an increase in reliance on off-budget funding will also be in the mix.
Let’s Talk Specifics
With regard to specific measures, speculation includes a likely increase in the personal tax threshold, removal of the long-term capital gains tax, dividend distribution tax etc., support for renewable energy sector, new national employment policy, boost to infra financing, industrial policy with focus on exports, boost capital infusion into banks and provide back-stop mechanism for non-banks, amongst others. Any decisions regarding the Direct Tax Code is unlikely to be a part of this year’s Budget.
With revenues expected to bear the burden of an increase in spending, the borrowing program should remain unchanged. At a record high (gross), supply absorption worries continue to trouble the bond markets. More importantly, lower borrowings are necessary to ease the cost of capital effectively.
Policy rates are falling, but the spread vis-à-vis government bond yields and corporate bond yields have been slow to narrow. Part of the reason for this sizeable spread is high public borrowings.
That the central government’s gross borrowings were pegged at a record high in the Interim Budget, spooked markets and which combined with states and PSUs stands at an elevated 8 percent of GDP. It becomes imperative that plans to increase spending is accompanied by plans to augment revenues rather than funded through the debt markets.
Much of the near-term narrative will be dominated by pre and post-budget observations, but the larger picture remains equally important.
We believe the time is ‘RIPE’ for growth to climb out of the current slowdown and return towards its potential rate over the next two-three years.
‘R’eforms will be crucial, with the ball already set rolling in the government’s first term. Rather than the rollout of another bunch of fresh reforms, there is value in ensuring efficient and effective implementation of the already announced measures. This will not only narrow income inequality but also grow the pie to supportive more redistributive policies and raise productivity.
Growth is a combination of physical capital, human (labour) capital and total factor productivity (calculated as a residual). Tapping observations of the Conference Board Total Economy database, we note that since 2011-12, India’s capital stock growth has moderated (slowdown in investment growth), while TFP has improved but gains from labour have stagnated.
Better TFP readings could be tied down to recent reforms and associated benefits that have helped growth at the margin, but without a commensurate pick-up in the contribution of labour and capital inputs, it will be a challenge to raise overall potential growth.
Some Labour Reforms Please!
‘Capital’ needs will require private sector capex investments to increase, which will also necessitate the need for the government to scale back its borrowing program (and those of PSUs). Raising ‘labour’ productivity needs more wide-ranging changes and states participation.
This will involve moving contractual and informal workers onto fixed contracts/ official payroll, which needs to provide firms to be provided with the flexibility to curb or expand their employee pool depending on operational requirements and business size. While there is an underlying push towards turning industries into being more capital-intensive, India’s demographic trends will keep labour and employment challenges as the front and centre of policy priorities.
Just as challenging as labour has been land, with the latter involving acquisition troubles, slower digitalisation of records and lack of transparent auctions. Being a concurrent subject, states’ support is required to address the inflexible and restrictive nature of labour laws currently. Few states, nonetheless, made some progress, especially Madhya Pradesh, Gujarat and Maharashtra. More will require careful consideration of the political economy aspects, particularly for all the stakeholders.
Reviving the ‘I’nvestment climate is of paramount importance, which has been moderating for the past five-six years. Encouragingly, fixed capital formation as a percent of GDP bottomed out in FY17 and crept higher to 29.3 percent of GDP in FY19. The breakdown reveals that the government’s infrastructure spending has led much of the recovery. Lower cost of capital, resolution of stressed assets (which will add some of the dormant capex to the table) and clear visibility of consumption are expected to draw back private interests over the next 2-3 years.
Besides the domestic agenda, authorities will require ‘P’roactive efforts to guard against rising external risks. Multiple headwinds have emerged over the course of the first half of 2019. Developments on the US-China trade dispute and other protectionist policies, present both a challenge and opportunity for India. Slow global trade, for start, is a bigger risk for India than US-China trade tensions, but risks are that latter could be a trigger for a broad slowdown.
Our calculations on India’s trade exposure suggest that India is yet to benefit from any near-term substitution in US import demand. Diversion in investment flows, however, is an opportunity that India could benefit from, given the increasing presence of US and China interests.
Return to faster ‘E’xpansion mode on the cards. Apart from the cyclical swings, there is a clear need for potential growth to improve. Various studies estimate potential growth in the range of 7-7.2 percent. Annual GDP in the past decade has been oscillating around this level, peaking above 8 percent in FY16-FY17 vs a trough around 5.5 percent five years prior. The structural need to raise potential growth to provide for the economy’s rising employment needs, higher savings rate and in turn, boost investment capacity through domestic resources, should remain a priority. Hence a combination of effective reforms and improved productivity are crucial ingredients for the economy to return to potential growth and accelerate further.
Radhika Rao, an economist, is senior vice-president, DBS Bank, Singapore.