Cafe Economics
India will face especially complex policy challenges next fiscal year
Fiscal correction will be harder with slower nominal growth while a private investment upturn may pose an external strain
The Indian economy has come out of the pandemic in far better shape than most other large economies as well as some of our neighbours. Growth is higher, inflation is lower and debt levels are more manageable. Most of the high-frequency data for December points to a broad-based recovery in economic activity. India has also managed to avoid the crises that have hit countries such as Sri Lanka or Pakistan.
There are three ways to assess where the Indian economy stands right now in comparison to its position the year before the pandemic struck. Each provides a different lesson. The first is reassuring, the second is a reality check and the third is a worry. Let us consider them sequentially.
The reassuring news is that India’s gross domestic product (GDP) in the financial year ending in March 2023 will be significantly higher than in the financial year that ended in March 2020, the last one before the pandemic sent economies across the world on a downward spiral. The reality check is that the Indian economy is still smaller than what it would have been in case the pandemic had not struck, and the economy had continued on its pre-pandemic growth trajectory. This means there have been permanent output losses.
The worry is that the number of Indians employed is smaller than before the pandemic, at a time when the population has grown. The labour force participation rate is still around 3 percentage points lower than before the pandemic. The final frontier of the economic recovery is higher employment.
The Indian economy will likely lose momentum in the next financial year. Export demand will weaken as other major economies slip into recession. Domestic consumer spending may lose some steam as the excess stock of precautionary plus forced savings built up during the pandemic dries up. A lot will depend on urban wage growth. Private sector investment is showing some signs of picking up, but it is early days yet. Weaker aggregate demand as well as monetary tightening should bring Indian inflation back into the comfort zone of the Reserve Bank of India.
The result: nominal GDP growth will be back in the 10-11% range. One result of the normalization of nominal GDP growth—and thus the tax base—is that India will have to face two tricky macro policy choices, one on the fiscal front and the other on the external front.
Let us consider the fiscal situation first. High nominal GDP growth over the past two years helped the government improve tax collections, and thus meet its deficit targets despite higher subsidies. It also meant that nominal growth was much higher than borrowing costs, thus taking pressure off the government to cut the deficit more aggressively in order to stabilize public debt.
Why? There are two main components of any strategy to bring down public debt in an economy. The first is the difference between the growth rate of the economy and the average cost of government borrowing. The other is a reduction in the primary deficit of the government. Generally, the higher the difference between economic growth and the cost of government borrowing, the lower the pressure to go for a sharp fiscal correction to stabilize public debt over the medium term.
However, next year will be different from the previous two. Nominal GDP growth will be lower while government borrowing costs will be higher. The fiscal correction that will be needed to stabilize public debt will thus be higher than before. It remains to be seen whether the Union government can manage a sharper fiscal correction in 2023-24, especially given the fact that it is heading into the next general elections, and that the need to defend our borders against Chinese aggression will require higher defence spending.
The second policy paradox is about supporting a revival in the private investment cycle, which is essential for sustainable growth over the next decade. Higher investment activity in the economy at a time when we have a persistently high fiscal deficit will mean that the extra domestic demand will likely spill over into a wider current account gap. A lot then hinges on the fiscal strategy of the government, whether government savings increase, or more realistically whether government dis-savings decrease. The changing structure of aggregate demand—from government spending to private sector spending—will have implications for the external balance.
These two tricky policy choices—of sustaining the fiscal correction when nominal growth is trending down and of supporting the private sector investment cycle without triggering further pressure on the current account—may become bigger issues of discussion in the next financial year.
However, much will also depend on the state of the global economy. Will monetary tightening eventually bring down inflation in many large economies? Will some sort of military truce in Ukraine bring energy prices down further? And, perhaps most importantly, what will the reopening of China mean for the rest of the world economy?
Niranjan Rajadhyaksha is CEO and senior fellow at Artha India Research Advisors, and a member of the academic advisory board of the Meghnad Desai Academy of Economics
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First Published:11 Jan 2023, 01:06 AM IST
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