Balancing capex and deficits in an era of coconuts, factories and high-speed trains

The new Union budget presented by Nirmala Sitharaman on Sunday was crafted against a set of unique circumstances that have emerged in an increasingly turbulent world over the past year.

First, in a profound change in fiscal strategy, the finance minister had announced a year ago that she would aim to bring down the burden of public debt over the next five years, rather than mechanically focus on the annual fiscal deficit alone. Second, the remarkable economic stability secured since the end of the pandemic has recently (and paradoxically) been accompanied by foreign investment outflows as well as a weakening rupee. Third, the upending of the old global economic order by US president Donald Trump has meant that India has to build strategic depth in key parts of its economy, through either domestic production or by plugging into supply chains even as they are being reconfigured.

Budget 2026 continues with the recent run of budgets based on sensible assumptions about revenues, spending and borrowing. The budgets presented by Sitharaman during this decade have repaired the credibility of Indian fiscal policy. The conservatism is evident this year as well. For example, the tax-to-GDP ratio in the financial year 2027 is actually assumed to be lower than it will be for the current financial year, which is an implicit financial buffer built into the government budget. It is far better to overshoot modest revenue targets rather than undershoot ambitious ones.

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Disciplined fisc

The finance minister has yet again managed to meet the fiscal deficit target she had committed to last year, of 4.4% of gross domestic product (GDP). This was achieved despite the fact that tax collections were weaker than expected, as growth in nominal GDP slowed and tax rates on consumption were reduced. Nominal GDP growth is expected to bounce back to 10% in the new financial year, compared to the anaemic 8% in the current financial year. That seems a reasonable assumption.

Net tax revenues of the Union government in the financial year 2026 are likely to be ₹1.62 trillion lower than expected. Higher dividends from the Reserve Bank of India helped cover some of the gap in revenues, but there were also significant spending cuts in key centrally sponsored schemes for housing, sanitation, water supply, and rural roads. Key subsidies on food, fertilizer and fuel were funded as promised. The spending targets on schemes that were cut back have largely been reinstated for the fiscal year that begins in April.

The finance minister is now committed to bringing down public debt as a percentage of GDP. It is the new Holy Grail of Indian fiscal policy, and an overdue move that aligns with international best practices. Sitharaman said in her speech that a lighter public debt burden would “gradually” free up resources for spending on priority tasks, as interest payments on government debt came down. Public debt is expected to fall from 56.1% of GDP in the ongoing financial year to 55.6% of GDP in the next financial year.

Debt on decline, interest on rise

There are three levers to bring down the ratio of public debt to GDP — the fiscal deficit, the interest rate on government borrowing and the growth in the underlying nominal GDP. The government controls the first, the RBI controls the second, while the third is beyond the direct control of either. It is not clear how public debt will decline as a percentage of GDP when the planned fiscal deficit reduction this year is only a very modest 5 basis points of GDP. Faster nominal GDP growth may have to do much of the heavy lifting. However, it is significant that the interest burden in the new budget is actually higher than in the previous one — 26.26% compared to 25.65%. A higher interest burden sits uncomfortably with the aim to put public debt on a declining path.

The fiscal deficit is an accounting number that is easy to communicate to the financial markets. In contrast, the trajectory of public debt over a longer period of time is an exercise in statistical estimation. That necessarily makes the new fiscal strategy more ambiguous than the previous one, since much depends on assumptions about economic growth, borrowing costs, and annual deficits. To reduce ambiguity, which can confuse the bond markets, it would be good to get an independent report on public debt dynamics in the future.

The stock market reacted sharply to the new budget. Much was a knee-jerk reaction against the increase in the securities trading tax on futures and options. However, there have been deeper concerns on Dalal Street in the past few months. There has been sustained selling of Indian equities by foreign investors, who say there are more attractive investment opportunities in other emerging markets. India has been a consistent underperformer in stock market returns in recent years.

A capacity-building kernel

To reverse the outflow of capital, there have been calls for a more liberal capital gains tax regime for foreign investors. The government has clearly not heeded those calls, for now. The Indian stock markets have held their ground because of the steady inflow of domestic money into mutual funds, but the fact remains that India needs around $60 billion of foreign portfolio investments, net foreign direct investments, and remittances to fund its trade deficit every year. India has had rapid economic growth, economic stability, and a modest trade deficit, but weak inflows of foreign money have put the rupee under pressure.

Finally, the question of economic strategy. The barrage of schemes announced in the course of the budget speech—from coconuts to gaming to culture tourism—perhaps drew attention away from the fact that the government has signalled its intention to build domestic capacity in key intermediate goods such as pharmaceuticals, rare earths, semiconductors, electronic components, and chemicals. This is in response to the geopolitical threats to global supplies of these key inputs. There were also important announcements on seven new high-speed rail corridors, infrastructure investments in smaller cities, and mapping “city economic regions”. The finance minister was bang on point when she described cities as “engines of growth, innovation, and opportunities”.

Geopolitics is part of the explanation. Some of the announcements could also be seen as a strategic shift in anticipation of the fact that India is now looking more like an upper-middle-income South-East Asian country rather than a poor South Asian one. However, delivering the goods with industrial policy is a far cry from announcing intentions, and this is especially true when it comes to job creation. But then, that is actually in the realm of broader national policy rather than the annual budget alone.