Here’s the good news: the finance minister successfully beat market expectations on multiple counts. First, he budgeted a lower fiscal deficit (4.6% of gross domestic product, or GDP) than was expected by the market, and advocated by the 13th Finance Commission (4.8 %). The budgeted net borrowing of Rs3.4 trillion for FY12 was a whopping Rs40,000 crore less than the debt market expected, and caused bonds to rally 7-8 basis points.
Second, he did it without broad-based excise duty increases that some in the industry had feared. Instead, expenditures were only budgeted to grow 3% over the previous year (instead of the 10% growth witnessed in FY11). This would appear to be admirable fiscal restraint at first pass. And so the market cheered: the equity market rose, the currency appreciated for a while, and yields fell.
Here’s the bad news: the math does not add up. To understand the scale of what the government has proposed, consider this: net of asset sales (which is how the withdrawal of any fiscal stimulus must be evaluated) achieving the budgeted fiscal deficit of 4.6% of GDP in FY12 would entail an effective fiscal consolidation of a staggering 1.7% of GDP in one year. This is eight times the consolidation that was achieved last year (net of asset sales) and has never been done in Indian economic history.
It is not hard to see why there would almost certainly be slippages if one were attempting a consolidation of such magnitude without tangible tax increases or expenditure cuts. For one, the FY12 budget estimates are predicated on optimistic assumptions of tax buoyancy. It is estimated that the tax buoyancy in FY11 will be about 1.2 (rate of growth of gross tax collections being 20% higher than nominal GDP growth) whereas that of FY12 is being estimated at 1.3. Tax buoyancy typically reduces as one proceeds into the recovery stage. So, one would have expected estimated tax buoyancy to reduce and not increase.
Even if one were to grant that the budgeted tax buoyancy would materialize and the government were to meet its ambitious disinvestment target (recall, this year’s disinvestment proceeds will only be 50% of what was budgeted), there are enough indications on the expenditure side to suggest that the slippages could be large.
Unsurprisingly, subsidies seem to have been under budgeted again. While the allocation for oil subsidies has risen to Rs24,000 crore (a welcome departure from the Rs3,100 crore of the previous year), even this is expected to cover only half the government’s share of the under-recovery even if crude falls to $90/barrel. If crude stays at $100, the oil subsidy bill for the government will approach almost 1% of GDP – only 0.3% of which has been budgeted.
More worryingly, food subsidies have been budgeted at the same amount as last year despite the fact that higher minimum support prices, potentially higher procurement levels and a food security Act that is imminent, could push the subsidy bill up materially. Similarly, the allocation for Mahatma Gandhi National Rural Employment Guarantee Scheme (MGNREGS) has been held at Rs40,000crore, even though linking MGNREGS wages to the Consumer Price Index could result in significantly higher allocations. All told, a more realistic subsidy allocation could increase the fiscal deficit by at least another 0.5% of GDP.
As such, while the market cheers now, it could become clear that fiscal slippages will occur once the supplementary budgets in August and November materialize. Then, the current positive sentiment could rapidly evaporate.
With inflation the predominant macroeconomic challenge, increasingly being driven by demand pressures, what was needed was credible fiscal consolidation that would reduce aggregate demand and quell inflationary pressures. It did not have to be this ambitious, but it was important that it be credible. Authorities seem to have clearly chosen ambition over credibility.
Sajjid Chinoy India economist, JP Morgan
Comment at email@example.com