A piece of my mind: Budget should target 4% fiscal deficit, trade pacts

In India, after unprecedented 6% drop in real GDP in 2020-21 because of Covid and lockdowns, there was a remarkably strong recovery in the next three years with GDP growth averaging a little over 8%

A new year has begun and the central government Budget is only a couple of weeks away. The Budget for 2025-26 is being framed in an exceptionally uncertain international environment. Donald Trump will soon be sworn in as President of the world’s single super power accounting for more than 25 per cent of global GDP. He has already threatened a serious ratcheting up of tariffs and other forms of protectionism against not just China but also friendly nations such as Canada, Mexico and India. US foreign economic policies are likely to further downgrade the role of multilateral institutions such as the WTO, IMF, World Bank, and UN and its agencies. Instead, there will be much greater emphasis on transactional bilateralism in American foreign policy. Global forecasters foresee deceleration in world economic growth, mainly because of rising trade restrictions and possibilities of heightened inter-nation conflicts. 

In India, after the unprecedented 6 per cent drop in real GDP in 2020-21 because of Covid and lockdowns, there was a remarkably strong recovery in the next three years with GDP growth averaging a little over 8 per cent. Consumer price inflation too had accelerated but was seemingly contained to below 6 per cent by 2023-24. The current account deficit (CAD) in the balance of payments clocked below 1 per cent of GDP that year and the combined (centre and states) fiscal deficit had fallen to around 8.5 per cent of GDP in 2023-24 from a peak above 13 per cent in Covid-hit 2020-21. The banking system appeared to be in good shape, with low ratios of non-performing assets, and corporate balance sheets were strong. There was even some positive news in the usually dismal employment data. 

In the nine months since March 2024 the picture has altered considerably, with some underlying weaknesses sharpened. The quarterly GDP growth (Y-o-Y) slowed significantly from 8 per cent in January-March 2024 to 6.7 per cent in April-June, and further to 5.4 per cent in July-September. Inflation too has been stubborn, staying close to 6 per cent in the three months to November 2024. Although the CAD is unlikely to breach 2 per cent of GDP, export performance has continued weak, net foreign direct investment had dropped to 0.3 per cent of GDP by 2023-24 (the lowest level in more than 20 years), net foreign portfolio investment has been volatile with a downward bias and the rupee has weakened despite substantial sales of dollars by the RBI from its foreign exchange reserves. Since the peak of over $700 billion of forex reserves held by the RBI in late September 2024, they had dropped to $644 billion by end December, a sizable decline by any standards. A couple of areas merit some elaboration. 

The roller coaster trajectory of the combined fiscal deficit is mainly due to variations in the centre’s fiscal deficit, which doubled from 4.6 per cent of GDP in 2019-20 to 9.2 per cent in 2020-21 because of Covid and lockdown before coming down to 5.6 per cent in 2023-24. It is likely to be below the budgeted 4.9 per cent of GDP in the current financial year. The combined fiscal deficit is likely to be 7.5-8.0 per cent of GDP in the current year, which is a lot better than in 2020-21 but almost double the historical low of 4 per cent attained in 2007-08 and substantially higher than in other Asian developing nations. The key question is whether the creditable fiscal consolidation achieved in the last three years is enough for macro-stability to be maintained in the more turbulent world economy expected by many in 2025. There is a strong prudential case for the Budget to target further consolidation to around 4 per cent in 2025-26. That would also help to reduce the very high government debt to GDP ratio of 84 per cent prevailing in March 2024. Even a small reduction would signal the right intent. (Recall that the 2017 N K Singh Committee report on fiscal responsibility and budget management had recommended a target government debt to GDP ratio of 60 per cent). It would also check the inexorable rise in the share of interest payments in total government expenditure in recent years, which has inevitably crowded out some worthwhile development expenditures. 

In the first dozen years of this century, India’s exports of both goods and services grew strongly. As a share of GDP total exports almost doubled from 13 per cent in 2000-02 to an average of 25 per cent in the three years 2011-14, with the goods share accounting for 17 per cent and services share for 8 per cent of GDP, much of it due to IT-enabled services exports. Since then, the services exports share of GDP has held its ground and then increased to over 9.5 per cent in the last two years. However, the performance of goods exports has been seriously disappointing, with its ratio to GDP falling markedly to around 12 per cent by 2016-17 and languishing at that low level except for a temporary uptick in 2021-23. As a consequence, the share of total exports in GDP was below 22 per cent in 2023-24, as compared to the 25 per cent peak a decade earlier. 

The weak performance of goods exports over the last decade is of great concern for several reasons. First, it is the largest earner of foreign exchange. Second, it is an important provider of low-skill jobs. Third, it is a significant component of aggregate demand. Fourth, it has been an important arena of opportunity for micro, small and medium enterprises. Among the factors behind the decline in the goods share of GDP over the past decade has been the substantial real (inflation-adjusted) appreciation of the rupee after 2009-10 (as measured by indices of real effective exchange rates published by the RBI), India’s weak performance in plugging into global value chains and the trend increase in import tariffs (especially on inputs and intermediates) since 2015-16, except for the welcome reductions in the July 2024 Budget. 

Against this background, the forthcoming Budget should undertake further reductions in import tariffs, especially on inputs, and seriously consider an announcement of India’s intention to join one or both of the two Asian mega-regional free trade agreements, RCEP and CPTPP. Outside the Budget, the RBI should reduce its rupee-supporting sales of dollars from reserves in order to facilitate some orderly reduction of the real effective exchange rate. As the old saying goes “a stitch in time saves nine”. 

  The author is honorary professor at ICRIER and former chief economic adviser to the Government of India.

Views expressed are personal