This huge jump in the fiscal deficit was because the government ended up with gross tax revenue of ₹20.1 trillion against the revised estimate of ₹21.63 trillion, a gap of more than ₹1.5 trillion. Also, any government cannot cut expenditure beyond a point.
The current financial year, 2020-21, is expected to go the same way. With the economy expected to contract during the year, there is a grave danger that the central government and the state governments may not earn as much tax as they had hoped to, at the beginning of the year.
This will mean higher fiscal deficits for the governments. Current estimates suggest that the combined fiscal deficit of the central and the state governments could cross 10% of the GDP during this year from the current 7-7.5%.
This is something which will impact you and I. In fact, it already has.
The central as well as some state governments have decided not to increase dearness allowance and dearness relief that they pay to their employees and pensioners. That also explains why governments have increased the taxes on petrol and diesel; people are paying much per litre than they should have given the massive collapse in oil prices.
As the governments borrow more to finance their fiscal deficits and accumulate more debt, interest rates tend to go up. The Reserve Bank of India (RBI) is trying to drive down interest rates and in the process returns from bank fixed deposits (FDs) have gone down.
At a larger level, a spike in government borrowing increases the danger of rating agencies downgrading India’s credit rating even further. This will impact everything from systematic investment plans (SIPs) to the value of the rupee with respect to the US dollar.
Clearly, a higher fiscal deficit is not just something that the government has to deal with, but it also has an impact on our financial lives.
How it affects spending
In late April, the central government decided that the increase in dearness allowance and dearness relief that was due to its employees and retirees (pensioners) won’t be paid. Further, it also decided not to pay any increase due until 1 July 2021.
According to a report in Mint, the move will impact 11.5 million employees and pensioners of the central government and help it save ₹37,530 crore. State governments have also implemented similar measures and are expected to save approximately ₹82,566 crore.
Hence, government employees, both at the central and the state level, are already bearing the cost of the higher fiscal deficit. Typically, in any economic downturn, the purchasing power of government employees remains intact. But that is not happening this time around. The indirect impact of this loss of income will mean lesser spending from the government employees and pensioners. This will hurt incomes of many other individuals and businesses.
What does not help is that several governments (like Telangana, for instance) have been unable to pay a full salary to their employees. Again, this means a cutdown in spending which will impact others.
Desperate governments have been trying to shore up their tax revenues. Take petrol. Between 1 January and now, while oil price is 42.2% lower, the price of petrol in Delhi has barely fallen by 5.2%. This is primarily because the union excise duty on petrol charged by the central government has been increased dramatically. The sales tax charged by the state governments has also gone up. Ditto for diesel.
How it affects savings
The slowdown in tax collections was clear even before the last financial year ended on 31 March 2020. This meant that the government would have had to borrow more to bridge the fiscal deficit. When the government borrows more, it crowds out the private part of the economy which is looking to borrow, pushing up interest rates in turn for everyone.
To take care of this and a slowing economy, RBI has been trying to drive down interest rates. It has done so by cutting the repo rate or the interest rate at which it lends to banks to 4% currently, from 5.15% in February 2020. It has also pumped money into the financial system by buying bonds.
As of 1 June, the excess liquidity in the financial system stood at ₹4.02 lakh crore. This is excess money which banks haven’t been able to lend and hence, have deposited with RBI. In January, the government was able to borrow for 10 years at a yield of 6.6%. By June, this had fallen to 6%.
With so much excess liquidity prevailing in the financial system, interest rates on deposits have gone down. Data from Centre for Monitoring Indian Economy (CMIE) suggests that between the end of March and 22 May, the interest on fixed deposits is down around 50 basis points. One basis point is one hundredth of a percentage.
Lower fixed deposit interest rates is another way how people will pay for a huge slowdown in tax revenue collection. One aspect that is often missed out on is that deposits are a major form of savings for a majority of Indians. If we look at data between 2011-12 and 2017-18, deposits formed around half of household financial savings.
If deposit rates go down, as they have over the last few years, people need to save more in order to meet their broader saving goals of building a corpus for the education and wedding of children, as well as having sufficient money for retirement. This has an impact on current consumption, which has an impact on incomes of others.
Five years back in June 2015, the State Bank of India paid an interest of 8% per year on a 5-year fixed deposit. An amount of ₹1 lakh over a period of five years would have grown to around ₹1.47 lakh. Currently, the bank offers a 5.4% interest on a five year fixed deposit. At the end of five years, ₹1 lakh invested will grow to ₹1.3 lakh. Clearly, the difference is significant.
The interest rates on fixed deposits currently largely vary anywhere between 5-6%. In comparison, the small savings schemes pay from 5.5% (the one-year time deposit) to 7.6% (Sukanya Samridhi Yojana scheme). The interest rates on offer on the small savings schemes are still higher than the interest rate on fixed deposits.
While the interest rates on small savings schemes in the time to come are likely to go down, the difference between interest rates on these schemes and fixed deposits is likely to be maintained. This means it still makes sense to have long-term savings parked in these schemes. Other than higher interest rates, some of these schemes also offer a tax deduction.
The money raised under small savings schemes goes to the National Small Savings Fund (NSSF). The NSSF helps the government bring down its fiscal deficit. In 2019-20, the government spent ₹1.09 trillion towards food subsidy. A bulk of this food subsidy would have gone to compensate the Food Corporation of India (FCI) for selling rice and wheat at subsidized prices to meet the need for food security.
The total food subsidy that the FCI had claimed during the year stood at ₹3.18 trillion. Hence, more than ₹2 trillion of FCI’s bill remained unpaid by the government. If the government had cleared FCI’s bill, its expenditure and fiscal deficit would have shot up. But that hasn’t happened. The NSSF lends money to FCI to finance a large part of the bill unpaid by the government. By operating through NSSF, the government avoids a higher fiscal deficit and manages to push the problem to a later date.
For this to continue, it is necessary that money keeps pouring into the small savings schemes. And for that to happen, the interest rates on these schemes need to be higher than those on banks fixed deposits.
How govt can fill the hole
The government plans to bridge the fiscal deficit by borrowing more money this year. Initially, it had planned to borrow ₹7.8 trillion. On 8 May, it said it will now borrow ₹12 trillion to finance the fiscal deficit. This is debt that someone will have to repay in the years to come. As the late Arun Jaitley said in his first speech as the finance minister: “We cannot leave behind a legacy of debt for our future generations. We cannot go on spending today which would be financed by taxation at a future date."
The trouble is that even all this borrowing may not be enough. Suggestions have been made by several economists that the government should monetize the deficit. In simple terms, this basically means that RBI should print money and hand it over to the government to spend and meet its expenditure. In fact, this was a norm until 1997, when an agreement between RBI and the government ended this.
Writing in The Indian Express on 28 May, the former RBI governor D. Subbarao, rightly observed: “Since the government started borrowing in the open market, interest rates went up which incentivised saving and thereby spurred investment and growth." On the flip side, it can be argued that now is the time to incentivize lending and not bother much about savers. The thing is there are other problems with printing money as well.
Take the case of the US. Between, end February and end May, the Federal Reserve of the US has printed close to $3 trillion. Despite this huge money printing, investors haven’t left the US. The reason for that is other than being the major international reserve currency, dollar is also deemed to be a safe haven currency. Hence, investors like holding the dollar.
The same cannot be said about the Indian rupee. Even a hint of direct money printing by RBI can lead to international investors leaving India. First and foremost, the stock market will fall, hurting retail investors, who invest through the SIP route, the most. Interestingly, the foreign investors have kept the stock market going by net investing a total of ₹22,707 crore in it, from 1 May to 2 June.
If foreign investors exit the country, they will want to convert their rupees into dollars. This will lead to the demand for dollars going up and the value of the rupee will go down against the dollar. Of course, RBI can intervene by selling dollars and buying rupees, but it doesn’t have an endless supply of dollars. So, there is a limit to that. Further, a weaker rupee would mean that everything from studying abroad to holidaying abroad will become more expensive.
The flip side to not printing money is the government borrowing more money. Beyond a point, that can lead to a ratings downgrade. Given that, the government is basically stuck between the devil and the deep sea. Having said that, currently, the market feels comfortable with the idea of the government borrowing more. This can be seen in the fact that the yield on the 10-year treasury bond has more or less stood steady at around 6%, since May. Hence, borrowing clearly seems like a lesser evil than printing money.
To conclude, the government needs to look at innovative ways—like selling land banks, cutting goods and services tax (GST) and income-tax rates—to shore up tax revenues. Also, it needs to prioritize its expenditure big time. As things stand, it looks like the citizens will have to bear the cost of falling tax revenues and a higher fiscal deficit.
Vivek Kaul is the author of the Easy Money trilogy.