Budget Hits and Misses

Indian Express July 27, 2024

The Union Budget presented yesterday was expected to set out a roadmap for the country’s growth and development. Did it live up to expectations?

To answer this question it is important to understand the economic context in which the Budget was presented. Despite official data showing that the Indian economy grew at 8.2 percent in 2023-24, evidence suggests a worrisome slowdown in aggregate demand. Concerns have already been expressed about consumption. In 2023-24, private consumption is estimated to have grown by a mere 4 percent, a steep decline from the 11 percent growth rate in 2021-22 when the economy was recovering from the pandemic. Much of this slowdown can be attributed to economic distress in rural India.

In addition, the two biggest drivers of growth, private investment and exports have not been performing well. The government has consistently increased its spending on infrastructure since 2020-21 in the hope that this would “crowd-in” private investment. However private investment continues to be weak, with no sign that things are going to turn around any time soon. In fact new project announcements (as measured by CMIE) have been declining since September 2023, suggesting that private investment might even start falling. The news is not great on the exports front either. Merchandise exports fell by 3 percent in US dollar terms during 2023-24. While services exports have been doing better, they have also slowed considerably.

The demand slowdown has created a jobs crisis, perhaps the biggest challenge confronting this government. By June 2024, India’s unemployment rate had increased to 9.2 percent according to CMIE data, up from 8 percent in 2023.

The ask from the Union Budget therefore was a policy framework that would encourage the private sector to expand capacity, generate employment and thereby pave the way for sustained, rapid growth. This growth strategy had to be accompanied by fiscal consolidation to bring down deficits and debt levels that have been running high since the pandemic.

Analysed against this ask, the Budget was characterised by both hits and misses.

From the macro stability perspective, this Budget exceeded expectations. It reduced the projected fiscal deficit for 2024-25 to 4.9 percent of GDP from 5.1 percent announced in the interim budget earlier. As a result, the government is now in a better position to achieve its long-stated goal of reducing the deficit to less than 4.5 percent of GDP in 2025-26. The Budget also improved the quality of government expenditure, increasing the share of capital expenditure in total expense to 23 percent in 2024-25, from 12.5 percent in 2019-20. This is the highest share of capex in 3 decades.

From the growth perspective the government, perhaps for the first time, acknowledged the problems in the Indian economy, albeit indirectly. The government's concerns showed in the announcement of a slew of measures targeted towards agriculture, employment, skilling, MSMEs, and even the tweaks in the direct tax regime. The concerns were also reflected in the decision to keep capex unchanged at Rs 11 lakh crore, the same level as the interim budget. Had the economy truly been growing rapidly, there would hardly be a need for the government to continue to stimulate it, especially given the fiscal constraints.

Having said that, the Budget did not outline an economic strategy to tackle the problems nor did it lay out an economic vision for the next few years. Instead, the plan seemed to be to address the deeper structural problems using schemes. It is not clear how these schemes will solve the problems, or even, how they will really work.

For instance, one of the main Employment Linked Incentive schemes is to give Rs 15,000 to new employees in the formal sector. It is not clear who is the targeted beneficiary of this incentive given that availability of formal sector jobs itself is a big problem. Likewise, reimbursing employers for their EPFO contributions on new employees for two years (upto Rs 3,000 per month) is likely to have only a marginal impact on the cost to companies and hence on job creation.

The other schemes also seem too small to address the problems. In the agricultural sector, the budgetary allocation for NREGA was kept unchanged at the same nominal level as in the interim budget, even though the rural economy is in significant stress. The tweaks in the direct tax slabs under the new tax regime are also likely to have only a marginal impact on household demand. Similarly, the Budget announced that additional tribunals would be set up to speed up resolution under the Insolvency and Bankruptcy Code (IBC, 2016), even though the real problem lies in staffing of the existing tribunals.

A glaring gap in the budget was a lack of mention of privatisation. PSUs have been witnessing high valuations in the stock market making it an opportune moment to sell them off to interested buyers. This could also help boost private investment. A good example of this has been Air India privatisation where the new owners have been making huge investments to turn around the company.

Another big miss was not providing a strong fillip to merchandise exports and making the most of foreign demand for goods, given sluggish domestic demand. The Budget did announce reductions in customs duties for some items but given the state of the economy, the need of the hour was a major reversal of the protectionist stance adopted since 2015 by significantly lowering import tariffs, dismantling trade barriers, and signing free trade agreements with major trading partners.

In summary, the Union Budget scored well on fiscal stability but could have done better by setting out a well-defined growth strategy. The Finance Minister did mention that the government is working on some fundamental, structural reforms without mentioning any details or timelines. We can only hope that these reforms will demonstrate that the government has a better grasp on the economy’s underlying problems.

RBI’s surplus: To spend or not to spend

Indian Express July 4, 2024

With a new government at the Centre, the economic policy discourse has now shifted to speculating about the Union Budget for 2024-25. This year’s budget is especially important for one specific reason. In an unexpected turn of events, the RBI announced last month that it is transferring a sizeable dividend to the government, significantly more than what was anticipated. This has triggered much discussion about how the government can spend this windfall. We need to ask a more fundamental question: Should the government spend it at all?

Fiscal management should be guided by two general principles. First, deficits should be kept at prudent levels. In India, that level should ideally be around three per cent of GDP for the Centre according to the long-standing Fiscal Responsibility and Budget Management (FRBM) Act. Second, governments should spend a bit more than this norm when the economy is doing badly and a bit less when the economy is doing well.

The purpose of varying the deficit, as specified by the second principle, is to stabilise the economy. In bad times, when private sector demand is falling, the government needs to step in and boost demand to prop up the economy. The needs are reversed when the economy starts to recover. As private demand revives, the government needs to curtail its spending lest overall demand races ahead of supply, fostering inflation. A critical aspect of this second principle is that policies must be symmetric. Larger-than-normal deficits need to be followed by smaller-than-normal deficits so that government debt gets stabilised instead of spiralling upwards.

Following these two principles can keep a country out of debt problems while stabilising the ups and downs of growth cycles. That is why these principles are followed in prudent countries all over the world.

But not in India. Here, governments have always struggled to spend within their means, irrespective of whether the economy is slowing or booming. In the 20-year period from 2000-01 to 2019-20, the average fiscal deficit of the Centre was 4.6 per cent of GDP, much higher than the three per cent medium-term target set by the FRBM Act.

During the pandemic, the deficit shot up to 9.2 per cent of GDP in 2020-21, a large increase but a reasonable one, considering the size of the shock to the economy. But curiously even after the economy recovered, the deficit has been slow to come down. In the Interim Budget presented earlier this year, the Finance Minister announced that the government was targeting a deficit of 5.1 per cent for 2024-25. In other words, three years after the pandemic ended, the deficit is still higher than the pre-pandemic levels, and nowhere close to the FRBM norm.

For this reason, a standard way for economists to assess the success of monetary policy is by looking at core inflation. If core (that is, underlying) inflation is close to the target, it suggests that monetary policy is doing its job of controlling demand, notwithstanding any temporary deviations caused by flare ups in food or commodity prices. For instance, in the US, after several quarters of aggressive monetary tightening, headline inflation has cooled down quite a bit. Annual inflation in the US fell to 3.1 per cent in January, compared to 6.4 per cent a year ago. However, core inflation continues to be sticky and has been rising more than expected. Also, wages in the services sector have been persistently high. Both these indicate that demand conditions remain strong, thereby causing the US Fed to delay rate cuts.

Since the Centre has been slow to reduce its deficit, India’s fiscal metrics have deteriorated. The consolidated central and state government deficit is now around 8.5-9 per cent of GDP (compared to the six per cent recommended by the FRBM Act). Total government debt has been more than 80 per cent of GDP over the last few years, compared to an average of 74 per cent in the period from 2010-11 to 2019-20.

It is against this background that the RBI announced last month that it will transfer Rs 2.11 lakh crore to the central government as dividend, double the amount that had been budgeted. The crucial question now is: What should the government do with this unexpected bounty?

According to some commentators, the government should increase its capital expenditure (capex). As per the Interim Budget, the capex growth rate is supposed to slow down in 2024-25. But now with this surplus dividend, the government may be tempted to step up its capex spending. That would be a mistake.

The general sentiment in India seems to be that any spending on capex is great news. This is not correct. Look at China, for example. As part of their infrastructure building spree, they built two to three airports in the same city and are now struggling to repay the debt that was incurred for these projects. What is therefore needed in India is to calculate how much capex is truly needed and of what kind.

Governments spend on capex for two reasons: To stimulate growth and to meet the needs of the economy. Let’s address the second criterion first. Infrastructure in India is definitely a problem that needs to be solved. But not all at once. Since the pandemic, the government’s capex spending has been growing at an average annual rate of 30 per cent. It is not obvious that this pace needs to be increased, or even sustained. On the contrary, recent developments demonstrate that the speed of construction — and focus on new projects, rather than maintenance — has serious downsides.

In addition, not all capex is essential for growth. For example, using Rs 1.6 lakh crore to revitalise telecom MTNL and BSNL is surely not critical, especially when affordable cellphone services are being provided throughout the country by private operators. Likewise, it is not obvious that spending lakhs of crores on bullet trains can be justified in a country whose per capita income is less than $2,500.

Regarding the first criterion, we have to ask the question again: Why does the government need to stimulate an economy that is doing so well? Given the strong economic performance, it should instead use the surplus dividend from the RBI to bring the fiscal deficit down closer to three per cent.

There is, however, a caveat to this discussion. And this relates to the true state of the Indian economy. What if the economy is actually weaker than what the 7-8 per cent growth figures suggest? Then there may be a case for the government to keep spending to support the economy.

There seems to be a lack of consensus on this fundamental point. If the economy is not doing very well, then we should not be surprised if the budget uses the surplusdividend to announce a further increase in infrastructure spending.