Mature Budget, but with grey areas

The full budget for 2019-20 presented on July 5 did not contain the kind of stuff that would fire up the financial markets and cause a rush of adrenaline in taxpayers and investors. In that sense, and in many others, it was not similar to budgets in the past. And what is a good thing for the sake of continuity and consistency, it largely picked the thread from where it was left in the interim budget. For the lay and the cognoscenti alike, reading both the documents is necessary to get a feel and import of the budget announcements. The fiscal projections of 2019-20 remain largely unchanged. 

A good part of the full budget is essentially in the nature of a vision document with an over-arching goal of raising the GDP of the country to US$ 5 trillion in 5 years, and, hence, contains matters that are generally considered outside its scope. But given that annual budgets have long provided an opportunity to the government to state and publicise its most important fiscal and other policy pronouncements, it is no surprise that the newly-elected government chose to further extend the budget’s envelope at the inception of its second term. But this has caused a bit of discomfort in that the budget speech didn’t contain the usual long list of allocations to various ministries and to the on-going and new schemes of the Central government. To be sure, the interim budget did that in good measure.            

Role of private sector

Before the budget, there was a kind of agreement among the analysts that it should address the three main problems now facing the Indian economy: marked slow-down in the growth impulse, on-going distress in the agricultural and the informal sectors, rising unemployment and the liquidity and solvency issues in the non-banking finance companies (NBFCs).  To their dismay, the budget did not announce any fresh fiscal initiative in respect of all these, except for a one-time six-month back-stop facility of 10% to PSU banks buying high-rated pooled assets from NBFCs.

Before the budget, there was a kind of agreement among the analysts that it should address the three main problems now facing the Indian economy: marked slow-down in the growth impulse, on-going distress in the agricultural and the informal sectors, rising unemployment and the liquidity and solvency issues in the non-banking finance companies (NBFCs).  To their dismay, the budget did not announce any fresh fiscal initiative in respect of all these, except for a one-time six-month back-stop facility of 10% to PSU banks buying high-rated pooled assets from NBFCs.

Post the budget, it was made clear by the government that the initiatives announced in the interim budget for providing cash support to the small and medium farmers as also the large public and private spending in the various economic and social infrastructure programmes will adequately address the other issues. Although it has long been apparent that given the structural lack of fiscal space In India, the scope of providing any significant fiscal boost to the economy even at the time of a growth slowdown is very limited, this government is now somewhat forthright and unorthodox in this matter by not relaxing expenditure control under the pretext of any ‘pump-priming’. The budget perhaps shows the confidence and maturity of the ruling political dispensation when it acknowledges that the country’s growth in output and employment will henceforth be led by the private sector. This is a paradigm shift.

Critical assumptions

The budget implies an investment-led recovery in growth and employment in this fiscal and thereafter, based on few critical assumptions: One, PSU banks, which at present account for about 80% of bank credit will resume lending in a big way, especially after another Rs. 70,000 crore of recapitalisation this fiscal. Two, real interest rate and cost of capital will drop further with capital markets becoming more open and efficient.   Three, both FDI and portfolio investment inflows will increase sharply.  

Here is a risk as to the first assumption, if the past is any guide. What is the guarantee that the government, in its bid to push growth to meet its overarching US$ 5 trillion goal will not nudge PSU banks to lend indiscriminately, as had happened during 2008-11? It needs to be recognised that reform of the PSU banks is not even half done by now. Their boards are not yet populated by professionals with demonstrated domain knowledge and expertise, the uniform compensation policy followed by them at the behest of the government does not enable them to hire the right people, and their risk management systems and capabilities are very weak. Further, the ‘command and control’ relationship that exists between PSU banks and their bosses in the finance ministry has not undergone any change. This leaves open the scope for resumption of ‘direction from the top’ for credit and other decisions, as was the case in the not-too-distant past.         

With the current incremental capital-output ratio (ICOR) at about 4, it is not clear how the real growth target of 8% can be achieved without running a much higher current account deficit of the order of 5% of GDP, assuming there is no significant wastage of capital by way of NPAs of banks and bankruptcies. Again, if the past is any indication, current account deficit at 5% will make the exchange rate of the rupee vulnerable to sharp downward pressure.

Equilibrium or Disequilibrium?

Since the focus of the budget is on making India a US$ 5 trillion economy in five years, it will be apposite to look at it from a broad macroeconomic perspective. A quick back-of-the-envelope calculation will be helpful: Based on the latest available data, India's current gross capital formation is around 32% of GDP, while its net capital formation is in the range of 20-22% of GDP. Both the gross and net capital formations are the result of the use of gross domestic savings (around 31% of GDP) and foreign inflows (current account deficit) of around 2.5% of GDP.

With the current incremental capital-output ratio (ICOR) at about 4, it is not clear how the real growth target of 8% can be achieved without running a much higher current account deficit of the order of 5% of GDP, assuming there is no significant wastage of capital by way of NPAs of banks and bankruptcies. Again, if the past is any indication, current account deficit at 5% will make the exchange rate of the rupee vulnerable to sharp downward pressure. It may be pragmatic for the authors of the Economic Survey to discard out-of-hand the so-called Anglo-Saxon paradigm of equilibrium in macroeconomic thinking and modelling in favour of a hypothesis of perennial disequilibrium for the Indian economy, exhibiting itself in a binary manner - ‘virtuous’ or ‘vicious’ growth cycles. But at each discrete state of the Indian economy, the equilibrium principle of savings-investment gap and its imperatives will still apply:

Since the savings rate as also productivity cannot be increased significantly even over a period of five years, much higher net capital formation that will be needed for a 8% growth trajectory can be met only by running a bigger current account deficit, which will invite external sector vulnerability. Among other adverse outcomes, the foreign currency sovereign bond issuance programme of the government could receive a serious blow, as a consequence.      

Foreign currency sovereign bond issuance – opportunity and risk

The issues relating to the Central government raising general-purpose debt in foreign currencies by issuing sovereign bonds in the overseas markets have been discussed and debated for decades on end and it is good that the present government has decided in its favour. As per reports, the government will soon prepare a plan in this regard which will complement its internal borrowing plan for the current fiscal. The positives for this are clear: lower internal borrowing rate for the government and more financial resources at the disposal of the private sector. Also, a true benchmark sovereign foreign currency borrowing rate will emerge, replacing the extant proxy issuers like Exim Bank, SBI etc.  which will eventually make the pricing of external borrowing by Indian corporates more transparent and efficient.

The issues relating to the Central government raising general-purpose debt in foreign currencies has been debated for decades on end and it is good that the present government has decided in its favour. The positives for this are clear: lower internal borrowing rate for the government and more financial resources at the disposal of the private sector. Also, a true benchmark sovereign foreign currency borrowing rate will emerge, replacing the extant proxy issuers like Exim Bank, SBI etc.  which will eventually make the pricing of external borrowing by Indian corporates more transparent and efficient.

But the attend currency risk could be significant, as all the foreign borrowers know well. Also, whether the ex post cost of borrowing in rupee terms will actually be cheaper will depend on the realised currency risk. However, unlike the corporate borrowers, the government has a few bizarre incentives to ignore currency risk: as the government does not follow market-to-market and accrual accounting, the impact of currency risk is not recognised before it is realised at the time of coupon payments and principal redemption. And the fiscal impact of higher interest and/or redemption cost in the rupee caused by any depreciation of the rupee can be offset and overlooked by fresh issuance of sovereign foreign debt and so on. The government needs to put in place credible risk management and disclosure mechanisms to prevent the easy option of kicking the can of currency risk down the road. For the long-term success of this initiative, the fiscal and overall macroeconomic management should improve.                        

Epilogue

Overall, from the point of view of a pure budgeting exercise, this is a good one, with both the projected revenue receipts and expenditure looking reasonable. However, as in the past, there are still some issues with off-budget receipt and expenditure which, by some estimates, keep the fiscal deficit understated by about 50 basis points. The ‘vision document’ part of it reads well (although there are some typos and syntax errors there), and a minimalist way of looking at it is that the government will not sacrifice the long-term goals for any short-term gains in future.  Time consistency is the essence here.     

(Himadri Bhattacharya is a former central banker and consultant to the IMF)