Growth through high deficits not healthy

The recent data on GDP/GVA growth in the third quarter of 2017-18 has again revived expectations that the deceleration in economic activity because of GST and demonetisation may have bottomed out. Some of this good news is also mirrored in the data on corporate earnings as well as other high-frequency data. It is expected that India will grow faster than the emerging markets (EMs) as well as advanced economies (AEs).

Sundry projections, including those by the Economic Survey, World Bank and IMF, expect the Indian economy to grow in the range of 7-7.5 per cent in 2018-19. It appears that the Indian economy still is not expected to cross the eight per cent Rubicon in the near term. Hence, the key challenge for 2018 appears to be not to reach the full potential but to maintain the path to recovery.

While recent data has shown the recovery to be broad-based, what has been a pleasant surprise is the sudden jump in investment. This is surprising, because the data on investment proposals has not shown growth in the same period. Nevertheless, the economy is rebounding and is appearing to do so on the back of increased spending as well as investment by the government. Indeed, the increased government spending helped cushion the possibility of a sharper fall in GDP in 2017-18, especially as private investment continued to remain muted. The pessimism in the domestic market was overcome also, to a certain extent, by the steady inflow of both foreign portfolio investment (FPI) and foreign direct investment (FDI) in 2017. This helped in managing the current account deficit at stable levels at around 1.2 per cent of GDP in the second quarter of 2017-18 and is expected to remain in a manageable range.

FDI is expected to continue its robust growth in 2018-19 as well, especially on the back of better consumer spending. The government’s recent focus on agriculture and allied activities and its ambitious infrastructure schemes can be expected to boost rural incomes and rural spending. Inflows from FIIs are typically volatile and a much stronger US economy, with the US Fed also steadily increasing rates, is not going to help matters. However, more than foreign fund inflow, what is required is that Indian exports are able to benefit from the era of all-round world economic growth in 2018, something that could not happen as per expectations in 2017. A rapid and sustainable increase in exports will also help Make in India as well as boost job creation.

More worrisome is the enhancement of the fiscal deficit target. There is no arguing against the fact that an expansionary fiscal policy is required to boost a slowing economy. In such a scenario, what is vital is the quality of the enhanced fiscal spending as well as sources utilised in financing the expenditure. The healthy rise in tax revenues was outweighed by a sharp deceleration in non-tax revenue, reflecting deceleration in spectrum auction proceeds, dividends and profits of state-owned enterprises and the Reserve Bank of India. Part of the shortfall in revenues was met via disinvestments and thus the government hopes to breach the disinvestment target set for 2017-18 by collecting ~1 trillion and further expects to raise ~800 billion in 2018-19. However, disinvestment proceeds cannot be viewed as a long-term source of revenue generation. Hence if a longer path to fiscal consolidation has to be taken, it should be based on sustainable, recurring revenue sources.

A higher fiscal deficit also reflects the government’s worsening financial position, reinforcing the negative view on inflationary risks, which have started to build up and are expected to remain at elevated levels on the back of pay revisions, increased government spending, and expectations of hardening crude oil prices. In a sign of the times to come, State Bank of India has already announced an increase in both deposit and as lending rates. With recent CPI data continuing to stay above the five per cent mark and the economy in a recovery mode, RBI may go in for a rate hike sooner or later. Along with the twin-balance-sheet problem, even with progress being made under the insolvency code and infusion of additional capital in the PSBs, a rate hike may still act as a dampener to revival of private Indian investment.

That said, beyond government spending, the rise in GDP growth must be supported by robust private sector investment. This has been a sticky point for the economy over the last few years. Apart from economic reforms engineered to boost demand and income, the private sector may also be looking for a stable regulatory environment and stimulus to encourage their appetite for credit. From a longterm perspective, we believe that an inflection point may have been reached and consumer and business spending should see improvement in the period ahead. Ultimately, economic behaviour will respond not so much to big ticket policy announcements, but to actual implementation of proposed schemes.

The rise in GDP growth must be supported by robust private sector investment. But a higher fiscal deficit may fuel inflation, and the RBI may hike rates, which will act as a dampener on private investment

Anis Chakravarty is Lead Economist and Partner, Deloitte India and Umang Aggarwal is Economist, Deloitte India