Expect fiscal spending to remain elevated in FY22, and gradual fiscal consolidation to be funded by higher revenues. On the other hand, with elevated inflation, RBI is likely to gradually exit from very loose liquidity over the year
In order to sustain recovery, we think some large shifts will need to happen in 2021. And a closer look suggests that each of these will need fiscal support in order to be sustained:
—From goods demand to services demand: We think a rotation from goods demand (which is back to pre-pandemic levels) to services demand (which remains 30% shy of pre-pandemic levels) will be necessary to sustain the ongoing economic recovery. But a successful roll-out of the government’s vaccination drive will be necessary to build confidence around this shift.
—From rural to urban: As more activities restart, labourers who had returned to their rural homes during the lockdown may want to return to their urban jobs (where incomes are 2.5x higher), thereby shifting the centre of activity to urban centres. However, some labourers may find that their urban jobs do not exist anymore, and may require social welfare benefits for longer.
—From concentration of wealth to dispersal of welfare: Large firms and high-earners have fared much better than small firms through the pandemic. But it’s the small and informal firms that make up 85% of the labour force. In the short run, the accumulated savings of high earners can support GDP growth. But once that wears off, lack of demand can potentially lower medium-term growth. As such, the continuation of social welfare spending, particularly to support those at the bottom of the pyramid, will become important.
—From consumption to capex: Investment alone raises an economy’s capacity to create jobs. But it may not come easily at a time of low economy-wide capacity utilisation. Public capex and reforms may have to take the lead.
Each of these shifts would require government support, both financial and strategic, which, in turn, will likely determine the key themes for the upcoming Budget:
—Fiscal spending: While treading a path of fiscal consolidation is important, we think it should be gradual, with the government continuing to spend generously on the vaccination rollout, social welfare schemes and capex.
—Supporting capex: Given buoyant capital markets, the government could accelerate its disinvestment drive and use the funds for public capex. Building out the new Production-Linked Incentive (PLI) scheme as a true public-private partnership could also push up sector-specific investment. Creating an environment of tax and policy certainty can be effective.
—Strengthening banks: The combination of rising inequality and the current risk-aversion in India’s banks could lower the country’s medium-term potential growth. The necessary steps to support banks include reinstating the Insolvency and Bankruptcy Code, providing adequate recapitalisation funds for PSBs, and reducing the weight of government mandates on them.
—Pressing on with reforms: Carefully sequenced reforms, in our view, include: (1) focusing on export promotion, not import restrictions; (2) improving old reforms such as the GST while pressing on with new reforms on agriculture, labour and land; (3) upholding institutions such as inflation-targeting and the IBC framework, and outlining a new fiscal roadmap.
The fiscal realities of FY21
We expect the FY21 fiscal deficit at 7% of GDP (versus 3.5% budgeted and 4.6% last year). The following points stand out:
—60% of the fiscal slippage (vis-à-vis budget estimate) was led by higher expenditure and 40% by lower revenues;
—Lower revenues were a result of both lower tax revenues and disinvestment receipts, in equal part;
—Lower tax revenues were driven by weak direct tax collection. Higher oil-duties added an unexpected 0.9% of GDP to revenues, keeping overall indirect tax collections strong;
—Higher expenditure was led by current spending, particularly on social welfare schemes (such as MGNREGA, PM Kisan and food distribution). Yet India’s fiscal support package at about 2% of GDP was amongst the smallest across peers.
The fiscal possibilities of FY22
We expect the fiscal deficit to gradually fall to 5.8% of GDP in FY22, from an expected 7% in the previous year. In particular, we expect:
—Expenditure to remain unchanged and elevated at 15.4% of GDP, although the internal mix could change. We expect capital expenditure to rise by 0.5% of GDP and current expenditure to ease by the same quantum.
—We expect the rise in revenues to drive fiscal consolidation. Much of the rise in revenues (75% to be precise) is likely to come from higher tax collection. We expect gross tax revenues to grow 30% y-o-y, led by rising GDP as well as formalisation-led rise in tax buoyancy.
—We have only assumed a gentle rise in disinvestment receipts. In the event they surprise on the upside, fiscal consolidation could be larger.
—We expect central government gross market borrowing at Rs 11.5 lakh crore (and net market borrowing at Rs 8.5 lakh crore). Including states, we estimate general government gross market borrowing at just under Rs 20 lakh crore (and net market borrowing at Rs 15 lakh crore).
The changing drivers of inflation
The year 2020 was one of pent-up goods demand, and 2021 could be one of pent-up services demand.
But there could be a negative side effect of rising services inflation, for three reasons in particular:
—Adjustment costs: Pent-up demand often comes as a wave, not a dribble, and there could be some adjustment costs involved;
—Menu costs: Service providers tend to raise prices once a year. This was not possible in 2020. They may raise prices for two years together in 2021;
—Inequality can be inflationary: Large firms and high earners have done well through the pandemic. They have a wall of savings that they are now spending. Consumption patterns show that those at the top of the pyramid consume more services than goods. And that could be inflationary.
Add to this elevated commodity prices, and high inflation could well be a problem over 2021. Having said that, this may not turn out as badly as it did in 2009-10.
All said, we see inflation averaging 5-5.5% in FY22. This is higher than the 4% target, but under the 6% upper limit of the tolerance band. The question then is: how would RBI react to above-target inflation?
Perhaps one way forward would be to differentiate between cyclical recovery and potential growth. It could calibrate liquidity in line with the cyclical recovery. As pent-up demand leads to an economic rebound, RBI can gradually suck some of the excess liquidity out of the system (for instance, via continuing with the variable rate reverse repo auctions and allowing the temporary CRR cut to reverse), and thereafter hike the reverse repo rate in order to narrow the LAF corridor.
The aim through all of this could be to nudge overnight rates upwards and closer to the repo rate of 4% over 2021. This would also help push real rates out of negative territory (assuming medium-term inflation at 4%), which in our view is an important step to keeping inflation contained.
But perhaps RBI will only raise the benchmark repo rate once potential growth rises back up. As long as investment remains low, RBI may want to keep the repo rate at the current benign levels of 4%. We do not expect a rise in the policy repo rate over 2021 and 2022.
Just as inflation forecasts are critical for the inflation-targeting regime, growth forecasts will become important for monetary policy normalisation in the post-pandemic period.
Bringing it all together
Policy decisions in February are likely to determine the contours of growth over 2021. The role of fiscal policy, in our view, will come to the forefront as it makes space for essential spending (vaccination rollout and social welfare spending) and sustainable growth (capex led). Meanwhile, the central bank will likely take a breather after a fast-paced 2020. With a greater degree of freedom, we think it will embark on a gentle normalisation path, which would help push real rates out of the negative territory.
As the cyclical recovery progresses, RBI could push up short term rates towards 4%. But it may not hike the policy repo rate over the foreseeable future. Indeed, fiscal policy will likely set the contours of growth over 2021.
(Edited excerpts from HSBC Global Research’s report dated January 25, 2021)