Budget & MPC: Interim budget tries to strike a balance but the real story lies off balance sheet

By: and |
February 04, 2019 5:11 AM

Centre consolidated its deficit by 0.2% of GDP in FY19.

The cash-transfers turned out to be more targeted and less expansive than had been expected in some quarters, entailing an annual transfer of Rs6000 (~$85) for small and marginal farmers.

By Sajjid Z Chinoy & Toshi Jain

Indian policymakers tried to strike a balance between fiscal prudence and responding to the agrarian distress in the Interim Budget. For starters, the fiscal deficit for the FY19 came in close to our expectations, narrowing to 3.4% of GDP (JP Morgan: 3.3%) from 3.5% of GDP in the previous year, thereby belying some market fears of a large fiscal slippage. In fact, net of asset sales, the Centre consolidated its deficit by 0.2% of GDP in FY19.

Furthermore, the FY20 budget included a new programme of cash-transfers for farmers, against a backdrop of rural distress. The cash-transfers turned out to be more targeted and less expansive than had been expected in some quarters, entailing an annual transfer of Rs6000 (~$85) for small and marginal farmers. Authorities estimate that this will cost Rs750 billion in FY20 or about 0.4% of GDP on an annualised basis, but the programme begins retrospectively from December 2018. However, this in conjunction with tax rebates for the middle-class—which are expected to cost 0.1% of GDP—meant that new budgetary commitments added up to about 0.5% of GDP. Consequently, the Centre’s fiscal path going forward is less austere than markets had expected, with the government pegging the deficit for FY20 at the same level of 3.4% of GDP, even as we had expected some modest consolidation (0.2% of GDP), mainly as a signaling mechanism.

Furthermore, if one looks below the hood, the FY20 budget is not without risks. The entire 0.5% of GDP in new commitments is expected to be financed by assumed tax buoyancy in FY20. This is because we expect that when the actual numbers for this year print, tax collections will be lower than currently forecasted, resulting in expenditures having to be correspondingly curtailed. Therefore, the increase in Tax/GDP projected for FY20—over what eventually materialises this year—is expected to, de facto, bear most of the burden of financing the 0.5% of GDP in new commitments.

For example, aggregate GST collections have grown less than 7% over the last six months, but the Centre’s GST collections are effectively budgeted (given where we think they end up this year) to grow at an aggressive 25% next year. Furthermore, even personal tax collections may be a challenge to achieve. They are growing at 16% a year thus far, and need to sharply re-accelerate in the next few months, just to meet this year’s forecast. Even if that is achieved, personal taxes will need to grow over 20% next year (taking into account the rebates)—on a forecasted nominal GDP growth of 11.5%—to meet next year’s budgeted target. If this year’s forecast is not achieved, the asking rate is even higher.

In case this tax buoyancy is not realised, the worry is that expenditures—particularly capital expenditures—may again have to bear the brunt. Capex growth is currently running at just 4%, and we believe it will end the year close to or below 1.5% of GDP, below both where it printed last year (1.6% of GDP) and what authorities expect for this year (1.6% of GDP). Next year is already budgeted lower at 1.5% of GDP, and the risks are to the downside, given aggressive revenue assumptions. All that said, this is an interim budget. All of these assumptions could be revisited when the full budget is presented by the next administration in July.

However, looking at the Centre’s deficit is to miss the fiscal forest for the trees. First, “off-balance borrowing” has been on the rise, something that was re-affirmed in today’s Budget. For example, Food Corporation of India (FCI)—that should ordinarily be financed only from budgetary allocations—borrowed 1.3% of GDP from other sources in FY18, apart from what it received from the budget.

Similarly in FY19, FCI borrowed 1% of GDP from other sources. This helps the Centre’s fiscal math, but the “effective deficit” must include FCI borrowings, and therefore should be commensurately higher.

More generally, if one were to add the Centre, and the combined deficit of the states (which have expanded sharply in recent years), off-balance-sheet borrowing (e.g. FCI) and borrowing by all central public sector enterprises, India’s total public sector borrowing requirement (PSBR) remains above a hefty 8.5% of GDP in both FY18 and FY19. Furthermore, this is likely a lower bound, because it does not include state public sector enterprises on account of data constraints.

To be sure, some of this borrowing—particularly by states and CPSEs—is to finance much-needed capex. But borrowing of this quantum constitutes a large claim on domestic household savings, which have fallen in recent years from 23% of GDP to 17% of GDP. In fact, net household financial savings are at just 7% of GDP, suggesting all of it—and more—is being absorbed by the public sector.

As previously discussed (goo.gl/Xd4ztE), against the backdrop of these borrowing pressures, it is no wonder India’s yield curve steepened in recent years. In other words, for any given overnight policy rate, benchmark borrowing costs for the economy are higher now than in previous years. One can argue that large public sector borrowings are justifiable because private investment has been depressed. But what if private investments were to pick up, as is fervently hoped? It would need to be accommodated by the public sector reining itself in. Else, borrowing costs would rise further—and crowd out some private activity—or India’s current account deficit would swell, and private investment would need to be financed by (more risky) foreign borrowing.

Unexpected extra borrowing for FY19 by Rs350 billion—to help finance the retrospective start to the cash transfer programme—and the lack of consolidation in FY19, meant that borrowing was higher than markets expected. As such, net borrowing for FY20 is pegged at Rs4.73 trillion and gross borrowing at Rs7.1 trillion, also reflecting the fact that the “maturity switches” that were expected this fiscal did not materialise either. Consequently, bonds sold off, with the yield on the benchmark bond firming by 13 bps.

The sustained downward surprise to food prices has meant that headline inflation has significantly undershot RBI’s and market expectations in recent months, and is on course to undershooting their 4% medium-term target for at least the first half of 2019. At a minimum, this will induce the MPC to change its stance from “calibrated tightening” to “neutral” at next week’s policy review.

Furthermore, despite growth holding up and a slightly-less austere fiscal path, we believe the headline undershoot will be too compelling for the MPC to ignore, given its mandate of keeping headline inflation close to 4% on a durable basis. We therefore expect RBI to cut rates by 25bps in the first half of this year. While our baseline call remains a cut for the next MPC meeting, it has become a toss-up between the February and April reviews and will come down to how the MPC interprets the Interim Budget.

-Chinoy is chief India economist & Jain is economist, JP Morgan

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