Finance minister Arun Jaitley’s Budget FY17 walked the tightrope between supporting growth directly and fiscal consolidation. The fiscal deficit target stands cut 40 bps, to 3.5% of GDP, for FY17—in line with the committed fiscal consolidation path, although a less strict 3.8% was being expected. Fiscal contraction, at a time of slow growth, surely puts the onus of recovery on lower rates. Lower-than-expected net borrowing, at Rs 4.518 lakh crore (inclusive of Treasury Bills and Gold Bonds), supports a bullish view on yields. On balance, RBI Governor Raghuram Rajan can be expected to cut rates by 25 bps by April 5. Also, one to two more OMO/buyback auctions by March to support liquidity can be expected.
The finance minister has tried his best to address rural strain and support infrastructure within the bounds of fiscal consolidation. He has also contributed Rs 25,000 crore towards bank recapitalisation. The implementation of the 7th Pay Commission (and OROP for the defence) is seen as a major consumption stimulus, of 0.7% of GDP, at a time of weak growth. Jaitley noted in his Budget speech, “The next financial year 2016-17 will cast an additional burden on account of the recommendations of the 7th Central Pay Commission and the implementation of Defence OROP. The Government, therefore, has to prioritize its expenditure…”
The government’s decision to appoint a committee to re-look fiscal targets is welcome. It was not really necessary to cut the fiscal deficit at this time of slow global growth as it is already well below the medium-term average of 4.8% of GDP. While one will yield to none in championing the cause of fiscal consolidation, the fiscal path has to take cognisance of the growth cycle. After all, fiscal policy has to be counter-cyclical. It is equally important to appreciate that it is growth that drives the fiscal deficit in India rather than the other way round.
RBI Governor Raghuram Rajan is expected to cut the repo rate by 25 bps by April 5 with Budget FY17 sticking to the fiscal consolidation path. After all, CPI inflation, at 5.7% in January, has met Rajan’s “under-6% by January 2016” mandate. Inflation risks are also contained with growth, at
5-5.5% in the old GDP series, well below our estimated potential of 7-7.5%. At the same time, it needs to be highlighted that it will get increasingly difficult for RBI to cut rates further. Its repo rate, at 6.75%, has already dipped below 7% medium-term CPI inflation which surely sets inflation expectations.
RBI can be expected to OMO/buy back another Rs 20,000 crore by March. A bit of good news is that Budget FY17 has factored in further buyback beyond Wednesday’s auction. This will then generate $17 billion of permanent liquidity (including $6 billion of buyback by the government). Citi Research’s battery of regressions suggests that RBI needs to inject reserve money (RBI balance sheet less net worth) of about $30 billion this fiscal. With the fiscal deficit being cut, sufficient liquidity from RBI to ease lending rates is sine qua non for recovery.