Budget in the time of Covid pandemic

Battling with Covid-19 and its fallout is not over yet. Three areas where the Budget can take this forward and contribute to sustained economic recovery are explored here.

Monetary, fiscal cooperation

In India it is still mostly supply-side shocks that affect inflation but demand determines output. Keeping interest rates low and raising government expenditure will contribute to recovery. But this requires costs and inflation to fall. The Budget must rationalise indirect taxes and tariffs and maintain the focus on reforms that will reduce the cost of living and of doing business.

Government borrowing has risen from the budgeted ₹7 lakh crore to ₹12 lakh crore. The cost of borrowing at an average 5.82 per cent is the lowest in 15 years. Ten-year G-secs yields peaked at 8.18 per cent in 2017-18, when the Repo was at 6 per cent. They are normally 60 bps above Repo.

A study of yield determinants found although short rates (including Fed rates) affected long rates, OMOs had the most impact. Today the yield is 5.9, but the Repo is at 4 so the spread is still too high. Although OMOs occur regularly now G-secs were only about 20 per cent of the RBI balance sheet in 2018. The rest was foreign securities. This must have worsened now because of large inflows and reserve requirements.

In the post global financial crisis decade, emerging markets (EMs) as a whole did relatively badly although the crisis originated elsewhere.

One reason was the surges and sudden stops in capital flows driven by global risk-on and –off worsened by quantitative easing (QE) in advanced economies (AEs). QE has intensified with Covid-19. EM policy-makers have to take pre-emptive countercyclical measures.

The Budget makes announcements on FPI permissions. These are linked to domestic market development as they should be, but should also depend on our need of, and ability to absorb inflows.

There should be a calculation of the cost to the taxpayer when more FPI is allowed to buy G-secs (paying 6 per cent) but the RBI has to swap those for US G-secs (paying zero) as it accumulates reserves. Over-appreciation can hurt exports and raise interest rates to cover expected depreciation.

The Budget can also announce incentives for physical investment that would make productive use of inflows and reduce the amount the RBI has to absorb.

Fiscal deficit and stimulus

There is a chorus saying the government spent too little in the Covid-19 year. But it should be noted that spending was more or less maintained while revenues fell sharply in the first half.

The consensus estimate of the fiscal deficit to GDP ratio is about 8 rising from the targeted 3.5 by 4.5. Such a rise in the fiscal deficit is an automatic stabiliser showing the excess demand from the government.

It is larger than the 4 percentage point increase after the global financial crisis. Since tax revenue had recovered in Q3, the actual fiscal deficit in the Budget may be lower. It should include all off balance sheet items to give a true picture of the stimulus given. Moreover, since a rise in fiscal deficit is acceptable in Covid-19 times it is an opportunity to shift to clean accounting.

But the consensus estimate for fiscal stimulus is only about 2 — much less than AEs — since it is incorrectly restricted to announced additional expenditure and sometimes includes arbitrary cyclical adjustments to GDP.

This is incorrect also because budgeted expenditure is restructured in such a year, some items rise and others fall. Given our population size and large numbers affected, universal income protection as in US and Europe is just not feasible; we need to spend carefully, effectively and at the right time.

Comparing ourselves to the wrong countries has got us into trouble with farm and food subsidies also. East Asia maintained low food prices and high infrastructure investment in agriculture as long as food budget shares and population in agriculture was high had a successful agricultural transformation, while we locked ourselves into rising food prices and food subsidies so that investment and productivity fell. In Q1 2020 supply chains were disrupted and Q2 had the festival boost, Q3 and Q4 should show rising government expenditure as States receive GST payments mandated at 14 per cent nominal income growth, despite the sharp fall in revenue and growth.

The Budget is coming at the right time to give an additional stimulus as supply chains have recovered and the beginning of vaccination boosts sentiment. As revenue has recovered the government can spend more and analysts may see a rise in government expenditure.

They are looking for this since it directly adds to growth. There is also scope for a moderate rise in the fiscal deficit in this Budget.

One reason there is no excess demand despite large deficits maybe less leakage due to use of DBTs. Therefore more DBTs should be announced in the Budget targeting the lower and middle income classes whose propensity to consume is higher, who have suffered disproportionately under Covid-19, and who will now be ready to spend as confidence returns.

Debt and sustainability

Higher deficits in these two years are expected to raise the debt GDP ratio to about 85 per cent, the level it was in 2004, from the 2019 level of 70. The real debt ratio increases with the excess of the real interest rate (r) over the rate of growth (g), plus the primary deficit ratio (PD).

Over 2004-11 g much exceeded r, but the PD rose, still debt ratio fell 18 per cent to 67. Over 2012-19 g-r fell as g fell and r rose.

Therefore despite the PD falling due to strenuous fiscal consolidation efforts, debt ratio rose 3 per cent although central ratios did fall slightly. Interest payments to GDP ratio that fell from 4.5 to 3 in 2011 and have stagnated at that level since.

FY 2021 growth is expected to be high on base effects and low r. The fiscal deficit should rise as part of countercyclical policy to recover and exceed 2019 income levels. Spending of up to 0.5-1 per cent of GDP would be absorbed by a rising denominator (higher GDP growth) without raising the fiscal deficit. Reform, combined with expenditure on high multiplier, growth and employment enhancing items, will raise potential growth making higher growth sustainable. The vaccination drive is an opportunity to make India’s primary health infrastructure robust.

As growth is established and revenue rises, the PD must shrink in FY22. Avoiding the mistakes of 2000s (excess liberality) and 2010s (excess consolidation), with optimal values of high g and low r, will allow the 85 per cent debt ratio in 2021 to be back at 70 by 2025 — in five years compared to the 25 years it took earlier.

It can fall further to reach FRBM target of 60 in a few more years. Privatisation and monetising public assets to finance expenditure would help.

No excessive boost is required. The Budget only needs to ensure demand is kept one step ahead of supply, thus inducing private activity.

The writer is member of the RBI’s MPC. The views expressed are personal

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