Reviving growth: A delicate balancing act

The recent sell-off in Indian markets reflected the multiple challenges faced by the Government. For the first time in many years, the twin (budget and current account) deficits are likely to stop narrowing and start widening again. To complicate matters, economic growth decelerated five consecutive quarters from supply-driven factors such as slower investments, reforms (demonetisation, GST, anti-corruption) and other disruptions, etc. Together, they have limited the Government’s options to support growth without compromising its fiscal consolidation credentials and its efforts to keep the current account deficit to less than 1 per cent of GDP.

Markets have since calmed down after the Government refrained from more fiscal stimulus in favour of exploring alternative solutions that do not jeopardise macroeconomic stability. Speculation was rife that the Government might unveil fiscal stimulus measures, which would endanger the FY18 targets. If it did, it could have led the FY18 deficit target of 3.2 per cent of GDP to overshoot by 40-60 bps. To its credit, the Government chose to keep its powder dry.

In a signal that the FY18 targets will be adhered to, the borrowings plan for 2H was retained. The door was, nonetheless, left open for an increase in issuances should such the need for more stimulus arise later in the year. Instead, central public-sector enterprises, a major source of capex formation in recent years, were tasked to frontload capex spending and disburse additional funds. This year’s targeted increase will not be reflected in the Centre’s books and will be raised out of bond sales or available reserves with the enterprises.

There were two reasons behind the hesitation to increase spending. First, there is a need to strike a balance between growth and fiscal discipline. Second, more time is needed to assess downside risks to growth and revenue collections. Hence, we expect the Budget to modestly miss its FY18 targets from a revenue shortfall.

Any final decision on the fiscal front is likely to be taken in November-December 2017, closer to the last parliamentary session and ahead of the FY19 Budget. A modest miss in fiscal targets on the cards. Fiscal expenditure was front-loaded sharply in the early part of FY18 to offset the drag from slower growth engines. Revenues, unfortunately, failed to keep up. Together, the Budget deficit reached 96 per cent of the full-year target in April-August 2017, with seven months still to go. There are risks to the full-year deficit target from a potential shortfall in revenues.

Direct tax collections are expected to recover in the seasonally stronger 2H FY18, but indirect taxes (particularly on GST-led uncertainty) and non-tax revenues might disappoint.

GST-led uncertainty might slow indirect tax collections. GST revenues in July-August 2017 were modestly below target due to weaker tax compliance. Adding to it, input tax credit claims were substantial at roughly two-thirds of the monthly GST collection. While this is a significant drain, the authorities have sought clarity on these claim requests. It was being debated if the fuel taxes should be lowered/scrapped, as global oil prices rebound. In a bid to boost demand, the excise duty was cut slightly in early October, but this will entail fiscal costs. Excise collections are likely to be lower by ₹13,000 crore (0.1 per cent of GDP) for rest of the fiscal year, adding to the revenue headwinds.

Concurrently, non-tax collections have disappointed owing to a halving in the RBI’s dividend contribution, below-target divestment receipts and potentially disappointing collections from telecom spectrum auctions. India may also miss its budgeted nominal growth rate of 11.8 per cent if real growth remains weak in 2H FY18 amidst an inflation rate close to target. Given this backdrop, barring a sharp compression in expenditure, the FY18 deficit might miss the 3.2 per cent of GDP target by 20-30 basis points. In this regard, the adoption of the stringent FRBM (Fiscal Responsibility and Budget Management) deficit goalposts will be delayed.

The FY18 current account deficit (CAD) is set to widen to a four-year high of 1.6 per cent of GDP from 0.7 per cent last year. Although exports are likely to recover as the GST-led disruptions reverse in 2H FY18, imports will be stronger and widen the full-year trade deficit. Imports are expected to rise on price and volume basis. For example, the oil import bill, which makes up a third of total imports, is likely to be underpinned by persistently strong fuel consumption and higher oil prices.

Secondly, non-gold non-oil imports have risen sharply on higher manufacturing imports including electronics. The latter rose 37 per cent in April-August 2017 and displaced gold as the second biggest import item. Electronic imports are likely to remain strong as domestic production lags. Industry estimates showed that more than 60 per cent of the total domestic demand in 2014-15 were met through imports, according to the Niti Aayog.

Demonetisation and the GST have also disrupted domestic supply chains and led to higher manufacturing imports. Gold purchases should moderate following the closing of the tax loophole and the stabilisation in pre-GST inventories. In all, the goods trade deficit is set to widen this year, but resilient service sector earnings and remittances should help limit the scale of deterioration in the CAD to 1.6 per cent of GDP.

As demonstrated by the recent market volatility, India must reassure investors that a wider CAD does not necessarily imply pressures on the balance of payments. Hence, the following factors are necessary to keep the capital account surplus healthy. First, another strong year of foreign direct investment (FDI) will be desirable. Second, stable global financial markets are favoured. Third, raising the foreign debt investment limits will be preferred.

Externally, India will also face challenges from the reversal in two global tailwinds — low oil prices and easy global monetary policies. First, the beneficial impact from low oil prices is fading. Brent crude oil prices have risen to $55-57/barrel in September 2017 from an average $45 in 2016. The Indian crude basket briefly touched 2015 levels last week. High fuel and transport costs, coupled with GST-led uncertainties, bode poorly for inflation and inflationary expectations.

In an important global development, central banks have signalled their intentions to join the Fed in rolling back their ultra-loose monetary policies in the coming years. This will slow the net liquidity injection into the global economy in the medium-term.

India is in a tough place. Growth is expected to improve in April-June 2017 from base effects but it will not be able to lift full-year growth from below 7 per cent. With the twin deficits no longer narrowing, India’s will have a challenging time balancing the temptation to lift growth via more stimulus and yet not rattle investors who favour macroeconomic stability.

The writer is an economist with DBS Bank, Singapore