Fiscal consolidation is likely to continue
The financial year (FY) 2019 Union budget, to be announced on 1 February, is going to be critical for various reasons.
It will be the last full-year budget of the current government before general election, expected to be held in May 2019, and there are high expectations, therefore, of what the budget can or should deliver. This budget will also help determine the Reserve Bank of India’s (RBI’s) future course of monetary policy action, in our view, and in that regard will be watched closely. Last but not least, this will be the first full-year budget after the implementation of the goods and services tax (GST) in July 2017, and hence it will be interesting to note the estimates pertaining to indirect taxes.
We expect the government to target FY19 fiscal deficit at 3% of gross domestic product (GDP). This will help achieve a primary account surplus in FY19 (we estimate 0.2% of GDP), from a likely deficit of 0.1-0.2% of GDP in FY18. The last time India achieved a surplus in its primary account balance was in FY08, and, from this standpoint, the likely development of primary account balance turning into a surplus in FY19 should be positive for the debt dynamic and the overall bond market sentiment.
The government will likely reallocate more spending towards sectors such as infrastructure (roads and railways), affordable housing and rural development, to create more jobs and support rural demand, but this is unlikely to be done at the cost of pushing the overall spending envelope significantly higher. Certain sectors which don’t feature in the priority list will likely receive lesser allocation, making way for bigger transfers to the sectors that can help boost growth and employment. While infrastructure, affordable housing and rural development will likely see a large increase of allocation in year-on-year percentage terms, it may not translate into large increases in percentage of GDP terms, which matters more for the fiscal math.
Does India need a fiscal stimulus? According to our assessment, the sharp slowdown in the economy during 2017 was more of a reflection of transitory short-term disruptive factors brought about by demonetization and GST, which should not remain an issue in FY19, thereby obviating the need for any fiscal stimulus to support growth. We are forecasting real GDP growth to recover to 7.5% in FY19 from a likely 6.6% outturn in FY18; while this will continue to be lower than the potential growth rate of the economy (which we estimate to be 8-8.5% in the new GDP series), India will probably remain the fastest growing economy in the world, and, from this perspective, the need for a fiscal stimulus does not arise. With the general government budget deficit and debt/GDP already at 6.5% of GDP and 70%, respectively, the room for any meaningful fiscal stimulus is also absent.
Furthermore, there is a risk that the RBI could embark on an earlier-than-anticipated rate hike cycle if the fiscal targets are not met, and in our view the damage to growth recovery on account of potential rate hikes outweighs the benefits of a slightly expansionary fiscal policy at this stage.
After five-six years of steady slowdown, private sector capex looks to be finally bottoming out and there is expectation that recovery will take root from the second half of FY19. Fiscal prudence at this stage will help prevent market interest rates from rising to higher levels and, thereby, can play an important role in sustaining and accelerating the recovery in growth that is under way. Fiscal consolidation will also help ensure that India’s hard-earned macro stability does not come under serious threat in case of a sudden spike in global financial market volatility or/and intensification of any geopolitical risks.
In order to sustain the fiscal consolidation momentum over the medium term, the revenue side of the budget will need to improve meaningfully. Currently, gross tax revenue is about 11.1-11.2% of GDP, which is 70-80 basis points lower than the peak outturn in FY08 (11.9% of GDP). With growth momentum likely to improve from FY19, there should be some natural improvement in the tax/GDP ratio, but the overall tax base has room to increase substantially.
The implementation of GST from July 2017 is likely to be a game changer in this respect. While the introduction of GST has led to temporary disruptions in the economy, slowed down growth and made the revenue outlook uncertain for the near term, we expect this landmark tax reform to increase the indirect tax base and collection in the coming years, as the Indian economy becomes more formalized.
Our calculation suggests that the GST could add about incremental revenue worth 1.5% of GDP over the next six years, which will help to sustain the pace of fiscal consolidation in the years ahead, even with the government likely increasing its spending envelope for various social and productive needs of the economy. We also expect the private capex cycle to start showing meaningful recovery in the years ahead, which will help improve direct tax collection. Overall, we see revenue/GDP bottoming in FY18 and improving thereafter, which will help to sustain the fiscal consolidation, which envisages bringing the public debt down to 60% of GDP by FY23. We think it is possible to achieve this target, thanks to GST, and focus on making expenditure more targeted and productive.
Kaushik Das is India chief economist, Deutsche Bank.