In fiscal activism, India takes a chance on growth

By Sonal Varma & Aurodeep Nandi

On the surface, the government’s fiscal deficit (FD) target for FY21 at 9.5% of GDP is significantly higher than the 7.2% that the market was expecting (Nomura: 6.8%). However, part of this is because of increased transparency, wherein the government has taken cognizance of the burgeoning loans of FCI from the national small savings’ pool and reflected it onto its balance sheet. The revised FD estimate of 9.5% cannot be directly compared to pre-Budget projections. Rather, to gauge how much the government aims to spend in the remaining part of the year, we calculate the ‘adjusted’ FD that excludes this extraneous increase or ‘FCI effect’ over and above regular spending. Even assuming a higher subsidy outgo in FY21 due to the pandemic, we estimate that the ‘FCI effect’ is likely to around ~1.4% of GDP. Consequently, the ‘true’ FD for FY21 excludes this from the 9.5% of GDP target, and is probably closer to ~8.1% of GDP.

Even at ~8.1% of GDP, the FY21 FD in our estimate is higher by ~1.3% of GDP. We find that increased capital spending accounts for around 0.3% of GDP. This is largely offset by the government expecting higher revenues that we had projected by a roughly equivalent amount. Increased revenue spending accounts for ~1.3% of GDP, thus explaining a bulk of the fiscal slip. As a result, this suggests that considering both revex and capex, the government plans to spend ~1.6% of GDP cumulatively in Q4. In our opinion, this is an ambitious target. Currently, expenditure growth is trending at a run-rate of ~8% y-o-y, which sharply contrasts with the government’s aim to achieve a growth rate of over 18%. While we are already seeing considerable momentum in capital spending (current run-rate of 21% vs aim of ~31%), we are concerned with how the government plans to increase the revex growth rate from a little over 6% to 16.5%.

Our back-of-envelope calculations suggest the government’s aggressive spending targets for FY21 implies that over Q4, revenue spending would have to escalate by a significant 55% y-o-y, while capex would have to expand by over 60% y-o-y. The government announced FY22 FD at 6.8% of GDP, considerably higher than market/our expectations of 5.2%/5.3%. Consequently, in our estimate the ‘true’ FD in FY22 is ~6.1% of GDP.

Overall, the high levels of spending growth projected in FY21 implies that growth rates are naturally relatively modest in FY22. The government’s lower FD target for FY22 comes on the back of a nominal GDP growth assumption of 14.4% y-o-y (vs -4.2% in FY21). We believe this is conservative. The higher buoyancy for direct taxes is primarily due to aggressive assumptions on corporate taxes. While in isolation, such high buoyancy numbers might evoke scepticism, the more modest nominal GDP growth assumption taken by the government suggests the targets may ultimately be attainable.

On expected lines, the government has set up ambitious targets for non-tax proceeds. Dividends from the RBI and public sector companies/nationalised banks have been set at an elevated Rs 1.0trn (~0.5% of GDP). For disinvestment, prima facie, the target of Rs 1.75trn (~0.8% of GDP) seems high given that even in the pre-pandemic years (FY18-20). The government has also announced a new privatisation policy which states that there will be ‘bare minimum’ public sector presence in ‘strategic’ areas.

In a break from convention, the government has done away with its long-time practice of setting a medium-term fiscal deficit of 3% of GDP and has instead settled for a much less ambitious 4.5% by FY26 (15th FC recommended 4.0%). Per se, this is more realistic, given that India has had a weak record in respecting its 3% of GDP ambition. The key question is whether this is ambitious enough, especially with the government not offering any clarity on how it sees the public debt burden evolve along its fiscal consolidation path.

The move into fiscal activism is driven by two factors: first, spending more during lockdowns (other than for liquidity support) would have resulted in smaller multiplier effects, given higher precautionary savings in the private sector. With the economy now normalising, government spending is likely to have a greater bang-for-the-buck. Second, the government has shed its concern around sovereign ratings threat.

We estimate the fiscal impulse from the Budget remains positive at 0.04% of GDP in FY22, although this is understandably lower than the exceptionally high 3% of GDP recording in FY21. Given that fiscal impulse is computed with respect to the prior year, we think a better way to read this is to consider the fiscal impulse of FY21 and FY22 cumulatively, which comes to a little over 3% of GDP, spread over two years. Adjusting for the business cycle, we estimate that structural fiscal deficit at 7.9% of GDP in FY22.

The composition of government spending is skewed towards higher capex than revex. Capex has a higher multiplier. It could potentially boost GDP growth by 0.1- 0.3pp in the short-term and by 0.7-1.3pp over the medium term. On the whole, the budget aims to push growth not only via frontloaded spending, but by targeting it towards the more productive infrastructure sector. We reiterate our above consensus real GDP growth forecast of 13.5% y-o-y in FY22, vs -6.7% in FY21, with the budget adding upside risk to our FY23 projection.

From a sovereign ratings perspective, the budget has a few positives (bad bank, infrastructure spending, realistic assumptions, greater fiscal transparency) and few negatives (weak medium-term fiscal commitment, larger size of the government). At the margin, we believe rating agencies may view the budget as slightly more negative, given their focus on medium-term fiscal finances. Of the two rating agencies with a negative outlook for India, we believe the budget may have increased the probability of a downgrade from Fitch.

Through 2020, the burden of uplifting growth had largely fallen on monetary policy, while fiscal policy had taken a backseat. This appears to be changing with fiscal policy taking a more proactive role in driving growth, thereby reducing the burden on monetary policy.

In the near term, though, with growth still in the early stages of a recovery and demand side price pressure low, monetary policy is likely to stay accommodative. In our opinion, the market may struggle to absorb this supply and it will be challenging for the RBI to simultaneously inject liquidity in the market through OMO buybacks. Potentially strong capital flows in FY22 may mean that further FX intervention in line with the RBI’s aim to build forex reserves, needs to be sterilised, if the RBI does not want to add to liquidity.

At its next policy meeting on February 5, we expect the RBI to continue with policy status quo on rates and stance. We expect the RBI governor to push back on market expectations of liquidity normalisation and reiterate the commitment to ‘ample’ liquidity. Overall, despite a faster pick-up in growth, we expect the RBI to state that the output gap remains negative and demand-side price pressures remain muted, so policy support will be maintained to nurture the initial signs of a growth recovery, and stepped up further, if required.

Beyond the February policy we maintain our base case of policy stance shifting to ‘neutral’ from ‘accommodative’ in Q3, and the normalisation of the policy corridor to occur in H2. This should be followed by 50bp worth of repo rate hikes in H1 2022. With fiscal activism back, the baton of driving growth may pass from monetary policy to fiscal policy this year.

Varma is chief economist, India and Asia ex-Japan, and Nandi is India economist, Nomura. Views are personal

Excerpted from Asia Insights, Global Markets Research, Nomura, dated Feb 2