Budget 2021: Constructive, but not enough

While on the face of it, the pandemic made this year’s budget appear more challenging, in reality, it made it much easier by eliminating any meaningful policy trade-offs.

In the last two quarters, the economy has been recovering sharply and faster than suggested by official growth numbers, which remain based on antiquated year-on-year comparisons. According to the official year-ago growth numbers, the economy contracted 23.9% in Q2 and 7.5% in Q3. Year-ago comparisons have a serious problem in that they depend on what happened four quarters earlier and tell us very little about growth momentum. JP Morgan estimates suggest that, on a quarterly basis, India’s GDP plunged 25% in Q2-2020 and grew 21.5% in Q3-2020—a narrative markedly different from that portrayed by the official numbers. Indeed, the economy is likely to have grown another 10.5% in Q4-2020 and is expected to deliver a growth rate of -6.5% for the full fiscal year and then rise 13.5% in FY22.
These full-year growth numbers are higher than the forecasts of both the government and market consensus. The basis of optimism is twofold. First, by accident or design, India has managed to break the link between infection and mobility. The exact reasons are contested, but if the vaccination rollout proceeds as anticipated, then mobility should normalise by mid-year without threatening a new wave of infection.

The second is the recent shift in the government’s fiscal stance. After delaying for nearly six months, the government began to speed up spending in September. It is unfortunate that the government waited until tax revenue began to recover to ease its purse strings. While the adage “live within one’s means” is good advice for individuals and governments alike, it is intended mostly as a medium-term principle. Instead, a key objective of macroeconomic policy is to provide countercyclical support to an economy to dampen volatility in the short-run. Increasing spending when revenue is rising (presumably because an economy is also growing) accentuates, rather than dampens, economic volatility. Be that as it may, the boost from government spending was expected to be a key support to strengthen the recovery in FY22.

Decoding Finance Minister Nirmala Sitharaman’s Union Budget 2021

Thus, economics had simplified the budgetary choices. With the economy recovering and the equity market surging, taxes and privatisation would reasonably be expected to rise. The revenue increase could be used to reduce the deficit while keeping spending broadly at its current share of GDP. This would allow spending to grow 17-18%, in line with nominal GDP. The choice really boiled down to where to spend. Prudence dictated mostly on income support and infrastructure, particularly on public health.
In the event, the budget broadly met these ends, with one notable exception. For this year, the budget pegged the deficit at 9.5% of GDP, much higher than market estimates of around 7% and a five percentage point (ppt) rise over the previous year. But this is largely optical. Instead of funding food procurement through off-balance-sheet borrowing by FCI, as has been the case in the last few years, this year’s budget has rightly brought some of that spending back on its accounts. Excluding subsidies and interest payments, the increase in deficit is just 2 ppt of GDP.

For FY22, the budget targets a deficit of 6.8% of GDP. Much of the heavy lifting in the 2.7 ppt of GDP reduction is done by lower subsidies and higher privatisation. Excluding subsidies and interest payments, the budget targets a reduction of 0.5 ppt of GDP in overall spending, with capital expenditure rising only 0.2 ppt of GDP.

In the details, while there is a welcome emphasis on public health, improving the financing of infrastructure projects, and privatising banks and insurance companies, the glaring omission is the continued lack of income support. Why is this important? Underlying the strong headline recovery in growth, imbalances in the economy have widened significantly. The scarring in the labour market is extensive (private surveys point to a staggering 18 million job losses), and the likely damage to household and SME balance sheets substantial (the profits of listed companies rose 30% in Q3-2020, according to RBI, which implies a disproportionately large decline in household and SME income if overall GDP fell 7.5% that quarter). While a debt moratorium and other regulatory forbearance have concealed the extent of the damage, these measures simply postpone the eventual reckoning. A key risk is that not only is medium-term growth impaired because of the scarring, but also that banks turn risk-averse and do not extend credit exactly when the recovery is expected to gather strength once mobility fully normalises.

While the budget is constructive and helped allay fears of excessive fiscal tightening, it did not go far enough to mitigate the tail risk that the current economic recovery does not turn into a “dead cat bounce”.

Author: Jahangir Aziz, Chief Emerging Markets Economist, JP Morgan