The current economic slowdown
is exposing challenges in how the country manages itself fiscally.
First, it is well understood that a fixed annual fiscal deficit target is pro-cyclical, which means it makes a slowing economy go slower, and an accelerating economy go faster. This is already visible: One of the most worrying aspects of the GDP statistics reported last week was that nominal GDP growth hit a 17-year low of 8 per cent. This explains the very slow growth in tax collections in the past few months, and means that government spending, budgeted to grow at 21 per cent but growing only at 6 per cent currently, is likely to miss Budget targets. Recall that in the June quarter, private consumption grew just 3.1 per cent, investments grew at 4 per cent, and only government consumption grew at 8.8 per cent. As government spending slows too due to the shortfall in taxes, the economy is likely to slow down further.
A fixed target is a “first generation” fiscal rule that started being adopted in Western Europe some four decades ago. Over the decades, economists have documented its shortcomings, particularly given the natural inaccuracy of any growth forecast on which fiscal targets are based. Second-generation fiscal rules instead set medium-term targets, and provide escape clauses.
Even in India, when setting up the FRBM (Fiscal Responsibility and Budget Management Act) Review Committee in 2016, the then Finance Minister had stated that “there is a new school of thought, that instead of fixed numbers as fiscal deficit targets, it may be better to have a fiscal deficit range as a target…” The Committee also documented and explained this disadvantage of headline fiscal balance rules in its report. Its choice of a debt-to-GDP target as the medium-term fiscal anchor, since adopted by the government (40 per cent of GDP for the Centre, and 20 per cent of GDP for the states), sought to provide some flexibility to the government in navigating through economic cycles. However, it then prescribed a fiscal glide path to the Centre so as to meet the medium-term target by 2023.
The growth linked “escape clause”, which gives half a per cent of GDP of additional fiscal deficit buffer, would only get triggered with a “sharp decline in real output growth of at least 3 percentage points below the average for the previous four quarters”. The 5 per cent growth in the first quarter is a full 3 percentage points slower than the 8 per cent reported in the first quarter last year, but is only 1.8 percentage points slower than the average of the last four quarters, not enough to trigger the clause. The government, therefore, lacks wriggle-room to stem the slowdown fiscally.
A related issue is the anchoring of the bond market: The government appears to be apprehensive that at the first sign of fiscal slippage, even if for a year, the market would drive up yields on government bonds sharply, pushing up borrowing costs for the private sector, and thus undoing the demand impetus that the government’s fiscal stimulus would give. The term premium (that is, the difference between the RBI set repo rate and the yield on the 10-year government bond) is already elevated: At around 110 basis points, it is much above the average of about 60.
Illustration: Binay Sinha
Many market observers say this reflects fiscal stress and excessive off-budget borrowing by the government, but to us this appears as post-facto justification. Very few bond markets are as sensitive to a few tens of basis points of fiscal slippage as the Indian market is; even markets which have not been distorted by steady central bank purchases. If demand-supply were driving term premiums up, they would have fallen a while back: RBI’s annual bond purchases have been significantly higher than what anyone expected a year back. In our view, the term premium is likely to correct when consensus views on growth (was at 6.9 per cent for FY20; now anything above 6 per cent looks unlikely) and inflation do (consensus forecast a year out is 4.5 per cent, versus Monetary Policy Committee’s 3.6 per cent). But their anchor to a fixed target needs to change.
A third issue is the over-dependence on the Union government to manage growth through fiscal means, particularly given the limited space it has for discretionary spending once the fiscal deficit ratio is fixed. The shortfall in taxes hurts the states too, most obviously because 42 per cent of all central taxes go directly to the states. However, there is minimal direct impact of weaker GST collections, given the central government guarantee of 14 per cent tax revenue growth for the first five years of GST. All GST shortfalls, therefore, would be felt by the Centre, and the states are in a relatively better position. The most ominous detail from the GST data released over the weekend was the Rs 28,000 crore compensation paid to the states for the months of June and July: annualised, this would mean nearly Rs 1.7 trillion, well above the Rs 1.1 trillion expected as compensation cess collection.
It is worth reiterating that now state governments together spend 90 per cent more than the Centre. Dr Bibek Debroy, chairman of the PM’s Economic Advisory Council, has put forward an idea whose time may have come: A body where the Centre and the states get together to plan public expenditure. There has long been criticism of the large number of centrally sponsored schemes, where the Centre initiates projects in areas that are constitutionally in the State List (like rural housing and health), and then seeks part funding from state governments. Not only would such a forum allow the Centre and the states to collaborate better on longer-term targets (education in some states, health in some other, skilling or roads in a third, for example), but also, at a time of slowing growth, increase the number of available fiscal options to kick-start the economy or, at least, prevent the slowdown from getting worse.
One of the reasons policy changes become more likely during crises is that at such times inefficiencies in the way we work show up much more clearly than they would in normal times. Such periods can, therefore, be seen as opportunities to undertake some structural changes that prepare the economy for the next leg of growth.
The writer is co-head of Asia Pacific Strategy and India Strategist for Credit Suisse