By Sajjid Z Chinoy Head, Asia Economic Research, J.P. Morgan
The first full Budget of the government’s third term faced an unenviable task because it confronted two objectives ostensibly at odds with each other.
On the one hand, the global backdrop is getting more precarious. Markets are already under the grip of US exceptionalism, which has pushed up the dollar and kept US interest rates sticky. This has tightened global financial conditions and put relentless pressure on emerging market currencies. Now, trade policy is adding fuel to the fire. US authorities plan to impose tariffs on Mexico, Canada, and China this weekend, marking the onset of the much-feared trade war. This is expected to drive the dollar’s strength and put more pressure on emerging markets. A hostile global environment would argue for the Budget to hunker down and reinforce macroeconomic stability, so that India can weather the coming storm.
On the other hand, the domestic economy needs support. Growth has slowed in recent quarters and the ongoing earnings season suggests the recovery could take some time. A global trade war and the uncertainty it unleashes will only depress global growth prospects, putting the onus squarely on domestic growth drivers. This would argue for slower fiscal consolidation to provide more elbow room for the government to spend. It was not an easy trade-off, because this would have meant temporarily veering off its fiscal consolidation path, which may have been perceived to imperil fiscal credibility.
In the event, the authorities choose conservatism. This year’s fiscal deficit (FD) is pegged at 4.8% of GDP — lower than had been envisaged in July and much lower than had been envisaged last February — such that the Centre’s deficit has now seen a large consolidation of 1.6% of GDP over the last two years. On the back of those out-turns, the Budget calls for further consolidation of 0.4% of GDP next year to reduce the deficit to 4.4%.
The good news is this is a strong affirmation of the government’s commitment to macroeconomic stability. Fiscal credibility, alongside the war chest of forex reserves, a benign current account deficit, and inflation heading back to 4% should provide a cushion against external shocks.
But conservatism is not costless. For starters, by over-delivering on this year’s FD, the room for spending in the coming months is more constrained. Total government spending (like interest) recovered nicely to grow at 23% last quarter. If this year’s targets are to be met, spending will have to slow to just 8% this quarter. Furthermore, a reduction of the FD is a withdrawal of stimulus. So next year’s consolidation will be a drag on growth, such that a lot of the heavy-lifting will have to be done by monetary policy.
Having decided to consolidate, the question was how to do so in the least contractionary manner. Policymakers decided to boost urban consumption with a tax cut costing about 0.3% of GDP. This should undoubtedly help boost urban consumption, but there are trade-offs. It means the bulk of the consolidation is occurring through revenue expenditure compression. Conventional wisdom dictates that expenditure multipliers are larger than tax multipliers, and the preference is to consolidate through revenue augmentation rather than expenditure compression, but it remains to be seen how things play out.
Another area to watch out for will be tax buoyancy (TB). After clocking a TB of 1.4 in 2023-24, it has slowed to 1.1 on slowing growth. Next year, the implicit buoyancy (after adjusting for the foregone revenue of the tax cut) is budgeted is higher at 1.3. If this is not achieved, it will be important that policymakers let the automatic stabilisers play out. If tax targets do not materialise, it will not be prudent to cut expenditures further to achieve the FD target. Instead, the deficit should be allowed to widen to absorb some of the pressure.
Similarly, it will be important to ensure that public capex targets are hit next year. To its credit, central capex has almost doubled as a share of GDP over the last four years. That said, the Budget indicates this year’s original target will be missed, even as state capex is also lagging as states have prioritised subsidies. Public investment has been a key growth driver and it’s important we don’t take our foot off the pedal prematurely. This will inevitably involve increasing state capacity to execute higher levels of public investment.
All this reveals the delicate balance between preserving macro stability and supporting growth. The only way to dramatically alter this trade-off is a sustained reforms push. To appreciate why, it’s important to step back and not miss the bigger picture. Government spending has been doing the heavy-lifting for much of the last five years. However, with each year, the deficit will have to retrench more and more to create space for future shocks.
The space the fiscal cedes will have to be occupied by private investment for growth to sustain. So what will it to take to stoke private investment in a world clouded with uncertainty and laden with Chinese excess capacity? A sublime mix of demand visibility and animal spirits.
A big reform push is the key to re-stoking animal spirits. The Budget made encouraging starts on some fronts, focusing on some labour-intensive sectors, rationalising some Customs duties, and trying to give small and medium enterprises a fillip. But reforms are an ongoing process and will need to be consistently prioritised. The Economic Survey makes a compelling case for a big push on deregulation and liberalisation. This will simultaneously boost animal spirits and, by lowering transactions costs and enabling more creative destruction, make India more competitive globally. This should attract more multinational companies and create some export demand.
Similarly, reforms must strive to boost employment by making growth more labour-intensive. Only when a larger share of the pie goes to labour — rather than capital — will consumption get a sustained boost and clear the fog of demand visibility for firms. This, in turn, will require doubling down on health, education, and skilling, ensuring industrial policy is focused on labour-intensive sectors and rationalising labour laws.
The writing is on the wall. As this year’s Budget confirmed, India does not have the space for a fiscal stimulus in the coming years. What we need is a reform stimulus to crowd private investment in. Only then will the recurring tension between growth and macro-stability be alleviated against a hostile global backdrop.
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