Budget 2023: The Search For A Fiscal Road Map

The Covid-19 crisis led to a blowout of the fiscal deficit in India and across other nations at a time when India's public debt was already high. Amid returning economic normalcy and resilient growth, financial markets will watch out for how much the government targets reducing fiscal deficit in the next fiscal and for a credible consolidation path.

Fiscal deficit rose from 3.8% of GDP in FY20 to 9.5% of GDP in FY21. The fiscal deficit target for FY22 was pegged at 6.9% of GDP and is projected to ease to 6.4% of GDP for FY23.

Fitch while reaffirming India's 'BBB-' rating in December last year, had stated that "while India's rating reflects strengths from a robust growth outlook, it is offset by India's weak public finances, illustrated by high deficits and debt relative to peers."

Aditi Nayar, chief economist at ICRA Ltd., foresees the central government's fiscal deficit to exceed the budget estimate of Rs 16.6 lakh crore by Rs 0.8 lakh crore.

"However, as a proportion of GDP, the fiscal deficit in FY23 is unlikely to exceed the FY23 BE of 6.4%, on a higher nominal GDP of Rs 273.1 lakh crore as per the NSO’s first advance estimates vis-à-vis the budgeted figure of Rs 258 lakh crore," Nayar said in a research note on budget expectations.

Given the global headwinds and the domestic macroeconomic situation, India's GDP growth is likely to slow down next year, said Rajeshwari Sengupta, associate professor of economics at IGIDR.

Hence there might be some pressure on the government to continue to spend in order to support the economy, once again postponing the objective of fiscal consolidation, she said. "This would be a big mistake."

Prioritization of fiscal consolidation is non-negotiable from a macro stability perspective, according to economists at QuantEco Research. While covid resulted in significant increase in fiscal deficit the world over, in case of India, pressure on fiscal deficit had started to manifest before the onset of the pandemic.

Restoration of fiscal credibility will have multitude of benefits, ranging from keeping interest rates low by not crowding out private spending, helping the central bank achieve the 4% inflation target, increase attractiveness for foreign investors by amalgamating structural reforms within fiscal policy, etc, according to Shubhada Rao, Vivek Kumar, and Yuvika Singhal, economists at QuantEco Research.

In addition, regaining of fiscal space in times of economic recovery makes strategic sense as business cycles are getting condensed, and one needs to keep the powder dry for unanticipated shocks, they added.

For the central government, Fitch expects modest fiscal slippage in FY23 with a deficit of 6.6% of GDP (including disinvestment) relative to the 6.4% budget target, due to higher food and fertilizer subsidies, but revenue growth and expenditure switching will contain the measures' fiscal toll, while allowing capital spending to remain a priority, forecasting the central government to set a 6.0% of GDP deficit target in its upcoming budget.

The government has committed to pursuing a broad path of fiscal consolidation to attain a level of fiscal deficit lower than 4.5% of GDP by FY26.

What needs to be seen is how aggressively or gradually the government achieves this figure, said Radhika Pandey, senior fellow at the National Institute of Public Finance and Policy, who expects the government to target bringing down the deficit to between 5.8-6% next fiscal.

"Though fiscal consolidation is set to continue, the pace of reduction will be gradual," according to Pandey. While tax revenues have been robust, fiscal targets should be realistic, she said, adding that the government will to try and balance growth while it moves towards consolidation. 

However, the government needs to be bring back the rolling targets given in the mid-term fiscal roadmap, Pandey said. "The mid-term fiscal roadmap is critical and needs to be credible and well communicated."

"A clearly communicated medium-term fiscal consolidation plan is critical to enhance policy space and facilitate private sector led growth," stated an IMF country report, published in December 2022.

Announcing further deficit-reduction measures would reduce uncertainty and lower risk premia, the consultation paper said, in the short-term, fiscal consolidation would also support the RBI’s efforts to maintain price stability.

To be sure, fiscal consolidation is not necessarily equal to fiscal compression, said NR Bhanumurthy, vice-chancellor of Dr. B.R. Ambedkar School of Economics University. Running a larger fiscal deficit because of higher spending can prove counterproductive if the government increases revenue expenditure, since the multiplier effect is lower, leading to lower government revenue in turn, he explained. 

As such, the mid-term fiscal consolidation path will determine how much the government is able to spend, and will also help bring down India's debt-to-GDP, Bhanumurthy said.

The general government deficit (centre and states) is around 10% of GDP, the highest among G20 countries, Sengupta said. "Such a high fiscal deficit means that the government is caught in a vicious cycle."

Higher deficit leads to higher borrowing by the government from the bond market, which implies higher interest payments that in turn end up aggravating the deficit problem and pushing up the nation's debt, Sengupta explained.

Central government debt is estimated at 60.2% of the GDP for FY23 as per budget estimates.

"Over the past few years, interest payments have grown to more than 20% of the total expenditure of the central government, while the debt-to-GDP ratio has reached nearly 90%, much higher than the pre-pandemic average of roughly 70%," she said. This trajectory threatens to undo India's hard-won macroeconomic stability, she added.

Large government borrowing for an extended period of time crowds out the private sector by pushing up yields in the bond market. Hence it is imperative that the government adopts a fiscally conservative stance while presenting the next year’s Union Budget, laying down a clear glide path for fiscal consolidation, which must include a reduction of government spending, particularly on subsidies, said Sengupta.

Economists at QuantEco Research also said that elevated borrowing over a long period could reduce the fiscal space for the government to carry out developmental expenditure, including capex creation.

In the last 10-years, interest payments have increased from 35-36% of revenue receipts (and 22-23% of total expenditure) to 39-40% of revenue receipts currently (and 23-24% of total expenditure currently), according to QuantEco Research.

Fiscal consolidation would generally tend to lower government’s market borrowing. The magnitude of net borrowing by the central government is expected to moderate towards 3.7% of GDP in FY24 from 4.1% in FY23, according to QuantEco Research's estimates. To be sure, despite this anticipated moderation, net borrowing would stay elevated compared to the pre-Covid five-year average of 2.6% of GDP.

Fiscal prudence has been India’s strength in post-Covid world, said Ankita Pathak. While fiscal borrowing will remain elevated, the government is likely to find the funders, along with the full support from the Central Bank, she said.

While the headline number will shrink as Nominal GDP grows to look closer to 5.6% of GDP in FY24, borrowings will remain elevated but not unreasonable, Pathak said.