Budget 2020: Fiscal Deficit is No. 2, Growth Revival is No. 1

• The slowdown in Indian economy has raised a strong debate on two fronts. The first is whether it is structural or cyclical and the second is whether it is demand or supply-led.
• On closer examination, the current phase of slow growth with low inflation indicates the slowdown is demand-led.
• The number one challenge is to attain a higher and sustained growth, more so when the persistent cyclical downturn is showing signs of structural symptoms.
• The GoI should spend more to revive the subdued demand through counter-cyclical fiscal levers as well as creating a space for fiscal revenue through structural policy reforms.

Is the shine on India’s growth story wearing off? The secular decline in GDP growth for the sixth straight quarter to 4.5% in July-September 2019 has led to a growing scepticism. The economy has now entered a phase usually referred to as “Growth Recession”. The private final consumption expenditure (PFCE) to GDP, which had remained stable over the last decade averaging 56%, has been slowing down in the recent quarters. So has investment rate been continuously witnessing a precipitous decline for a longer time. Export growth plummeted to 4.7% in 2017-18 from 19.5% in 2010-11. The 12.5% growth in exports witnessed in 2018-19 on the back of US-China trade war was found to be ephemeral!

There are two impending questions on the current economic slowdown. The first is whether it is a cyclical or a structural slowdown. While a cyclical downturn is a temporary one around a stable potential growth, a structural downturn refers to a decline in potential growth itself. The average output gap (difference between actual GDP and potential GDP) for 2011-12 to 2018-19 has been -0.24%, signalling that the Indian economy has been growing at less than its potential.

The second question on which the debate refuses die down is whether the current slowdown is demand-led or supply-led. This identification is important from the policy formulation and redressal perspective. Judging by the government’s earlier response, it seems that the GoI believes it is a supply-side slowdown; for instance, it made a big-bang corporate tax cut announcement.

The last time India witnessed a similar slowdown was in 2011-12, when the growth slowed down for six straight quarters from Q4-2011 to Q1-2012; a fall by 5.4%. In contrast, the current slowdown started from Q1-2018 and has dragged till Q2-2019 and GDP growth fell by a good 3.4% already. However, one shouldn’t be fooled by the numbers. The devil lies in the details!

Gross capital formation as well as government expenditure fell during both the slowdowns, when one compares preceding six quarters of the slowdowns. Export growth improved more than double from 6.5% to 16.7% during the previous slowdown as compared to the current one where it improved from 5.5% to 9.2% only. More disturbing is the fact that whereas private consumption and imports improved during the previous slowdown, both of them have fallen during the current slowdown. This squarely points to a decline in the absorption capacity of the Indian economy.

Moreover, inflation registered double-digit figures on an average during the previous slowdown, whereas average inflation for the current slowdown has been less than 5%. One can ascribe this to the inflation-targeting approach that began in 2015, led by the Monetary Policy Committee. To say it in very crude terms, while earlier slow growth along with high inflation is an indication of supply side bottlenecks, but in comparison, current slow growth with lower inflation clearly suggests a slowdown on demand-side.

The PFCE recorded a modest growth of 5.06% in Q2-2019. For an economy like India where consumption forms almost 60% of the GDP, this assumes even greater significance. Domestic car sales and two wheeler sales (a proxy for urban demand) for the first two quarters of 2019 combined fell by an average of 30.08% and 15.98%. Domestic tractor sales (a proxy for rural demand) during the same time fell by 12.91%. With consumption growth closely linked to income generation in standard macroeconomic language, this brings home a major structural issue of what is ailing consumption growth in India, viz., the declining trends in rural and urban wages.

Corporate wage growth peaked at 20.5% in 2008-09 post the financial crisis. This growth has now fallen further down to 5% in 2018-19. The major reason for this has been the emergence of a twin-balance sheet problem, which forced corporates into a massive deleveraging drive to clean up their balance sheets along with various other cost-cutting measures. The growth in rural wages also declined from its peak of 27.7% in 2013-14 to almost 4% in 2018-19 for varied reasons. First, on the global front itself, there was a slowdown since 2013-14 accompanied by a collapse in commodity prices. Domestically, the Indian economy had to deal with two successive droughts in 2015 and 2016, which again dampened agricultural growth. Rural non-farm employment also fell due to the slowdown in the construction sector. Lastly, employment generation under MNREGA is relatively lower during the current period as compared to previous years.

The government may need to refocus on the allocation to MNREGA as it has decreased to Rs 60,000 crores in 2019-20 as compared to revised estimate of Rs 61,084 crores for 2018-19. The forthcoming budget needs to reallocate more funds to MNREGA to increase employment and hence income generation amongst rural India, which in turn, can then drive up consumption. Increased focus on rural India will achieve the twin objective of attaining inclusive growth. The personal income tax cut or increasing the income exemption limit will help increase urban middle income who form the consumption base, and therefore, in turn will stimulate urban demand.

Another main pressure point for the Indian economy has been the investment slowdown. One of the factors that closely affects the investment is interest rate – the cost of capital. Here we need to look at the real interest rates and not fall into the trap of decreasing nominal interest rates. The real interest rates have seen a rise since September 2018, even though nominal interest rates have been falling. This is because the WPI has come down from 5.04% to 0.88% in September 2019. This sharp decline in WPI as compared to the nominal interest rates has kept the real interest rates higher; hence impinging borrowers and investments. The rising incremental capital output ratio since 2016-17 has not helped either. Add to that the falling capacity utilization and we have a recipe for a certain disaster! The consistent fall in the gross domestic savings has only exacerbated the problem.

This fall in savings has been led by the household sector, which has been borrowing more and saving less over the years. However, the extravagant spending has not translated into demand for domestic goods. Savings leakage to the international economy might be one culprit, for instance, as we have seen increased international tourism spending besides rising Chinese imports. What can the government do here? In a country like India where the monetary transmission mechanism is weak at best, we need to do away with relying too much on interest rate cuts to stimulate the investment climate and revive animal spirits! Having already slashed corporate tax rates from 30% to 22%, focus should now be on reviving investment demand, because in the case of persistently subdued demand, higher profits left with corporates merely will not translate into higher investments. The budgetary allocation to infrastructure and connectivity schemes like Pradhan Mantri Gram Sadak Yojana should be raised to integrate the rural economy with the urban; again leading to equitable growth. The continued uncertainty surrounding tax laws such as, GST needs to be quickly addressed along with more robust implementation process and rationalisation of tax rates for that only will boost tax revenues. Government needs to pay attention to MSME sector by way of easing GST filling process and allocation of more funds as they account for more than 40% of manufacturing output and exports and provide for more than 25% of GDP. Hence, public investment needs to step up to revive private investment through the Keynesian crowding-in effect.

The question though is with the falling tax revenues and tightening fiscal space. The slashing of corporate taxes is a positive long-term measure and will yield benefits over time, but does little in the short run! The latest figures reveal a central fiscal deficit of 3.33% and state fiscal deficit of 2.60%. This pegs the total deficit at 5.93% of GDP. These numbers, however, do not account for the internal and extra budgetary resources (IBER) which includes the funds raised by the way of profits, loans and equity. The increased borrowings of FCI and NHAI over the last few years have not been accounted in the fiscal deficit figures, which if accounted for, could push the central fiscal deficit by at least 1% more of GDP.

While fiscal consolidation is a pressing task, it should be remembered that it is only number two on the priority list. The number one and the formest challenge is to attain a higher and sustained growth, more so when the persistent cyclical downturn is showing signs of structural symptoms. Hence, the GoI should spend more to revive the subdued demand through counter-cyclical fiscal levers as well as creating a space for fiscal revenue through structural policy reforms.

With gross capital formation having fallen precipitiously to 30% of GDP from its peak value of 39.8% in 2010-11, the focus should be on investment-driven growth, given that the export-led strategy may not succeed immediately in the face of ongoing bleak global outlook and slowdown. Indian exports lack competitiveness in the international market. The challenge, however, is to make sure that the political agenda stays out of budgetary spending with a focus on spending in productive sectors rather than on populist measures. Profit margins of the private sector have been constantly declining for some time now and if not provided with resurgent demand in the economy, we could very well be in for a sustained slowdown rather than sustained growth. The focus of the current budget has to be on the structure, not on the cycle!

By

Professor D. Tripati Rao, Business Environment Area, IIM Lucknow
& Ishan Mittal, Post-Graduate Programme, Second Year, IIM Lucknow