Nascent growth recovery, while heartening, will still need government support

One of the key attractions of every Budget season is the tightrope walk between growth vs fiscal prudence. Next year will be no different except that the tightrope will be set significantly higher from the ground.

For a recovering pandemic patient, the Indian economy is doing well. Unlike other countries, India has defied expectations and gotten through the festive season without seeing a resurgence in pandemic cases and deaths. This has cleared the decks for a much faster pace of economic normalisation. The latest readings of the Nomura India Normalization Index (NINI) — that attempts to gauge the extent of normalisation — suggests that consumption and investment indicators are already fast-approaching pre-pandemic levels, and while the services sector is lagging on the supply side, the industrial sector is already clawing back lost ground.

The view through binoculars also looks reasonably positive for now. A protracted period of ultra-accommodative monetary policy has led to a fall in real lending rates and spreads for corporates and households that should eventually come as lagged relief to the interest-sensitive sectors. With vaccine inoculation now set to reach the masses, an “ultimate unlock” of the economy should eventually occur, and lagging sectors such as travel, tourism and hospitality will finally emerge out of the pandemic’s shadow. As other countries too start benefiting from the “vaccine pivot”, India’s export growth and capex cycle should also start recovering. A spate of reforms undertaken so far on labour, manufacturing, and broader ease of doing business should also fan some of these tailwinds. Overall, we project real GDP growth to pick up by a stellar 13.5 per cent y-o-y in FY22 after averaging -6.7 per cent in FY21.

However, the nascent growth recovery will still need support. The impact of the pandemic on the informal economy, and the eventual feedback loop to the formal economy, will appear statistically only with a lag. India is most likely living through a classic K-shaped recovery, wherein corporates and households with stronger balance sheets have recovered more robustly, while smaller firms and poorer households probably remain trapped in a vicious cycle of poverty and indebtedness instigated by the pandemic. The World Bank estimated in its January 2021 outlook that close to 100 million people will sink below the poverty line ($1.90 per day) by the end of the year in South Asia.

Given this macroeconomic outlook, how will the FY22 Union Budget shape up? The pandemic developments carry two important implications: First, the improving situation means that unlike other countries that are amid lockdown 2.0, India doesn’t have to worry much about renewing survival-styled fiscal support measures. The flip side, given the K-shaped recovery and the new “pandemic poor”, is there will be more mouths for the government to feed, employ and socially assist. We’ve seen this already play out this year in terms of the rural employment guarantee budget being stretched to its seams.

This means that the budgets for spending heads such as subsidies, employment generation, rural development and other social sector programmes are likely to remain large. The vaccination costs add to the bill. The government will also have to sharpen its focus on capital spending to contain damage to potential growth. From a fiscal standpoint, it is hard to imagine much relief in terms of the government’s expenditure burden.

However, the Budget is ultimately part intent and part arithmetic. The fiscal deficit next year arithmetically depends on the fiscal deficit that the government manages in FY21, as well as on the GDP growth projection for FY22. In the case of the fiscal deficit this year, after months of registering expenditure compression, we are now seeing the government crank up its revenue and capex spending machines. Similarly, with the growth cycle improving from Q3 FY21 onwards, we are seeing some belated momentum in revenue numbers, although too little and too late to avoid the massive increase in fiscal deficit this year. Nevertheless, the government’s parsimony earlier in the year on the pandemic rescue package will stand it in good fiscal stead. We expect the fiscal deficit in FY21 to widen to roughly 7 per cent of GDP, limited to double the pre-pandemic target of 3.5 per cent of GDP.

For FY22’s fiscal deficit projection, the GDP growth assumption is crucial not only as the denominator (higher nominal GDP makes for a lower ratio), but also because of its impact on the numerator. If higher nominal GDP growth (real GDP growth plus inflation) is not solely a consequence of higher inflation — as we expect to be the case next year — it should lead to higher tax collections. In addition, the government may feel encouraged to rely on higher fuel and sin taxes to bolster coffers. The government will also most likely once again look under the disinvestment mattress. Overall, we expect the fiscal deficit in FY22 to improve to around 5.3 per cent of GDP.

One of the key attractions of every Budget season is the tightrope walk between growth vs fiscal prudence. Next year will be no different except that the tightrope will be set significantly higher from the ground. On the one hand, it would be unwise to rip off the band-aid too quickly just as the economy is healing. On the other hand, there’s the macroeconomic necessity to clean up after the blowout of public debt this year. Rating agencies will be looking for signs of a credible and calibrated plan to return to fiscal consolidation and to ensure debt sustainability, especially with both Moody’s and Fitch having already downgraded India’s rating outlook to “negative”.

Fiscal management, after all, is a bit like flying an aircraft. You can soar as high as you like, but eventually, it’s all about how smoothly you can land.

This article first appeared in the print edition on January 18, 2021, under the title “The K-Shaped Budget”. The writer is India Economist and Vice President at Nomura

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