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Sajjid Chinoy: India's Budget - hoping for credibility over ambition

The government needs to swallow the bitter pill of fiscal consolidation or risk putting the economy on life support

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I would contend that the upcoming Budget will be one of the most important policy pronouncements of this government since it came to power in 2004. The was always going to be a test of the government’s resolve to return to active policy-making after the events of the last year. But, as if the stakes weren’t high enough already, last week’s election results have upped the ante. There is, now, a widespread belief that the results may have significantly reduced the government’s degrees of freedom. The concern, therefore, is that not only will long-standing and politically- sensitive reforms (land, pension, retail) remain on the back-burner for the foreseeable future but, more worryingly, that much-needed this year will either be cosmetic or inadequate and the hard decisions to rationalise subsidies will continue to remain in abeyance. So this year’s Budget is more than just a Budget for FY13. It will be seen as a signal of the government’s intent for the rest of its term.

But beyond its signalling properties, there is a more fundamental reason credible fiscal consolidation is critical this year. India’s structural deficit has risen alarmingly over the last few years. The virtuous cycle of high growth and fiscal discipline in the mid-2000s turned India’s primary deficits (fiscal deficit ex interest payments) into surpluses, averaging one per cent of during this period. This changed in 2008. A large pre-election supplementary followed by a large fiscal stimulus in early 2009 in the aftermath of Lehman turned the primary surplus into a deficit of 2.5 per cent of GDP. The large fiscal stimulus amidst elevated global uncertainty in 2009 was understandable. But its incomplete and glacial withdrawal since then, and especially with growth averaging well over eight per cent, was inexplicable. India’s primary deficits have, therefore, averaged close to 2.5 per cent of GDP since 2008 — a dramatic swing of 3.5 per cent of GDP over the last four years (and nearly 5.5 per cent of GDP over the last eight years), a key reason aggregate demand has remained high and inflation stubborn since the crisis.

More worrying, an increase in the structural deficit of this magnitude has likely crowded out private investment over the last few years. It is no co-incidence that India’s fixed investment to GDP ratio is four percentage points lower post-crisis, at the same time that the government’s primary deficit has increased by precisely that magnitude!

And why does this matter? Because if growth is to re-accelerate in the coming years, it will have to be investment-led. As we have witnessed since the crisis, consumption-led growth (either public or private) is never sustainable and inevitably stokes inflation. Unfortunately, news on the investment front is less than sanguine. Investment is not just languishing anymore, it’s actually contracting! There is a growing belief that a variety of factors are needed to jumpstart it: (i) aggressive monetary easing by the Reserve Bank of India (), (ii) de-bottlenecking key supply-side constraints (land, coal, clearances); and (iii) credible fiscal consolidation to free up resources and put downward pressure on long rates.

I would contend that expectations on rate cuts are likely to be belied. Contrary to market beliefs, the trajectory of India’s inflation path post-April is unlikely to allow RBI to slash rates this year. With every passing day that crude prices edge up, the greater will be the expected quantum of market disappointment. The mantle of jump-starting investment will, therefore, have to move from RBI to North Block in the form of credible fiscal consolidation that crowds in private investment.

So what would constitute a good Budget? Credibility, not ambition. The last two years have offered important lessons for policy makers. First, it is better to under-promise and over-deliver (FY11) than over-promise and under-deliver (FY12). Second, details matter. The euphoria surrounding last year’s ambitious consolidation lasted precisely 24 hours, till markets read the fine print and realised that the consolidation was not predicated on realistic assumptions. Given the current economic and political constraints, policy makers will do well to achieve a budgeted consolidation of 0.5 per cent of GDP in FY13.

To be credible, the burden will have to be shared between revenue mobilisation and expenditure compression. On the revenue side, it’s important that the recent slide in the tax-to-GDP ratio is reversed by both increasing the tax base (services) and rolling back the stimulus (excise and services). This would be a stepping stone towards an eventual goods and services tax () and reduce the reliance on asset sales — proceeds that are notoriously unpredictable, as was discovered last year. Corporate India is likely to complain about higher tax increases in this environment. But one cannot run with the hares and hunt with the hounds. India’s tax-to-GDP ratio is significantly below its peers, and fiscal consolidation cannot be achieved without revenue mobilisation.

That said, expenditures, and in particular subsidies, will have to be compressed. With FY13 being the first year of the next plan period, the pressure on healthy increases for plan expenditures will be high. Furthermore, if there was ever a doubt about whether the government would be intent on pushing through with an expanded , it dissipated after the state election results. In light of this, authorities will have to bite the bullet on rationalising oil and fertiliser subsidies (which, together, are expected to touch almost two per cent of GDP this year). And this is where the signalling role of this year’s Budget will come to the fore. Serious efforts to stop the fiscal bleeding on this front will be a clear sign that authorities are prepared to bite the bullet. If, on the other hand, no road-map is provided on increasing/de-regulating prices and subsidies continue to be under-budgeted, than it will be clear that the new political reality is going to force authorities to pursue the path of least resistance till 2014. More generally, if health spending is to be upped to 2.5 per cent of GDP in five years, it will have to come in lieu of other subsidies, not in addition to them.

In sum, even a modest (0.5 per cent of GDP) but credible consolidation based on rationalising subsidies, broadening the tax base and (finally) rolling back the stimulus is likely to be cheered by markets. Conversely, if you see another year of ambitious consolidation (one per cent of GDP and more) based on ambitious asset sale revenues, remain very sceptical.

Let’s be clear. Consolidating the fisc through expenditure compression of politically-sensitive subsidies at a time when growth has slowed below seven per cent is an unenviable task. But we must swallow the bitter pill now. Or risk hospitalisation later.


The author is India Economist, JP Morgan sajjid.z.chinoy@jpmorgan.com 

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