Budget 2020 may set off a virtuous growth cycle

The Union Budget for 2020-21 is due this week. A lot of hopes are riding on the measures to reverse the cyclical slowdown of the economy.

The first advance estimate of the National Statistical Office (NSO) puts the real GDP growth for 2019-20 at an 11-year low of 5 percent. The International Monetary Fund (IMF) has also slashed its growth forecast for India for this fiscal to 4.8 percent in its January world economic outlook update, from 6.1 percent estimated in October.

In the IMF’s latest country assessment report for India released in December, a growth-at-risk analysis had talked about only a 5 percent chance of growth slipping to 5 percent or lower. Its revised forecast is, therefore, akin to an extreme outcome on the left tail of the distribution of growth curve. This illustrates a significant challenge facing the government and policymakers – a complete slowdown in aggregate demand, both private consumption and investment – with consumer sentiment and business outlook weak.

On top of that, lenders’ risk aversion continues, with an almost 60 percent decline in the flow of funds to the commercial sector in the first half of 2019-20 compared to the first half of 2018-19 – bringing to the fore the asset quality and financial risks. So, the Budget announcement is highly awaited as a comprehensive and multi-dimensional policy response to counter the growth slowdown, with fiscal stimulus as part of it.

The foremost question on the minds of investors is on the fiscal space available to the government to mount a comprehensive countercyclical response. A breach of the fiscal deficit target of 3.3 percent of GDP (gross domestic product), up to a maximum permissible limit of 0.5 percent under the FRBM (Fiscal Responsibility and Budget Management) Act, looks highly likely, given the large tax revenue shortfall this fiscal year. Tax revenue growth until November at 0.8 percent is running significantly lower than the budget estimates and the total direct collection appears to have de-grown until January, on the back of a corporate tax cut.

Moreover, concerns are being raised, including by the IMF, on the actual public fiscal deficit position being worse than stated, if we take into account the funding of food subsidy and capex through borrowings of public sector entities from the National Small Savings Fund (NSSF) and the issuance of fully-serviced bonds outside the market borrowings programme of the Centre.

For instance, the IMF estimates that the central government fiscal deficit in 2018-19, taking into account these off-budget liabilities, was actually 5.4 percent, compared to 3.4 percent as stated in the budget documents. To that, if we add the fiscal deficit of states, the general government fiscal deficit stood at 8 percent of GDP, with government debt to GDP ratio at 69 percent, placing India unfavourably among emerging markets with similar sovereign ratings.

High level of government debt, in turn, leads to a large part of its spending on interest payments (over 3 percent of GDP), and that along with other committed spending like subsidies and salaries, curtails the space for more productive capacity expansion and social sector. Also, rising government market borrowings can crowd out private sector borrowings, or as we are witnessing at present, keep the cost of borrowing for the private sector high even as the monetary policy has turned accommodative. A historically high term premium (spread between the repo rate and the 10-year bond yield) on sovereign borrowings has also led to higher cost of borrowings for the corporate sector in the credit market, prompting the Reserve Bank of India (RBI) to conduct special open market operations to reduce this term premium.

However, pursuing fiscal consolidation with the aim of reducing debt-to-GDP to 60 percent of GDP, at a time when the nominal growth at 7.5 percent has slipped below the average interest rate on government debt at 7.8 percent, is going to be not only difficult but counter-productive, by making fiscal policy pro-cyclical at a time when a counter cyclical response is needed.

Debt sustainability and gradual reduction requires nominal GDP growth to exceed the average cost of government borrowings. A faster reduction in the debt-GDP ratio requires lower market borrowings through fiscal consolidation. Importantly, with the monetary policy in for a prolonged pause with rising inflation and transmission of past rate cuts lagging despite abundant liquidity, the fiscal policy will have to step in to support economic activity.

Additionally, in the current environment of weak private demand and growth well below the potential level, another year of high general government deficit is unlikely to translate into a current account deficit larger than 1-1.5 percent of GDP in 2020-21, which can be easily financed through net capital inflows. In all likelihood, the government will provide some more discretionary fiscal stimulus in 2020-21, on top of the corporate tax rationalisation in September 2019, to support growth.

The orientation of the fiscal policy, especially in terms of balancing and addressing various elements of aggregate demand and the extent of fiscal expansion (as measured by the fiscal deficit), will be critical to determining the strength and persistence of the growth impulse. Measures to support private consumption -- both rural and urban -- are quite likely through a rationalisation of personal income taxes and higher payouts under the PM-Kisan scheme, from the current Rs 6,000 per year. Other measures could also include widening the social security network through schemes announced last year like provision of pension to farmers and the unorganised sector labour force. This is likely to provide a boost to the consumer sentiment and also help in shoring up household savings, which need to be incentivised.

For a more sustainable and virtuous push to actual and potential growth, however, the Budget proposals should aim at supporting private investments and government’s own capex spend -- both through on-budget and off-budget financing – which will be more critical. There is an urgent need to resolve the issues, including in the financial sector, to kick-start private investment activity.

According to NSO’s estimates, gross fixed capital formation is expected to register only 1 percent growth in the current fiscal. Resuming a healthy supply of credit from banking and non-banking channels while keeping financial stability risks in check, is an important pre-requisite for improving overall economic and investment activity.

Given the high level of lenders’ risk aversion, support from the government and the RBI is needed through capital infusion into banking and non-banking sectors. A quick resolution of legacy bad loans along with a regulatory framework aimed at early recognition and resolution of bad loans and creation of a liquid and vibrant securitisation market, especially for mortgages, are also the need of the hour.

Therefore, Budget proposals on the lines of creating a public asset rehabilitation agency to resolve and deal with legacy bad loans -- as was suggested in the Economic Survey of 2017 -- to speed up the process of resolution and free up capital for lending and/or direct capital infusion into large systemically important non-banking financial companies (NBFCs) or housing finance companies (HFCs) through an SPV (special purpose vehicle) --similar to the US TARP (Troubled Asset Relief Programme) mechanism -- are now being anticipated. Similarly, to revive the real estate sector, besides the measures already announced last year to provide last-mile financing to stalled projects, tax incentives to individuals to clear the existing housing stock are also expected.

In terms of direct investment by the government, budgetary constraints due to a large share of committed revenue expenditures are for real. However, a public investment push is required. Government investment, particularly in the infrastructure space, helps crowd-in private investment.

Moreover, the fiscal multipliers of capex spend at every level of the government is higher than of revenue spending (like subsidies or a tax cut). Last month, the Centre announced a national investment pipeline (NIP) for the next 5 years, which aims at Rs 102 trillion in investment across key sectors of the economy.

Besides direct investment through budgetary allocations in areas like railway and roads and through the resources of central PSUs (public sector undertakings), such ambitious targets require active participation of the private sector through viable PPP (public private partnership) models and large foreign investments.

It is, therefore, quite likely that the Budget would also propose opening up of a number of sectors like insurance, pension and aviation for greater FDI (foreign direct investment) to attract stable foreign capital. Strategic disinvestment in key public sector enterprises has already been announced. Asset monetisation by the government, similar to what has been done in roads, in other infrastructure sectors will also generate resources to support investment.

Finally, the pursuit of fiscal consolidation should involve shoring up the tax-to-GDP ratio by enhancing GST (goods and services tax) revenues and direct tax reforms and curtailing de-merit subsidies. On the indirect tax front, GST changes are not under the purview of the Union Budget anymore, but the need for streamlining the GST rate structure by reducing the number of rates, bringing the currently excluded items under the GST net and improving compliance through a more robust IT system are required to help increase the indirect tax revenue.

The RBI’s latest report on state finances estimates that the weighted average effective GST rate was reduced to 11.6 percent in 2019, after starting with a rate of 14.4 percent in May 2017. These rates are lower than the 15.3 percent recommended by the Subramanian Committee. Thus, in the process of moving towards a more optimal rate structure, the weighted average GST rate may have to be raised, by moving some of the items with lower rates to higher ones.

An overhaul of the direct tax code has already begun after the corporate tax cut with removal of exemptions last year and a similar approach is required on personal income taxes, too. As per the 2019-20 Budget estimates, tax revenue forgone on account of tax exemptions was 5 percent of GDP. On the spending side, the latest estimates from an NIPFP (National Institute of Public Finance and Policy) working paper suggest that de-merit subsidies for the Centre and states combined was at 5.7 percent of GDP. These are still quite high and there is scope to reduce them further, especially in the case of states.

Along with fiscal consolidation, a proper accounting and statement of the fiscal deficit and government debt is crucial, which can be addressed by gradually moving to the accrual system of accounting from cash accounting at present. And, as recommended by the FRBM review committee led by former revenue secretary N K Singh, an independent fiscal council should be put in place to evaluate the health of public finances and monitor the impact of changes in the fiscal policy.

In summary, this highly-anticipated policy announcement comes against the backdrop of big expectations from all key economic agents and stakeholders. Given the various pulls and pressures, it will undoubtedly be a tough balancing act, but as long as India manages to revive investments, boost consumer sentiment, help revive supply of credit and de-risk the financial sector, it can usher in a growth recovery back to around 6 percent over the coming financial year and a faster rate beyond in support of its $5 trillion economy objective.