At last, the Finance Ministry breaks the shackles - Capital Economics
India Economics

At last, the Finance Ministry breaks the shackles

India Economics Update
Written by Shilan Shah
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India’s Finance Ministry set aside the desire for near-term fiscal consolidation and today announced significant stimulus in the FY21/222 union budget. That should support the economic recovery over the coming quarters, albeit at the cost of putting upward pressure on bond yields.

  • India’s Finance Ministry set aside the desire for near-term fiscal consolidation and today announced significant stimulus in the FY21/222 union budget. That should support the economic recovery over the coming quarters, albeit at the cost of putting upward pressure on bond yields.
  • Finance Minister Nirmala Sitharaman acknowledged in today’s Union Budget that this fiscal year’s central government deficit would significantly overshoot the target of 3.3% of GDP for FY20/21, estimating that it would come in at 9.5% of GDP. The target for FY21/22 has been set at 6.8% of GDP, which is much more accommodative than most had expected (CE forecast: 5.0% of GDP, Bloomberg median 5.5%).
  • Ambitions of reducing the fiscal deficit to 3% of GDP over the medium term as required by the Fiscal Responsibility and Budget Management Act have also been cast aside, with the Finance Ministry estimating that the deficit will only drop to 4.5% of GDP by FY25/26. Reflecting the looser-than-expected fiscal stance, bond yields have risen by about 15bp across the curve. Local equities have jumped by 4%, compared to gains of 1-2% in other Asian markets.
  • While the overshooting in FY20/21 is largely the result of the collapse in revenues due to the pandemic, the accommodative stance in FY21/22 appears to mainly reflect a ramping up of spending. This is a marked departure from the Finance Ministry’s underwhelming response to the COVID-19 crisis so far.
  • Among the most important measures announced, public healthcare spending – which at 1.3% of GDP is one of the lowest in major economies – will be nearly doubled. This includes the COVID-19 vaccination drive which is estimated to cost 0.2% of GDP. Funds have also been allocated to support the banking sector, including a fresh recapitalisation package. At 0.2% of GDP, this is smaller than we think will eventually be needed, but it is nevertheless more than we had expected to be announced. Meanwhile, the Finance Ministry has also increased the budget for the (subsidised) agriculture loans scheme, perhaps in an attempt to appease farmers that are protesting long-term agriculture reforms.
  • In all, expenditure is set to rise by 14% next year, the largest annual jump since FY12/13. Including the spending boost within the official budget should help to ease concerns (including ours) about the recent expansion of off-balance sheet activities, which risked undermining the Finance Ministry’s credibility over the long term.
  • On the revenue side, no major tax changes have been announced. However, it’s worth noting that ambitious targets for GST collections and asset sales – which we will return to in forthcoming research – mean that the generous fiscal deficit target will probably still be missed in FY21/22.
  • Bringing all of this together, the Finance Ministry’s measures are likely to provide much-needed support to the economic recovery over the coming quarters. Our forecast for GDP growth of 12% in 2021 already lay above the consensus (9.8%). Nevertheless, if the vaccination programme – which has gotten off to a slow start – picks up pace in the coming weeks, we’d now be inclined to nudge up our forecast.
  • The Budget has monetary policy implications. A more accommodative fiscal stance reduces pressure on the RBI to loosen further. At the same time, as long as inflation isn’t a concern, the RBI will want to prevent the fiscal support being offset by a tightening in the bond market. The RBI also has one eye on the public debt trajectory, which will have worsened as a result of the fiscal measures. It could do this by stepping up open market operations – as it did on a few occasions last year to cap bond yields. But given that inflation has dropped sharply, we are still comfortable with our non-consensus forecast that the MPC will deliver a 25bp cut at the conclusion of its meeting on Friday.
  • Beyond that, we expect the RBI to keep policy rates low for the foreseeable future and potentially to lean more on financial repression policies to keep borrowing costs manageable. (For more see our Update, “What next for government borrowing costs?” 9th September 2020.)

Shilan Shah, Senior India Economist, shilan.shah@capitaleconomics.com