Economic setting allows quick fiscal consolidation

The World Bank in the latest Global Economic Prospects has looked at the impact of investment accelerations on growth and productivity. The analysis concludes that countries which underwent periods of sustained double-digit increase in investment growth for a period of 6 years, reaped an economic windfall where output growth increased by 2% and productivity increased by 1.3%. India is half way through such an episode.
The World Bank in the latest Global Economic Prospects has looked at the impact of investment accelerations on growth and productivity. The analysis concludes that countries which underwent periods of sustained double-digit increase in investment growth for a period of 6 years, reaped an economic windfall where output growth increased by 2% and productivity increased by 1.3%. India is half way through such an episode.

Summary

The interim budget comes in a backdrop where the growth momentum is becoming more entrenched, macro-economic stability is strengthening and confidence among businesses and consumers is improving.

The interim budget comes in a backdrop where the growth momentum is becoming more entrenched, macroeconomic stability is strengthening and confidence among businesses and consumers is improving. Encouragingly, investments driven by public capex remains a key growth driver. In fact, the rate of real fixed investment is at its historic high in 2023-24, show NSO’s GDP estimates. Inflation, especially core, has eased over the year, helping the monetary policy to remain on hold and withdraw the pandemic era stimulus. That, combined with healthy bank balance sheets, has facilitated growth momentum, as rates have increased without significantly curbing the flow and demand of credit. Global economic headwinds are losing some steam. Major global central banks are now expected to cut rates over CY2024. After a year of resilient global growth, soft landing is emerging as the consensus on the US economy, though most forecasts indicate a prolonged period of low global growth ahead.

Weak spots in the domestic growth story are visible too. For one, private consumption, the largest component of GDP, is expected to register tepid growth this year. The slowest farm sector growth in 8 years is contributing to it, with rural demand lagging. Food inflation remains high and broad-based and is adversely impacting mass consumption. Urban consumption may lose steam too, as pent-up and festival season demand cools. Manufacturing sector growth is expected to come off sharply between the first and the second half of this year. External drag on growth will persist too. Geo-political tensions can keep up the pressure on oil and other commodity prices, though a sizeable foreign exchange reserve will help contain spillovers. On balance, the economic setting is the most positive it has been since the onset of the pandemic. The budget can thus focus on strengthening the long-term growth impulses provided by public investments, building buffers to counter future shocks and putting public debt on a downward trajectory to free up space for productive spending.

In terms of key targets, the stated objective of reducing the budget deficit to 4.5% of GDP by FY2025-26 from 5.9% this fiscal, will require accelerated pace of fiscal consolidation going ahead. The target for the next fiscal is likely to be set at 5.2% of GDP as a result. That in turn will require the government to reduce the budget size to a level closer to the pre-pandemic levels. The budget size as a percentage of GDP could be set at 14.2%, down from 14.9% this year. This translates into a 2.5% increase in government spending – which would be the slowest annual increase in 20 years. Given that over 60% of the spending is committed in nature, with interest payments accounting for almost one-fourth of the total, this reduction is likely to come at the cost of lower capital spending. However, considering that government capex has been a major driver of investments and post-pandemic growth, a significant reduction poses a risk to reaching higher potential GDP. The World Bank in the latest Global Economic Prospects has looked at the impact of investment accelerations on growth and productivity. The analysis concludes that countries which underwent periods of sustained double-digit increase in investment growth for a period of 6 years, reaped an economic windfall where output growth increased by 2% and productivity increased by 1.3%. India is half way through such an episode with three consecutive years of over 10% real fixed capital formation growth. This report further identifies fiscal consolidation which improves macro-economic stability, as instrumental in sparking investment accelerations. Thus, the government while aiming to reduce the fiscal deficit will still need to maintain a capex focus, until the crowding in of private sector capex becomes more entrenched. Other than that the government may look to provide support to rural consumption, by increasing the payout in the PM-KISAN scheme for instance. Spending priorities will broadly remain unchanged given this an interim budget.

On the financing side, with an unchanged tax code, the tax-to-GDP ratio is likely to remain around 11.2%, reflecting stable short-run elasticity with respect to the nominal GDP growth. Tax buoyancy level is slowly reverting to its pre-pandemic levels, which along with improving compliance levels will help increase the tax revenue from the existing base. Moreover, reforms undertaken since 2017 aimed at widening the base and simplifying the tax code including introduction of GST, simplification in the direct tax regime and digitalization, are helping to improve tax revenue mobilization too. To augment tax revenue, a rationalization of GST rates and exemptions combined with broadening of the direct tax base, will help achieve a more meaningful improvement. Non-tax revenue is yet to reach its pre-pandemic level and improving mobilization from this source will require stepping up disinvestments and asset monetization.

Market borrowings will remain a major source of financing the fiscal gap. Net market borrowing levels for the next fiscal are likely to be pegged around Rs. 11 trillion – which is more than double the level prior to the pandemic and at nearly the same level this year. Overall, the public debt to GDP levels at over 80%, will remain elevated. Servicing of a large public debt curtails discretionary fiscal space. A sovereign ratings upgrade is also contingent upon reducing debt through a time bound fiscal consolidation towards a 3% of GDP deficit. That will help India become the third largest global economy with an investment driven, sustainable and inclusive growth.

Gaurav Kapur is chief economist, IndusInd Bank Ltd. Views are personal.

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