India: Back at fiscal crossroads, says DBS

The Indian government’s commitment to fiscal consolidation will be put to test in the February’s FY16/17 (year ending March 2017) Budget.

Fiscal prudence was given a priority in the past four years, which helped to narrow the twin deficits and avert rating downgrades.

Recent developments threaten to derail these improvements, says Singapore’s DBS bank in a report on the Indian economy.

Before jumping into the FY16/17 fiscal math, it discussed the progress in FY15/16 (year ending Mar16). The Apr-Nov15 deficit amounted to 87% of the budgeted target, less precarious than the past two years.

While signs are that the deficit target will not be breached, there are few hurdles to take note of. These include impact of slower-than-estimated GDP growth, bank recapitalization needs/pension adjustments and lower divestment proceeds.

The slowdown in (nominal) GDP growth threatens to widen the deficit as a percentage of GDP. This implies that even if the deficit target at INR 5.6trn is met, weaker nominal GDP growth of 7.4% in 1H FY15/16 (instead of budgeted 11.5%) would widen the deficit to 4.1% of GDP (vs targeted 3.9%). It remains to be seen to what extent official nominal GDP estimates are lowered next month.

Additionally, a mid-year increase in bank recapitalisation plans and defence pensions amount to 0.2% of GDP of extra spending. Any fallout on the budget deficit is however likely to be contained as savings are generated within the existing space.

Total expenditure growth remains on track, with over two-thirds of the full-year target disbursed in first nine months of the year. While revenue expenditure rose 3% YoY, capital expenditure grew 30% YoY (Apr-Nov’15 YoY), surpassing the budgeted pace.

Qualitative aspects of expenditure have also been positive, with higher disbursements to roads/ highways/ transport sector, urban development etc. Mandatory caps on non-plan expenditure that routinely kick in the March quarter should also help cover the additional spending needs.

On revenues, stronger indirect tax collections are expected to offset lower direct tax receipts. To raise indirect tax revenues, duty on fuel products were lifted three times this fiscal year, along with service tax adjustments.

Non-tax revenues meanwhile were boosted by a record jump in RBI’s surplus transfers (22% YoY) and dividends from state-owned companies. A miss in divestment proceeds (0.5% of GDP) however seems more likely than not after less than a fifth of the target has been raised by Nov15. Difficult market conditions and uncertain valuations will make it challenging to line-up fresh stake-sales in the Mar’16 quarter.

In sum, DBS expect the deficit target to be met, even if it widens as a percentage of GDP.

FY16/17 fiscal goals will be challenging

After meeting FY15/16 goals, the government’s commitment to fiscal discipline will be put to test in FY16/17.

The medium-term fiscal roadmap pegs the FY16/17 fiscal deficit at -3.5% of GDP from an estimated -3.9% this year.

Recent developments will make meeting these goals a challenge.

The need to strike a balance between:

a) fresh spending commitments;

b) a pro-growth stance an;

c) compensate for low tax buoyancy/divestment proceeds, threaten to derail deficit targets.

“We see a risk that a higher 3.7% of GDP target is adopted for FY16/17, just as the windfall from low commodity prices fades,” it said.

However, if the government prioritises fiscal discipline, this will necessitate a cut in capital expenditure (negative shock to growth), further rationalisation in subsidies and need for fresh revenue sources. Ambitious growth and revenue targets will also revive credibility concerns as in the past.

The numbers

Assuming a modest miss in the FY16/17 target, the main risks to this year’s targets are:

a) additional spending commitments;
b) higher public investments and,
c) weak tax/divestment proceeds.

Firstly, an impending increase in the public sector wage bill is the biggest burden on next year’s finances. The seventh pay commission estimated that the financial impact of the wage/allowance adjustments will amount to INR 1.02trn, of which 72% will be borne by the central government’s budget. As a % of GDP, it amounts to 0.65%-0.7% (~0.5% under the central government) marginally less than the 0.77% under the sixth pay commission.

According to recent press reports, implementation of the pay commission’s proposals may be staggered to ease the fiscal impact. As yet, there has been no official confirmation of this.

Higher capital infusion into public-sector banks is the other priority.

During a mid-year review, funding needs were raised by two-thirds of this year’s budget. Another 0.2% of GDP needs to be set aside in FY16/17 as part of a roadmap to meet banks’ capital needs.

These funds are meant to ease the banks’ burden of rising stressed advances which jumped past 11% (of total advances) as of Sep15. Risks are that additional bank recapitalisation needs crop up in the year, particularly as other fund-raising avenues are hurt by financial market volatility.

Next, the government assumed a pro-growth approach by boosting capital expenditure by 25% in FY15/16 budget. Higher public-sector participation in jump-starting the investment cycle is needed to compensate for a sluggish private sector.

While capital investment as a percentage of GDP has bottomed out, project commissioning and new investment announcements slowed in the Dec’15 quarter. Overcapacity across sectors has also lowered appetite for greenfield investments.

Against this backdrop, higher public expenditure is necessary to maintain growth momentum. The National Investment and Infrastructure Fund (NIIF) will also help finance the construction of public infrastructure projects. From an estimated 1.7% of GDP, DBS expect capital expenditure to rise to 2.0% of GDP in FY16/17 surpassing the share of subsidies – a first in many years.

At the same time, further rationalisation in subsidies will also be needed. Further reduction in fuel subsidies is unlikely after last year’s allocations were halved to 0.2% of GDP. Diesel and petrol prices have now been de-regulated, with only LPG/ kerosene remaining under the umbrella.

Some adjustment in food subsidies is likely. An official high level committee estimates about INR 300bn (0.2% of GDP) in savings on such changes.

Lastly, weakness in direct tax collections has been a long-standing concern. While tax buoyancy in 1H FY1516 was encouraging, income and corporate tax collections are running below this year’s budgeted pace. Corporate taxes are due to be lowered by 5% over four years FY16/17 onwards. A roadmap towards this end is likely in February, but will be revenue neutral as tax exemptions/ holidays are scrapped simultaneously.

In the meantime, indirect revenues improved sharply in FY15/16 and a replay is likely in FY1617. Any further increase in fuel excise duties/ import duties /and service tax adjustments would also help.

Under non-tax avenues, divestment proceeds continue to disappoint.

In the first nine months of FY15/16 only a third of the public-sector asset sales target has been met. Earlier indications of a new strategy to regularise asset sales proved to be a challenge given the volatility in the financial markets and free-fall in commodity prices. There is a need to be realistic on this front.

DBS suspect that a smaller but more realistic target of 0.3% of GDP will materialize (vs FY15/16’s ambitious 0.5-0.6%).

Deficit risks

All told, the bank see the risk of that the FY16/17 target is adjusted higher to 3.7% of GDP. Such would dispel doubts over the quality of consolidation, while also minimising a negative shock on growth due to lower public expenditure.

Investors and rating agencies are unlikely to punish the economy for these missed targets, given the improvement in external balances, growth prospects and the fact that they follow largely from lower inflation.

However, wider deficits carry risks: i) delays to rating upgrades; ii) stalls the improvement in the public debt-to-GDP ratio; and iii) narrows room for monetary stimulus.

Delays in fiscal consolidation for a second year mean rating upgrades are unlikely for at least a year.

Second, the room for monetary stimulus will narrow to ensure demand-driven inflationary pressures stay in check.

Finally, the favourable public debt dynamics that India has enjoyed in recent years could also reverse as nominal GDP growth falls below the government’s borrowing costs (i.e. 10y bond yield), as highlighted by the Finance Ministry’s mid-year review.

India’s public debt-to-GDP ratio has been easing in recent years, before stabilising around 60% of GDP.

Longer-term, structural improvements are required to put fiscal balances on a stable footing. The need to lift tax revenues from the current 10% of GDP is a priority. Passage of the nationwide Goods and Services tax at the upcoming parliamentary session is being watched in this regard. Its passage would help the government stay on the medium-term roadmap, even if the FY17/18 deficit goalpost of 3% of GDP is delayed by a year.

Sources: All data are sourced from CEIC Data, Bloomberg, government agencies and central bank. Transformations and forecasts are DBS Group Research. Fii-news.com.