Slower deficit reduction raises risk of rate hikes
We had hoped that the FY18-19 Union budget would surprise markets positively by setting a fiscal deficit target of 3% of gross domestic product (GDP). Instead, the authorities chose to adopt a slower consolidation agenda to support the ongoing recovery in growth; targeting fiscal deficit at 3.3% of GDP for FY19, with an upward revised 3.5% of GDP in FY18.
The FY19 budget targets revenue at 9.7% of GDP, unchanged from the likely FY18 outturn, while total expenditure is expected to reduce to 13% of GDP (from 13.2% of GDP in FY18). The revenue estimates are broadly realistic and credible; indeed, revenue as a share of GDP is expected to remain unchanged at 9.7%, while nominal GDP growth is expected to improve to 11.5% year-on-year (y-o-y) in FY19 (from 9.5-10% y-o-y in FY18). The authorities have targeted a 0.3% percentage point GDP increase in net tax revenue (to 7.9% of GDP in FY19 vs 7.6% of GDP in FY18), but total revenue remains unchanged at 9.7% of GDP, as non-tax revenue is estimated to be lower by 0.3% percentage points of GDP in FY19 compared to FY18 (1.8% of GDP vs 2.1% of GDP).
Setting the disinvestment target at Rs80,000 crore (0.4% of GDP), lower than the likely FY18 out-turn (Rs1 trillion; 0.6% of GDP), is a prudent strategy as this year's strong performance may become difficult to repeat in FY19, if financial market volatility increases.
On the expenditure front, the budget announced increased allocation in growth-critical areas of rural development, infrastructure, agriculture, and roads/transport/highways but even then the overall spending target has been set lower at 13% of GDP for FY19 versus 13.2% of GDP expected out-turn in FY18. Total spending is expected to increase 10% yo-y in FY19, lower than the nominal GDP growth rate (11.5% y-o-y), and hence does not give rise to fiscal sustainability concerns. Budgeting, as a share of GDP, lower outlays for key items such as interest payments, defence and subsidies (these three items together constitute half of total expenditure) is commendable, but these items are subject to uncertainties, given the uncertainty regarding the global oil price trend, interest rate trajectory and various geopolitical risks. Nevertheless, the projections on the expenditure side broadly realistic.
But is the fiscal stance supportive of growth? India's fiscal parameters tend to be somewhat unconventional, with some one-offs treated above the line. It is important to control for them to assess the true fiscal stance. Based on the budget numbers, we estimate that once privatization (or disinvestment) revenue and bank recapitalization costs Rs10,000 crore likely budgetary support) are excluded, the true primary deficit works out to 0.9% of GDP in FY18, which is expected to come down to 0.6% of GDP in FY19. Consequently, the fiscal impulse on growth (which we calculate by taking the difference of primary deficit between each successive year) is likely to be mildly negative (0.3% of GDP) or, at best, remain neutral (if the calculation is done on the basis of headline primary deficit) in FY19, in line with the trend of the last several years. The revised estimates for FY18 show that the fiscal stance was positive for growth this year, without which economic momentum may have been hit further. But even with a higher-than-expected budget and primary deficit target for FY19, the fiscal stance is unlikely to be incrementally expansionary in the next fiscal year, as per our analysis.
We also find that the quality of fiscal consolidation (as measured by revenue deficit to fiscal deficit ratio) has deteriorated in FY18, after improving steadily since FY10. The revenue deficit to fiscal deficit ratio was 81% in FY10 and was budgeted to reduce to 59% in FY18; instead, the ratio has increased to 74% as per the revised estimates. As per the FY19 budget estimate, the ratio is expected to reduce to 66.6% in the next fiscal year, but will still be higher than the out-turn achieved in FY17 (59%).
It is encouraging to note that the government has agreed to accept the Fiscal Responsibility and Budget Management Act's recommendation of sticking with a mediumterm fiscal consolidation path. The revised fiscal deficit targets are 3.1% for FY20 and 3.0% for FY21, which are achievable given the expected economic recovery and higher revenue potential from the goods and services tax (GST).
From an output gap perspective, there is not enough justification for a rate hike in the near term; consequently, an earlier-than-anticipated rate hike cycle could potentially slow down the pace of recovery expected in FY19.