Budget 2019: Contrary to Modi government 1.0’s fiscal consolidation claim, the central government’s debt-GDP ratio has inched rather modestly towards 40%, which is what the newly amended FRBM Act (2018) targeted by FY25.
Budget 2019: A decisive political mandate and a fragile economy have raised expectations for a power-packed FY20 budget. This is anticipated to be significantly different from the interim one. As Modi government 2.0 prepares to reshape revenue parameters in view of the sharp shortfall in FY19 and reorient expenditures accordingly, it is tempting to seek recourse to structural deficit and defer fiscal consolidation permitted by the amended FRBM Act (2018). Many, wary of such a move, counsel restraint. But before adjudicating on the most appropriate fiscal policy in the current context, especially with the financial sector in considerable turmoil, a medium-term macroeconomic risk analysis is called for!
To spend or not to spend
Contrary to Modi government 1.0’s fiscal consolidation claim, the central government’s debt-GDP ratio has inched rather modestly towards 40%, which is what the newly amended FRBM Act (2018) targeted by FY25. Moreover, it piled up much more debt outside the budget, raising extra budgetary resources (EBRs) flagged by the CAG and widely reported in the financial press. Analysts estimate the general government deficit (Centre and States), including these EBRs, at 8.5-9.0% of GDP. The NK Singh FRBM review committee had estimated available total financial resources (domestic and foreign) at 10% of GDP; its broader proposition was for equal distribution between public and private sectors, or 5% of GDP each. Analysts worry that if the largest dissaver, the government, is appropriating about 90% of the economy’s financial surplus, then what is left for the private sector.
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Thus, the big picture is amply clear—the resultant high cost of capital is real and crowding-out of private investment a distinct possibility. Many economists, including this author, who were highlighting the role of structural rigidities in obstructing monetary policy transmission, missed this point until the gigantic amount of EBRs came to light. But now, the loop appears complete—lending rates (cost of capital) are high because of high bank term-deposit rates, which compete with small savings, interest rates on which are linked to treasury yield with high term premium. The elevated term premium, in turn, reflects market’s worry about general government debt piling up as financial savings dry out! It is unfortunate the monetary policy committee (MPC) and RBI have been reluctant to flag this.
The fallout has deprived the economy of reaping the dividend from lower inflation. Some analysts advocate that RBI infuse more durable liquidity in the system. But such prescriptions are, at best a short-term solution, raising long-term inflationary concerns. Many also advise the government to lower small savings rates. But here, too, one is not sure if this could trigger a flight of savings to mutual funds and stocks for better yields as long-term inflation expectations remain unanchored. The most sustainable way forward, therefore, is for the government to retreat from further EBR accumulation and stay the course as per FRBM Act, 2018.
What could go wrong?
If the central government opts to deviate from the new glide path or does not rein in EBRs, then debt will further accumulate and inevitably require even sharper corrections in coming years to meet the 40% debt-GDP ratio target for the centre in FY25. If growth concerns persist into FY21, the government might be forced to amend the FRBM Act once more (already revised in 2015, pushing the 3% fiscal deficit target to March 2018, which remains unachieved), further delaying the road map. This would risk credibility, impacting the term premium. It could also complicate the 16th Finance Commission’s job of prescribing fiscal austerity to state governments, which is essential to achieve the general government debt-GDP ratio target of 60% in FY25.
Of course, it could be argued, as indeed some do, what is so sacrosanct about a 60% debt-GDP ratio! If inflation hasn’t flared up despite such massive government borrowings in the last five years and the current account deficit remained within 2% of GDP (considered sustainable through capital account financing), then why should the government worry? After all, the government deferred the consolidation path thrice in the last five years and heavens will not fall if it did so one more time!
What if growth slowdown is structural not cyclical?
Most analysts characterise the current slowdown as cyclical, which could persist for two quarters before a recovery in H2:FY20. RBI projects a gradual recovery from Q1:FY20 itself, in fact, with GDP growth returning to 7% and above in the second half. But circumspection is required about the nature of new GDP estimates: while consumption moderated somewhat, investment fell quite sharply in the last quarter. Why should that happen? While slower consumption was anticipated following the NBFC stress and consequent lending slowdown, investment was expected to pick up in line with bank credit growth and steadily improving capacity utilisation through FY19.
If these estimates are indeed closer to reality, the presence of some structural elements in deceleration of both consumption and investment cannot be ruled out. Some leading indicators for April-May 2019, for instance, further contraction in motor vehicle sales, slower air traffic growth and deceleration in credit off-take, support such apprehension! For evidence, look at the press analyses of Q4 results: most corporates faced a sharp increase in interest expenses that significantly impacted net profit margins—early signs of balance sheet stress. If firms could not pass on their costs due to demand constraints, then why should they invest, irrespective of where capacity utilisation stood! If GST, the biggest reform, and the construction of miles of roads and railways under Modi 1.0 have not yielded the efficiency gains to offset the rising cost of capital, then surely it is time to introspect! Under the circumstance, should the government take on more debt to increase the misery of the private sector?
Eternal trouble makers: Oil prices and Capital flows
Another issue flagged above is if the fiscal deficit during Modi 1.0 was no less than the UPA-II period, then how did inflation not flare up? To us, the answer is very simple: because private investment demand was near-dormant, aggregate demand remained somewhat controlled. As capacity utilisation gradually moves towards a threshold, one would expect private sector investment to revive. But, if the government continues to borrow more, pressures could build up. Luck has favoured the government with low oil prices and abundant capital inflows, but to expect these two volatile elements to remain benign in the medium-term is risky. Global trade and finance is being pushed into layers of uncertainties each day and one can only hope these do not suddenly turn into a volcano, forcing major trading countries towards competitive devaluations! Better to prepare for such eventualities by creating the space for private sector to borrow within the domestic economy.
It is time for reckoning: Set realistic tax and non-tax revenue targets—recognise that ambitious tax revenue targets germinate tax terrorism in non-linearly. Restructure revenue expenditure to create space for capex. Stay the course on borrowings to avoid any unmitigated risks and allow monetary policy to work its way.
(The author is a Delhi-based economist. Views are personal.)