The Hindu Business Line : What has the Budget done for growth?

Given the current domestic and international economic scenario, a further moderation of growth is expected in 2008-09. Since the parliamentary election is due in the current year, it is no surprise that the Government initiated measures to sustain the growth rate of the economy. The Budget in particular has provided support to education and agriculture sectors. The Budget also recognised that inflation remains a concern as the supply-side pressures in the form of internati onal oil price and food price continue to increase.

The policy challenge would be to ensure that the economy retains its current growth trajectory, without letting inflation get out of control. An analysis of the components of aggregate demand in recent years indicates that it has been driven predominantly by a sharp increase in domestic consumption (C) and private and public investment (I).

During the current fiscal however, private consumption has been a drag on GDP growth. Out of the one percentage point decline in GDP growth at factor cost this fiscal, a reduction of 0.7 percentage points is expected to come from the slowdown in private consumption growth. In contrast, a decline of only 0.2 percentage points in GDP growth will come from investment.

Further, as compared to 2003-04, the contribution of investment to GDP growth has increased substantially. While exports have grown consistently, imports have grown even faster, which means the ‘net exports’ component of aggregate demand is negative. However, in spite of the sharp appreciation of the rupee during the current fiscal the contribution of net exports to GDP growth has remained constant at -0.4 percentage points.

Domestic consumption

Private consumption: During the last four years of blistering growth, increase in private consumption has made most important contribution to aggregate demand. The main drivers of domestic consumption during the current growth phase have been:

A burgeoning middle-class estimated at 250 million.

Significantly higher wages, especially in IT and IT-enabled services (ITES), financial services and back-office services.

Increase in supply and demand of consumer goods and services.

In addition to the above, until 2006-07, macroeconomic policies such as relatively low interest rates and lower taxes encouraged consumption by reducing the cost of borrowing and increasing disposable income. During 2007-08 however, the picture changed as monetary tightening measures in the form of increase in interest rates and CRR were put in place by the RBI to control inflation and inflationary expectations.

As a result, the cost of borrowing went up and the demand for interest sensitive sectors such as automobiles fell. The growth rate of bank credit for purchasing consumer durables declined from 11.2 per cent (y-o-y November 2006) to 4.4 per cent (y-o-y November 2007). Correspondingly, the growth rate of production of consumer goods declined from 10.2 per cent (April-December 2006) to 5.9 per cent (April-December 2007). Overall, the slowdown in consumption growth is likely to result in a 0.7 percentage point decline in GDP growth out of a total of 1 per cent decline that is expected in GDP growth this year as compared to the last.

The changes in the personal income tax structure and an increase in the threshold level for income-tax in Budget 2008-09 would boost disposable income for taxpayers. This measure should help boost consumption spending next year.

Government consumption

Government consumption as a share of GDP at factor cost (constant prices) is expected to slow down marginally this year to 10.4 per cent compared to the 10.7 per cent last year. The most encouraging feature of government finances in recent years has been an improvement of government savings and the increasing fiscal responsibility it has exhibited. The reported fiscal deficit is estimated at 3.2 per cent of GDP for 2007-08 and the government intends to lower it further to 2.5 per cent of GDP during 2008-09 — 0.5 per cent less than the FRBM target. However, as noted before, fiscal deficit does not take into account the off-Budget items of government expenditure. As a proportion of GDP, interest payments are expected decline from 3.6 per cent in 2006-07 to 3.4 per cent in the current fiscal. As a proportion of GDP, subsidies are expected to fall from 1.3 per cent in 2006-07 and 1.1 per cent in 2007-08 (BE).

Investment

The trend of increasing investment in the economy relative to GDP, both public and private, continues unabated. Gross Domestic Capital Formation (GDCF) at constant market prices for 2007-08 is estimated at 36 per cent of GDP, as compared to 33.8 per cent for the previous year. At current market prices, the ratio was 35.9 in 2006-07 and is estimated to be 38 in 2007-08. Correspondingly, Gross Domestic Savings rose to 34.8 per cent of GDP at current prices during 2006-07, leading to a savings-investment gap of -1.1 per cent of GDP.

The improvement in investment was driven by a significant increase in the private corporate sector investment, which has doubled as a share of GDP in a matter of four years — from 6.6 per cent in 2003-04 to 14.5 per cent in 2006-07. It is encouraging that the efficiency with which capital is being used is increasing.

Rising investment, along with the efficiency with which it is being used, augurs well for the economy. Over the same period, government investment increased from 6.3 per cent of GDP to 7.8 per cent. It is notable that private corporate sector investment started to rise rapidly after the public saving record began to improve and freed up resources for private investment. Also, corporate profits grew as domestic demand and economic growth improved consistently in recent years.

It appears however, going forward, growth of capital formation will slow down as GDP growth slows down. The y-o-y growth rate of real gross fixed capital formation peaked in 2004-05 at 18.9 per cent. Since then it has fallen to 15.1 per cent in 2006-07, though it is expected to increase marginally to 15.7 per cent.

Trade

As a percentage of GDP, net exports in goods and services have remained steady over 2007-08, albeit, contributing negatively. In real rupee terms, export and import growth has slowed down to 6.4 per cent each during 2007-08 from an average of over 20 per cent growth in exports and over 22 per cent in imports over the last three years.

While traditionally India has run a trade deficit, in the fiscal years 2002-2005, the situation reversed and in real rupee terms net exports of goods and services contributed positively. As the economy gained further momentum, demand for imports also rose rapidly and subsequently the trade of goods and services balanced again in the negative zone in the last two fiscals. The net exports to real GDP ratio was -4.2 per cent in 2006-07 and is estimated to be around -4.1 per cent in 2007-08. This trend is likely to persist in 2008-09 as well, as moderation in global economy and high value of rupee will lower the demand for exports of goods and certain services.

Summing up

The economy will continue to grow over 8 per cent in 2008-09, but moderation in the current fiscal is expected.

Addressing supply-side inflation concerns will be of crucial importance.

Investment, both public and private will continue to increase as a share of GDP, but their growth rate would moderate.

Further growth can be sustained only with addressing infrastructural bottlenecks and skilled labour supply shortfall, which are posing supply-side constraints on growth.

Public investment in agriculture and in rural development, particularly in the health and human services and infrastructure sector, will need to be increased further to reduce infrastructural bottlenecks and make growth more inclusive.

(Excerpts from Union Budget Impact & Analysis by CRISIL Research.)