India's election-year challenge

Fiscal consolidation must take precedence in the upcoming Budget, even if it's an interim one

With the country’s attention focused on India’s moon landing and the G20, what hasn’t received as much attention is that over the past 18 months the Reserve Bank of India (RBI) has managed a difficult juggling act to keep macroeconomic stability. By early 2022, India had accumulated over $670 billion in reserves, equivalent to more than 10 months of imports, nearly twice the current account deficit, and 12 months of forward debt servicing needs.

The RBI has since conducted foreign exchange (FX) sales of almost $90 billion to allow a more gradual depreciation of the rupee from Rs 75 to the dollar in February 2022 to about Rs 80 by December 2022, and

Rs 83 by September 2023. During this period, the US Fed raised interest rates by 5 percentage points to combat inflation, while the RBI raised the repo rate from 4 per cent in February 2022 to 6.5 per cent today, an increase of 2.5 percentage points but still significantly lower than the Fed over the same period to sustain our recovery.

Now, fiscal adjustments are needed as we prepare for the next Budget — even if an interim one. If India keeps the fiscal deficit too high for too long, it unnecessarily risks macroeconomic instability. The mistake of keeping fiscal deficits too high for too long after a crisis, which it made in 2012-2014, resulted in high inflation and a huge current account deficit that led to a sharp depreciation of the rupee when the US Fed announced a taper to its quantitative easing (QE) programme.

India recorded a fiscal deficit of more than 9 per cent of gross domestic product (GDP) in financial year 2021-22 (over 13 per cent of GDP if state deficits are included) as revenues fell and expenses rose during the pandemic. In FY23, it was reduced but was still a substantial 6.4 per cent of GDP (9.6 per cent of GDP with state deficits). For FY24, the budgeted fiscal deficit is maintained at 5.9 per cent of GDP (9-10 per cent with states included), but with elections looming, this could easily go above 6 per cent of GDP (10 per cent with states included). In FY23, the high fiscal deficit was justified due to the need for social assistance in the form of free foodgrains and elevated expenditures on the rural jobs guarantee programme (MGNREGA), health care, and high capital expenditures to support the economic recovery, a justification that carries over to FY24. 

However, there are several factors that have allowed India macroeconomic stability, despite high fiscal deficits, the effects of the Ukraine war on oil and commodity prices, and the sharp increase in interest rates in the developed world.

 

The most obvious factor is the level of FX reserves. Between 2010 and 2013, when the advanced economies were flooding the globe with large stimuli, the RBI inexplicably allowed large FX inflows without building reserves. As a result, in 2013, India’s FX reserves were only $280 billion, equivalent to six months of imports and not enough to cover the current account deficit plus 12 months of debt servicing requirements. Hence, markets panicked when the taper tantrum hit, causing the rupee to weaken until the new RBI governor announced an interest subsidised exchange guaranteed scheme to draw in funds from non-resident Indians to help stabilise the rupee. The situation is different now, but caution is needed. India’s reserves have been depleted but still remain at a comfortable $594 billion, or equivalent to 8-9 months of imports. But going forward, despite its inclusion in the JP Morgan Index, the rupee may come under pressure for three other reasons if it keeps fiscal deficits too high. 

The first is that private investment (gross fixed capital formation), which was over 30 per cent of GDP in 2011-13, is now down to around 25 per cent of GDP. Net private savings (private savings minus private investment) in 2011-13 were very low, and therefore the current account deficit (foreign savings) jumped up to around 5 per cent of GDP in 2012-13, to finance a large fiscal deficit (government dissaving). When the US Federal Reserve in 2013 signalled a “Taper” — slowing down its QE programme — just the announcement was enough, given the large current account deficit, to spook foreign portfolio investors and pull funds from India leading to a panicky decline of the rupee by 20 per cent. A worrying sign is that India’s private savings have declined sharply — household financial savings were at a 47-year low, according to the RBI in FY23, as households have coped with the pandemic and rising inflation. And if the private capital expenditure revives after the election, necessary for a sustained economic recovery, net private savings may be negative and continued high fiscal deficits will translate into high current account deficits, which will make the markets nervous.

A second worrisome factor is the price of oil. The Organization of the Petroleum Exporting Countries oil price had spiked to between $120 and $140 per barrel in 2012. Today, crude prices are again inching higher but are still below $100 per barrel in current dollars. India has switched a large share of its oil purchases to discount oil from Russia. This share has jumped from 2 per cent of its oil imports in 2021 to around 40 per cent today. But oil prices are expected to cross $100 per barrel in 2024, and if the Ukraine war ends, Russia may not be willing to supply such large amounts of discounted oil.

A third factor is that while inflation has declined globally, it remains above the 2 per cent target for the US and Europe, which means the Fed and the European Central Bank may raise rates further. Additionally, further geopolitical and geoeconomic shocks may increase risks and uncertainties.

India must, therefore, make plans to reduce the fiscal deficit for financial year 2024-25, even in an interim budget, to balance all these different pressures and maintain macroeconomic stability. This will not be easy as interest payments alone have crossed 5 per cent of GDP, and in the run-up to the elections, there will be pressure to lower taxes and announce new spending schemes. But without substantial and credible fiscal consolidation, the risks to India’s recovery will remain high.

The writer is distinguished visiting scholar, George Washington University and his co-authored book Unshackling India (Harper Collins 2021) was declared the Best New Book in Economics 2022 by the Financial Times