Budget 2023-24: Fiscally conservative but lacking economic strategy

Budget 2023-24: Fiscally conservative but lacking economic strategy, Ideas for India, February 27, 2023.

The price pinch

Indian Express, February 16, 2023

Inflation is proving to be the Achilles Heel in the Indian economy’s recovery from the pandemic and subsequent global disruptions. After softening for three consecutive months, it spiked again in January. The Reserve Bank of India has been playing the part of an inflation targeting central bank over the last few months, raising interest rates in an attempt to rein in inflation. However the fight to bring inflation down is clearly far from over. The latest inflation data also raises the question if the RBI doing enough.

The inflation targeting framework mandates the RBI to achieve a CPI (consumer price index) inflation target of 4 percent. During the pandemic period of March 2020 to September 2021, CPI inflation averaged 5.9 percent. This was higher than the point target of 4 percent but still within the inflation targeting band of 2-6 percent. Since then, however, the inflation outlook has been worsening.

In 2022, CPI inflation was above the upper threshold of the RBI’s targeting band for 10 consecutive months which meant that the target was not achieved for three quarters in a row. Inflation began softening towards the later part of the year. By December 2022, CPI inflation was down to 5.7 percent. This led many to believe that the inflation peak had passed, and that inflation was on its way to the official target.

This optimism was misplaced. Underlying inflationary pressures still persist. The softening of inflation in November and December 2022 was largely driven by a steep fall in vegetable prices. Excluding vegetables, CPI inflation was infact more than 7 percent. The misplaced optimism has now become evident. The January 2023 CPI inflation came out to be 6.5 percent, once again crossing the upper threshold of the RBI’s inflation targeting band.

The risks to inflation outlook that have continued unabated over the last few months have contributed to the latest spike in inflation as well.

First, with food accounting for 46 percent of the overall CPI basket, a rise in food inflation from roughly 4 percent in December 2022 to almost 6 percent in January 2023 has played an important role in overall inflation going up. Within food, one component that has proved rather stubborn is cereal inflation. Between May and December 2022, year on year cereal inflation nearly doubled from 5 percent to 14 percent. In January 2023, this increased to 16 percent. Within cereals, inflation in wheat has been steadily going up. Between May and December 2022, wheat inflation increased from 9 percent to 22 percent. It increased even further to 25 percent in January 2023.

The steep rise in wheat prices reflects shortages. Data from the Food Corporation of India shows that stocks in government warehouses declined from 33 million tonnes in January 2022 to 17 million tonnes in January 2023. The government has recently approved a release of 3 million tonnes in the open market. However this is insufficient to restore market supplies. Given that the next harvest will not be ready till April, and government stocks in February are further down to 15 million tonnes, this source of inflationary pressure is likely to persist for a while.

Secondly, core (non-food, non-fuel) inflation in January came out to be 6.2 percent. This is consistent with the unyielding core inflation of 6 percent for nearly three years now. A persistently high core inflation implies that price pressures have become entrenched in the system. Part of this can be explained by the continued pass-through of high input prices to final goods prices. Interestingly this is happening even when WPI (wholesale price index) inflation, which reflects input prices, has come down from a high of 16 percent in May 2022 to less than 5 percent in January 2023. This implies that with margins getting squeezed and profitability suffering, firms are spreading out the pass-through over a longer time period. This makes the core inflation trajectory uncertain.

Finally, external factors have a role to play as well. Inflation in developed countries continues to be high (6.4 percent in US; 8.5 percent in EU; 10.5 percent in UK). India is importing some of this elevated inflation through international trade in goods and services. Moreover, with China gradually opening up its economy after nearly three years of Zero-Covid restrictions, commodity prices are likely to go up which could exert renewed pressures on India’s inflation.

What have the policymakers been doing to address the inflationary concerns?

The government has done its bit by announcing a conservative Union Budget for 2023-24. It has accorded primacy to much needed fiscal consolidation, and has refrained from announcing populist measures which could have arguably fuelled demand, and hence inflation.

The RBI has been doing its job as well. It increased the policy repo rate from a pandemic-low of 4 percent to 6.5 percent in a span of 10 months. It has also adopted a hawkish tone as was evident from its latest monetary policy statement. Unlike last year when despite rising inflation, the monetary policy statements did not contain any forward guidance, in its February 2023 statement, the RBI emphasised the importance to "remain alert on inflation", thereby hinting that the monetary tightening cycle is not over yet. Is there anything else that the central bank can do?

Having missed the inflation target for three consecutive quarters in 2022, the RBI had to submit a report to the government describing a plan of action which would help bring inflation down. The law does not require either the RBI or the government to disclose the contents of this report publicly. However, given that inflation is proving to be difficult to rein in, and that the 4 percent target is not likely to be achieved next year either, releasing the report to especially highlight the remedial actions that the RBI plans to undertake might help stabilise inflation expectations, and facilitate the central bank’s own endeavour to fight inflation.

A credible glide path to bring inflation down to the target level is of critical importance particularly now with the national elections around the corner.

RBI needs to remain vigilant on inflation

Hindustan Times, February 6, 2023

Now that the Finance Minister has presented the Union Budget which is neither populist nor expansionary, all eyes will be on the Reserve Bank of India as it gets ready to announce the monetary policy on February 8. Inflation in India seems to be on a downward trajectory from the high levels it had reached in the first half of 2022. Yet the RBI must be cautious about taking its foot off the pedal as far as taming inflation is concerned.

The RBI has been following an inflation targeting framework for conducting monetary policy since 2016. The framework mandates the RBI to achieve a CPI (consumer price index) inflation target of 4 percent. For the most part of calendar year 2022, CPI inflation averaged at 6.9 percent. The inflation target was not achieved for 10 consecutive months in 2022.

From October onwards inflation seems to have been declining. The average CPI inflation in November and December came down to 5.8 percent. This means that inflation is now back within the RBI’s tolerance band. This is a positive development not only because inflation seems to be moving towards the 4 percent target but also because high inflation disrupts macroeconomic stability.

However this recent decline should not be interpreted to mean that inflation has ceased to be a problem. There are four main reasons why risks to inflation persist.

First, while headline inflation has come down, core inflation (non-food, non-fuel) has been quite stubborn. In December 2022, core inflation was 6.2 percent, same as the full-year average. Infact core inflation has been sticky around 6 percent for almost three years now—from April 2020 to December 2022. Persistent core inflation implies that price pressures have become embedded in the system.

There may have been three phases that can help explain the core inflation dynamics. In the first phase, once the pandemic hit India, and widespread mobility restrictions were introduced, supply chain bottlenecks became intense, services were shut, goods and labour were hard to come by. This started putting upward pressure on core inflation. In the second phase, as the land war broke out in Europe in February 2022, input prices skyrocketed and manufacturing firms began passing on the higher costs to consumers. We can then think of a third phase, when commodity prices began easing thereby softening the input price pressures on the producers but services began actively normalising. For two years the services sector could not adjust wages and prices. Now that the economy has fully opened up, they are having to pay higher wages to workers to compensate them for the price increases that occurred while they were away, and are adjusting prices accordingly. This is keeping the core inflation high.

Apart from core inflation, cereal prices have been steadily going up. Between May and December 2022, cereal inflation more than doubled. Within cereals, inflation in wheat went up drastically from 9 percent in May to 22 percent in December, while inflation in rice increased from 3 percent to 10 percent during the same period. Food accounts for 46 percent of the overall CPI basket and within the broader food-group, non-perishables such as cereals, spices etc., have almost a 37 percent weight. This means that these items determine the underlying trend in CPI food inflation. Non-perishables inflation increased from 5 percent in November to more than 8 percent in December 2022, reaching the highest level in more than two years. In fact, much of the decline in overall CPI inflation both in November and December was driven by perishables such as vegetables which registered a steep fall in prices. Excluding vegetables, CPI inflation increased to 7.2 percent.

Third, while inflation in the developed world has also been coming down, it is still quite high. Inflation in the US was 6.5 percent in December, while inflation in the European Union as well as the UK remains more than 9 percent. Through the channel of international trade in goods and services, India continues to import this high inflation.

Finally, as China opens up after three years of Covid-related restrictions, recovery of its economy from a growth slump is likely to exert upward pressure on commodity prices, given that China accounts for a large share of global commodity demand. This may fuel inflationary pressures in India which imports commodities.

What should therefore be done by the policymakers?

The government seems to have done its bit. With nine state assembly elections scheduled between now and January 2024, and the country going into general elections in 2024, the apprehension was that the government would announce a slew of populist measures in the Union Budget presented on February 2nd. This would not only disrupt fiscal consolidation, it could also aggravate inflation. Strikingly enough, the government has not given in to populist demand pressures. It has announced a steep increase in capital expenditure which is undoubtedly a demand stimulus but a lot will depend on implementation.

Now the ball is in the RBI’s court. It needs to remain vigilant on inflation. While the central bank has been tightening monetary policy from May 2022 onwards increasing the repo rate to 6.25 percent, it now needs to clearly indicate when it expects inflation to reach the target level of 4 percent, and what its plan of action is to bring this about, particularly to break the persistence of the core inflation.

A low, and stable inflation generates macroeconomic stability and creates a favourable environment for growth. On the other hand, high, sustained inflation hurts the poorer sections of the society the most and can have a detrimental political effect in an election year.

An uncertain fiscal math

Indian Express, February 2, 2023

It is helpful to think of the Union Budget as satisfying two important objectives--growth, and stability. Depending on the state of the economy and availability of fiscal resources, electoral compulsions etc, a given Budget is either more growth-oriented or stability-oriented. Which category does the Union Budget of 2023-24 fall into?

The Union Budget is an annual statement of the government’s income and expenditure. From that standpoint, this Budget was a critical one, for two main reasons. First, for several years the government has been struggling to spend within its means and the fiscal deficit had been increasing. In the pre-pandemic year of 2019-10, the fiscal deficit of the central government alone was more than 4.5 percent of GDP, much higher than the 3 percent medium term target set by the Fiscal Responsibility and Budget Management (FRBM) Act. During the pandemic period, the deficit shot up first to 9.2 percent of GDP in 2020-21, and then to 6.9 percent in 2021-22. Such high levels of fiscal deficit raise concerns about macroeconomic stability, and can be detrimental to the economy’s growth. Hence all eyes were on the Budget this time to see whether the government would continue on the path of fiscal consolidation that it had embarked upon in 2022-23.

Secondly, this was the last full-year budget before the country goes into general elections in 2024. There was a general apprehension that the government would throw caution in the wind, and use the budget to announce populist schemes for specific electoral constituencies.

Instead, the Budget was a relatively conservative one. It refrained from populist measures, and projected a fiscal deficit of 5.9 percent for 2023-24, implying a 0.5 percent reduction from this year’s deficit. From this perspective, it sounds like a stability-oriented budget.

The important question to ask is, how credible is the fiscal consolidation path? Three points are worth noting in this context.

First, the Budget adhered to the fiscal deficit target of 6.4 percent for 2022-23. This was facilitated by the government’s conservative estimates of nominal GDP growth and gross tax revenues for 2022-23. As the economy normalised from the pandemic, both nominal GDP growth and tax revenues exceeded the government’s expectations. In particular, GST (goods and services tax) revenue was boosted by two main factors: an increase in sales of luxury goods which carry higher tax rates, and a big jump in imports. Both these maybe considered one-off shocks. Nominal GDP also received a boost from rising inflation. In 2023-24, as the economy slows down owing to global headwinds and weak domestic demand, and as inflation cools off, it is plausible that tax revenue growth will be lower than the Budget estimate, and nominal GDP growth will be less than the estimated 10.5 percent.

Secondly, while total non-debt revenue for 2023-24 is projected to be around Rs 27 lakh crore, tax revenue is projected to be around Rs 23 lakh crore. This implies that Rs 4 lakh crore must come from non-tax sources. This seems ambitious. For example, the Budget has set a disinvestment target of Rs 51,000 crore. Given that the disinvestment receipts in 2022-23 are unlikely to be anywhere close to the target, it is not clear how the target for 2023-24 can be achieved, especially in a year when economic growth is predicted to slow down, both domestically as well as globally.

Third, given the decline in global commodity prices, the government will incur some savings in 2023-24 on account of its subsidy bill. And some more savings have been budgeted on account of reduction in current expenditure. Using this savings to bring down the fiscal deficit would have made sense. But the Budget has also announced a steep increase in capital expenditure. This raises questions about the credibility of the fiscal math. Moreover it also raises questions about what fraction of the expenditure burden is being passed on to the states. It is important to note that ultimately what matters from a macro stability perspective is the consolidated fiscal deficit of both the centre and the states.

On the growth front, the Budget announced a 33 percent increase in capital expenditure. The objective, like last time, is to “crowd-in” private investment. While many would applaud this sustained capex push, it is problematic for two reasons.

First, it maybe argued that the increased capex spending by the government since last year has not resulted in the desired “crowding-in” of private sector investment which continues to be sluggish.

Second, and more importantly, the capex increase conveys a worrisome message. The government clearly feels compelled to do the heavy lifting of investing and boosting demand in the economy because the private sector is not investing in capacity expansion. This is deeply concerning because for an emerging economy like India to grow at 5-6 percent, and more importantly, to create the jobs required to absorb the millions of young people entering into the labour force every year, it is imperative that the private sector starts investing on a large scale.

The other important driver of growth is exports. While the Budget did announce several customs duty reductions, these were primarily aimed at reversing the inverted duty structure (i.e. higher duties on imported inputs but lower duties on imported finished goods), and it also announced several customs duty increases. The Budget also does not contain any major steps to roll back the protectionist policies the government has been implementing over the last few years.

In summary, only time will tell what impact the “growth” measures announced in the Budget will have on the economy, and while the Budget seems to have ticked the right boxes on “stability”, it lacks clarity on how this stability will be achieved.