Impacting growth, liquidity management: Shifting sands of fiscal policy

There is a very high chance that the actual fiscal deficit target will undershoot even 4.9 per cent of GDP as there was a decline in government expenditure during the general elections

In the run-up to the general elections, there was chatter on rising risk of fiscal slippage, with speculation on rise in subsidies and targeted income schemes. The actual outcome has been dramatically different with the central government’s fiscal deficit target for financial year 2024-2025 (FY25) further reducing to 4.9 per cent of GDP from the interim target of 5.1 per cent of GDP.

 

Moreover, there is a very high chance that the actual fiscal deficit target will undershoot even 4.9 per cent of GDP. This is because during the general elections, there was a decline in government expenditure, as focus had shifted. Total expenditure in the first six months of FY25 is tracking lower by 0.4 per cent year-on-year (Y-o-Y), mainly due to sharp reduction in capital expenditure by 15.4 per cent Y-o-Y. Meanwhile, on the revenue collection front, tax collection was not impacted with gross collections tracking higher by 12 per cent Y-o-Y in H1FY25. This is higher than the budgeted growth rate of 10.8 per cent Y-o-Y for FY25.

 

 

The combination of lower government expenditure and strong tax collections has resulted in a fiscal deficit in the first six months reaching only 29% of the full year target compared to 39 per cent for the same period last year. This is the lowest in more than 20 years. The changing dynamics on the fiscal front is already impacting growth, liquidity management and fixed income markets. We start with an implication for growth, the decline in government expenditure in H1FY25 has contributed to the loss in momentum in GDP growth. 

 

Central government capital expenditure declined by 15.4 per cent Y-o-Y in H1FY25 compared to 43.1 per cent growth in H1FY24. To make matters worse, state government capital expenditure also declined in H1FY25, with focus shifting towards elections. General government expenditure has been a key support to capex cycle with private corporate capex still tentative. General government capex accounts for 13 per cent share in overall Gross Fixed Investment, with Centre and state governments being nearly equal contributors. The pace of expenditure has picked up post the elections and is expected to continue to pick-up momentum in the remainder of FY25. This is expected to be growth supportive in H2FY25, reflected in public services GVA and Gross Fixed Capital Formation.

 

Interbank liquidity conditions ease

 

The change in government expenditure pattern has had an impact on interbank liquidity conditions. Post the general elections, there was pick-up in government expenditure, both revenue and capital expenditure. This is reflected in overall government cash surplus (Centre + states) reducing to Rs 0.6 trillion as of November 8, 2024 from peak levels of Rs 5.1 trillion as of May 24, 2024. The surge in government cash surplus in May 2024 was due to the bumper RBI dividend of Rs 2.1 trillion. The pick up in pace of government expenditure has resulted in easing of interbank liquidity conditions since July 2024 onwards. System liquidity surplus has averaged at Rs 1.5 trillion per day over July to November. This has resulted in the Treps rate averaging slightly below the repo rate over the last few months. The Centre has also been conducting buybacks of g-secs, to utilise its cash surplus, which has also resulted in INR infusion. The easy liquidity conditions have persisted despite Balance of Payment turning negative in Q3FY25 due to foreign portfolio investors (FPI) outflows since October 2024. The favourable position on the fiscal front will be a source of comfort to the fixed income market, which is currently battling unfavourable global dynamics.

 

G-sec yields remain range-bound

 

The outcome of the US election has raised the prospects of a less dovish Fed with fiscal policies under the Trump administration expected to be inflationary. A large part of this risk has already been priced-in by the markets, resulting in a jump in UST yields. Despite adverse global conditions, g-sec yields have remained range-bound, supported by favourable fiscal conditions and demand-supply dynamics. As mentioned above, the fiscal deficit is likely to undershoot the 4.9 per cent of GDP target. Capital expenditure is expected to undershoot the budget target of Rs 11.1 trillion. In H1FY25, only 37 per cent of the capital expenditure has been done. To meet the Budget target, capital expenditure will need to jump by 52 per cent in H2FY25. Within capital expenditure, central government loans to state governments are tracking significantly below the full year target of Rs 1.5 trillion. It is likely that actual disbursement of loans to states could fall short of target levels by Rs 200 billion to Rs 500 billion, which represents savings of 0.1 per cent to  0.2 per cent of GDP. 

 

The Centre is not expected to reduce supply of g-secs as this is a bond index inclusion year. Preferring instead to reduce t-bill supply. Demand for g-secs remains supported by ongoing JP Morgan EM bond index inclusion and investor demand. The combination of rising formalisation of the economy and household shifting higher share of financial savings towards insurance, pensions and provident funds, has supported rise in investor demand. The addition to JP Morgan EM bond index has supported inflows into g-secs.

 

The changing pattern of government expenditure is having a three-pronged impact on the economy, via growth, liquidity conditions and markets. The prospects of fiscal deficit undershooting target levels will keep g-sec yields contained, despite surge in UST yields. The rise in pace of government expenditure in H2FY25 is expected to support GDP growth and interbank liquidity.

 

The writer is a chief economist at IDFC First Bank.

  (Disclaimer: These are the personal opinions of the writer. They do not reflect the views of www.business-standard.com or the Business Standard newspaper)