Managing fiscal fallout: Govt must make the necessary adjustments

Prime Minister Narendra Modi’s appeal to reduce the consumption of several items, including fuel and gold, has led to an interesting debate in the country. The intent behind the appeal is to reduce dependence on imports and conserve foreign exchange. Elevated prices of crude oil are expanding the current account deficit (CAD). Some economists expect the CAD this financial year to expand to over 2 per cent of gross domestic product (GDP), compared to below 1 per cent in 2025-26. Capital is also flowing out because of global uncertainties, resulting in significant pressure on the external account, which is reflected in the decline in the rupee’s value. While considerable focus is on the external account, the impact of the crisis in West Asia on the Union Budget also needs assessment.

 

Although it can be argued that it’s too early in the financial year to revisit Budget assumptions, starting the adjustment process at this stage will help. The Union government was aiming to contain the fiscal deficit at 4.3 per cent of GDP this year, which now looks difficult for a variety of reasons. The GDP base has been marginally revised lower in the new series. The government has reduced special excise duty on petrol and diesel to provide relief to oil-marketing companies (OMCs), and that is estimated to result in a revenue loss of about ₹1.5 trillion on an annual basis. It has also been reported that fertiliser subsidy is likely to increase by 20 per cent because of higher prices of inputs.  Further, oil companies, which are significant contributors to the central exchequer through corporation tax and dividends, may not be able to contribute much this year. Putting these elements together indicates that the fiscal deficit could expand to about 5 per cent of GDP.

 

Notably, higher fuel prices and limited gas availability are affecting economic activities, which could result in lower overall tax collection and add further pressure on the Budget. However, even as the real growth rate comes under pressure, a higher expected inflation rate could push up the normal growth rate and contain some of the crisis’ harmful effects on the Budget. To be fair, the final impact on the Budget will depend on how long the supply of crude oil and gas remains disrupted. However, as things stand, there is no clarity as to how long the Strait of Hormuz will remain blocked. Experts also believe that resuming normal supply could take time even after the strait is opened, keeping prices elevated for some time. Thus, the government would do well to start adjusting. There is an immediate need to revise fuel prices. OMCs are reported to be facing an under-recovery of about ₹30,000 crore per month. This is clearly unsustainable, and the government will eventually have to support them, with significant consequences for the Budget.

 

The government may also have to restructure its spending. The objective here should be not to cut capital expenditure because it supports growth. It is likely that some projects may see cost escalation because of higher costs of inputs. It would also be important that the government does not abandon its disinvestment plans. Although foreign investors are selling, domestic flows remain strong and are supporting the market. In fact, once things improve, the government should consider increasing the disinvestment target to contain the impact of the crisis. While the debt and deficit have declined from the pandemic highs, they are still at a high level and would limit policy space. Thus, to minimise medium-term risks, it will be important to keep the fiscal deficit closer to the target.