Slippery slope for fiscal consolidation

Context

The latest monthly data (April-December 2010) showing the government’s fiscal deficit at less than half the total budgeted amount for FY11 provided welcome news in a year that has otherwise been one of serious macroeconomic challenges, notably a stubbornly high inflation rate and a widening current account deficit. With government spending in the first nine months of FY11 amounting to 71 per cent of the full-year target and revenue collections at 85 per cent, the data suggest that the government will at least meet its fiscal deficit target for FY11 (5.5 per cent of GDP), if not undershoot it.

But this development does not derive from the structural change in the deficit that is needed if the government is serious about its goal of further narrowing the budget gap over the next three years. Although tax collections have been buoyant, revenues in FY11 have exceeded the government’s target mainly because of the far higher-than-expected non-tax receipts from successful sales of stakes in large state-owned companies and the auction of telecom spectrum. In fact, the Rs1.06 trillion (US$23.2 billion) earned via the sale of 3G mobile phone licences and broadband wireless access more than covered the Rs744 billion (US$16.3 billion) of extra government spending announced over and above the initial budget.

The government’s performance so far on the expenditure side does not imply fiscal prudence as spending is usually back-loaded. A quick glance at the government’s accounts for the past decade shows that up to December of any given fiscal year, spending is anywhere between 60 and 80 per cent of budget targets, but by March it more often than not hits the (usually upward revised) expenditure target. So even if the government meets its FY11 goal of keeping the deficit within 5.5 per cent of GDP, bringing it down to the targeted 4.8 per cent in FY12 and even lower in the years ahead will be a harder task than it now looks due to structural problems that we discuss in detail below. A government official quoted by the Telegraph newspaper on 5 January 2011 as saying “every paisa of tax revenues will have to be accounted for” to narrow the deficit to 4.8 per cent of GDP in FY12 was hardly exaggerating.

Liberal spending policies stoke inflation

Although a large fiscal deficit has been a chronic problem in India, the challenge of keeping the government’s finances under control is now especially difficult due to stubbornly high inflation, which rose 8.4 per cent year on year in December 2010. Finance Minister Pranab Mukherjee admitted in early January that India’s high economic growth is bloating the fiscal deficit and leading to an “unstable price regime”. He added that fiscal consolidation is necessary to check rising prices. His statements may at first appear contradictory – after all, high economic growth should boost tax revenue and help curb the deficit. However, the government’s focus on promoting “inclusive” development, as well as expansionary fiscal policies implemented to counter the global recession in 2008, have markedly widened the deficit.

As a result, the fiscal situation today is worse than in FY08 when the government managed to reduce its deficit to 2.6 per cent of GDP as stipulated by a parliamentary law that has since been abandoned. Although the FY08 figure excluded hidden liabilities which would have added around two percentage points to the deficit and which have since been brought above the line, it was still much lower than the current deficit numbers. But as soon as the government got the deficit down to a respectable figure, it could not resist the temptation to hike populist pre-election spending. The then Finance Minister P. Chidambaram announced a list of handouts in his FY09 budget – including a write-off of overdue bank loans to farmers and the implementation of a decadal pay hike for government employees – without any of the simultaneously recommended expenditure cuts.

The late 2008 financial crisis spurred the government to cut taxes and increase spending to offset the fall in private consumption and investment. These steps further hurt the exchequer, taking the deficit to 6.1 per cent of GDP in FY09 and 6.6 per cent in FY10. At that time the government had the partially valid excuse of pre-empting a growth slowdown through fiscal sops, just like most other economies across the world. But despite the strong domestic growth recovery that followed, India’s government has been slow to undertake structural reforms to reduce the deficit. The latest data show that government spending fell only marginally, to 11.2 per cent of GDP in H1/FY11 from 11.3 per cent in the corresponding period of the previous fiscal year.

To its credit, the government did carry out partial subsidy reform for both fertilizer and fuel prices in early 2010. However, it stopped short of taking tougher decisions on deregulating the prices of diesel and urea, which are consumed more widely than petrol and non-nitrate fertilizers (consumption of diesel is roughly four times that of petrol, and urea accounts for 60 per cent of India’s fertilizer consumption). Slow progress on these remaining decisions now leaves the government with a tough choice: either keep these subsidies in place and slip on its fiscal consolidation programme or remove them and let inflation rise further.

With inflation now taking centre stage on the policy front, the government is unlikely to tamper with administrative controls as any such move would be politically damaging. But the government will still need to either increase its market borrowing or print more money to fund its deficit, which in turn will further stoke inflationary pressures. The Reserve Bank of India (RBI) had to resume its monetary tightening cycle, increasing rates by 25 bps on 25 January for the seventh time in the past year and indicating that further rate hikes are on the cards. High interest rates combined with a large fiscal deficit will only serve to crowd out private investment in a country that is already heavily dependent on bank lending. As our December 2010 report How will India fund another quantum leap in investment? highlighted, bank lending accounted for nearly half the flow of funds available to the commercial sector between 2007 and 2010.

Tighter monetary policy will also be unable to deal with the problem of high food prices that is essentially a consequence of rising demand in a fast-growing, more affluent economy (see our December 2010 report The RBI is facing up to structural inflation). Our research over the past two years has systematically shown how government spending is boosting rural demand for more more costly and higher-quality food items (see for example our October 2010 note The virtuous circle of better rural roads and our August 2009 report Rural demand to the rescue). Although the government’s rural spending and employment generation programmes are helping sustain the Indian growth story, the lack of an adequate supply response through policy reform and greater investment is adding to inflationary pressures.

The structural drivers of the deficit

A thought-provoking article by Business Standard newspaper columnist A.K. Bhattacharya on 4 January 2011 showed that, as far as certain government financial decision-makers are concerned, little has changed since India embarked on its economic reform programme two decades ago. This is especially true of government spending: subsidies are estimated to total 1.7 per cent of GDP in FY11 compared with 1.9 per cent in FY92 (in FY09, they accounted for a record 2.4 per cent of GDP). As we pointed out above, a major cause of the bloated subsidy bill is regulated prices of diesel along with fertilizers and food. As we examine in detail below, the prospect for immediate reform in any of these areas appears bleak.

1. Fuel price reform: After taking office on 19 January 2011, the new Petroleum Minister S. Jaipal Reddy said the government is not considering any increase in diesel prices. He instead proposed to offset the losses incurred by oil marketing companies on the sale of the fuel via import or excise duty cuts and increasing the government share of the subsidy bill. Both these measures are negative for the fiscal deficit.

The government has yet to work out a subsidy-sharing formula that involves itself, the oil marketing companies Indian Oil (IOCL:IN), Hindustan Petroleum (HPCL:IN) and Bharat Petroleum (BPCL:IN), and upstream oil companies including Oil and Natural Gas Corp (ONGC:IN) and Oil India (OINL:IN). Market expectations are for the government to absorb around half the estimated losses in FY11 of Rs720 billion (US$15.8 billion) – an amount that is also higher than the initially estimated Rs590 billion (US$12.9 billion) due to rising global crude oil prices.

With international oil prices now far higher, at nearly US$90/bbl compared with around US$75/bbl in June 2010 when Indian petrol prices were deregulated, the government is unlikely to revise diesel prices because of high inflation and a tougher political environment for reform. Inflation is not likely to moderate to the RBI’s targeted 5 per cent any time soon: the central bank itself forecasts the WPI rate at 7 per cent by end March 2011. The ruling Congress Party or its key allies will also be competing in various elections in the summer of 2011 in the important states of West Bengal, Tamil Nadu and Kerala where the opposition is bound to make inflation one of the key issues.

2. Fertilizer price reform: Some sort of action was expected on the urea pricing policy in Finance Minister Mukherjee’s February 2011 budget, but as my colleague Amitabh Dubey pointed out in his 25 January note The economic impact of India’s latest corruption scandals, the government may now shy away from this reform (which is otherwise a logical corollary to the freeing of non-nitrate fertilizer prices). The skewed consumption towards nitrogen-based fertilizers in India is producing diminishing agricultural returns due to stagnating crop productivity and soil sickness among other deficiencies (for more details, read our August 2007 report Fertiliser subsidies).

Even in the best-case scenario, however, any reform will be cautious and inadequate because of concerns about worsening inflation and the political resistance to higher fertilizer prices. If the government decides to deregulate fertilizer prices altogether, it will most likely ask fertilizer-manufacturing companies to phase in the reform, just as it did for the non-nitrate fertilizers in February 2010. The government may also opt to raise urea prices by a fixed amount, just as it did in February 2010 by 10 per cent. In either case, the effect on the deficit will be limited.

3. Food price reform: The government’s plan to introduce an ambitious food security programme for poor households in the near future – providing 25kg of food grains per year at Rs3/kg (US$0.07/kg) – could increase food subsidies by more than 60 per cent to Rs900 billion (US$20 billion) annually. The Congress Party plans to make this its flagship programme ahead of the next national election in 2014, much as it did in 2004 with the National Rural Employment Guarantee Act. The latter has been a popular programme with the rural masses as it provides employment to one member of each poor rural household for 100 days each year.

As Chart 4 below shows, the quality of spending has also deteriorated with revenue (or recurrent) expenditure rising over the years at the cost of capital spending. The longer-term outlook for government spending suggests that no major expenditure reduction is likely, as the government is also proposing to launch new programmes on healthcare and education. M. Govinda Rao, a member of the Prime Minister’s Economic Advisory Council and Director of the New Delhi-based think tank National Institute of Public Finance and Policy, estimates that these programmes along with the food security bill could result in additional expenditure totalling 3 per cent of GDP that cannot be balanced by tax reforms. Meanwhile, the government is also facing pressure to increase capital spending in view of the continued poor state of infrastructure and constraints on private funding in terms of political, regulatory and financing difficulties.

Limits to revenue buoyancy

On the revenue front, the buoyancy witnessed in FY11 was exceptional – as we highlighted above – due to the one-off telecom spectrum allocation and disinvestment of state-owned firms. The government will continue to sell small stakes in its majority-owned companies but the total size of any such transaction is unlikely to match the level that will be achieved in FY11. The government has so far raised US$5 billion – including India’s biggest IPO to date, the US$3.4 billion offering by Coal India (COAL:IN) – and plans are afoot to raise another US$3.9 billion through follow-up share offers for Steel Authority of India (SAIL:IN) and ONGC by the end of March 2011.

Although the government is planning a number of other disinvestments in FY12 – including Indian Oil, Hindustan Copper (HCP:IN), Rashtriya Ispat Nigam, MMTC (MMTC:IN) and National Buildings Construction Corporation – a repeat of the revenue achieved in FY11 through the stake sales is still unlikely, even if the SAIL disinvestment were to be delayed into FY12.

This will make tax reform even more important in the future. Although tax collection in the April-December 2010 period increased 29 per cent year on year compared with budget estimates of 18 per cent due to the stronger-than-expected economy, it is risky for the government to rely on high GDP growth in order to fund its higher spending needs. For one thing, tax revenues will slow if global growth slows or if the RBI starts tightening monetary policy aggressively, since corporate taxes account for more than 30 per cent of total taxes. Second, although the quality of tax sources has improved, with direct taxes now accounting for a larger proportion of tax revenue than they did only five years ago, total tax revenue is still just 11 per cent of GDP.

The prospects for tax reform are mixed, with the Cabinet having approved the new direct tax code but the legislation yet to be passed in parliament. Furthermore, the introduction of the Goods and Services Tax (GST) continues to be delayed. As we noted in our June 2010 report Historic tax reform hanging in the balance, the lack of consensus among the central and state governments has postponed the implementation of the GST by at least another year to 2012.

Conclusion

India’s fiscal difficulties are not just an effect of countercyclical expansionary policies but also due to long-standing structural problems that require political will and muscle to tackle. The government will find it impossible to stick to its fiscal consolidation roadmap without sustained initiatives to cut spending or overhaul its tax system through steps starting with the implementation of the GST.

The next test of the government’s stated resolve on fiscal consolidation will be in Finance Minister Mukherjee’s end-February budget announcement. No matter what numbers he states, our expectation of the government taking any meaningful action towards that goal is low. The government has shown that it does not mind abandoning its targets in the name of “inclusive” development, which takes clear priority over sound public finances. Social and political pressures to increase spending on food, healthcare, education and infrastructure will only further strain the government’s expenditure accounts. Meanwhile, political inclination to reform the tax system and widen the tax net is little.

Investment implications

The bloated budget deficit makes it tricky for the government and the central bank to manage inflationary expectations, particularly amid rising commodity prices. Passing higher prices on to consumers and farmers would increase the already high inflation rate and prompt the RBI to further raise rates in the short term. But as any such move would be met with social and political opposition, the government is likely to absorb most of the commodity price increase, thereby further widening its fiscal deficit and exacerbating the high inflationary environment that India is currently facing.

As a result, the RBI will be forced to keep interest rates elevated, with consequent negative effects on the country’s GDP growth. A significant moderation from 9 per cent growth to around a more sustainable 7 per cent will ease the inflation situation but also lower asset prices and slow down the pace of capital inflows, which in India are dominated by equity-focused investments. The expected slowdown in capex and a weaker corporate profit outlook will hurt the equity market, with sectors such as industrials, infrastructure and banks likely to suffer the most. Consumption is still a strong theme in India, but higher interest rates and input prices will erode the profit margins of these companies as well.

In the coming year investors will have to wait until the full impact of the macro headwinds – from persistent inflation and monetary tightening to the government’s loss of credibility – can be assessed. Overly bearish sentiment could present selective buying opportunities in Indian equities. Positive turning points that investors should watch for include any meaningful steps towards subsidy or tax reforms in the February 2011 budget.

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