5 minute read 28 Sep 2020
Fiscal deficit in FY21

How far can India stretch its fiscal deficit to support economic growth?

By D. K. Srivastava

EY India Chief Policy Advisor

A noted economist, D.K. Srivastava is an Honorary Professor at Madras School of Economics and Member of the Advisory Council to the 15th Finance Commission.

5 minute read 28 Sep 2020
Related topics Tax COVID-19

This edition of Economy Watch explores if stretching fiscal deficit in FY21 would help overcome India’s growth challenges.

The 1QFY21 GDP growth numbers highlight an extremely challenging outlook for the Indian economy with only one sector namely agriculture, showing positive growth on the output side, and only one demand segment namely, government final consumption expenditure (GFCE), showing positive growth. The contractionary components have overwhelmed the overall performance to a negative gross value added (GVA) growth of (-)22.8% and a negative Gross Domestic Product (GDP) growth of (-)23.9%. With nominal GDP also contracting by (-)22.6% in 1QFY21, central and state governments’ tax revenues are also likely to contract in FY21.

Data from Controller General of Accounts (CGA) indicate that center’s gross tax revenues (GTR) during the first four months of FY21 have contracted by (-)29.5%. The contraction in the output sector ‘public administration, defence and other services’ at (-)10.3% in 1QFY21 has come as a surprise since this is the sector where policy stimulus should have been reflected. This sector reflects government expenditure comprising of expenditure by the central and state governments as well as public sector enterprises (PSEs). Primary expenditure of the central government in the first three months of the fiscal year showed a growth of 13%. Data compiled from CAG with respect to 19 states show a contraction of (-)1.0% in the primary expenditure of states during this period. While data on expenditure of PSEs is not directly available, the contraction of (-)47.5% in gross capital formation as given by the CSO for 1QFY21 is indicative of its contractionary momentum. Thus, it is the weakness of fiscal stimulus particularly the expenditures of the revenue-constrained state governments and the lockdown affected PSEs which led to the contraction of the largely policy related sector of public administration et. al. The policy constraints to India’s growth prospects are discussed at length in the ‘In focus’ section of September 2020 issue of Economy Watch.

India’s growth in an international perspective

In a cross-country comparison of quarterly growth performance, Chart 1 shows a comparison between the periods January-March 2020 vis-à-vis. April-June 2020. The countries covered here include China, US, Japan, Germany, Brazil, Mexico, France, UK and India.

FRBMA targets

Source: OECD, Reuters, Bloomberg

It is clear that some countries experienced the impact of COVID-19 relatively more in the January-March quarter of 2020 whereas India experienced the full economic impact of the pandemic only in April-June quarter of 2020. As such, within the selected group of countries, India had the best performance with a positive growth of 3.3% in the January-March quarter 2020, but the worst performance with a contraction of(-)23.9% in the April-June quarter of 2020.

Prospects for India’s FY21 growth

For the full year of FY21, India faces an uphill task in achieving a positive real GDP growth. Numerous rating agencies and multilateral organizations have forecasted the full year FY21 growth rates, and in some cases, also given the quarterly breakdown. None of the forecasters included here shows a positive real GDP growth. The best performance is reflected in RBI’s Professional Forecaster’s Survey at (-)5.8%.

FRBMA targets

In the quarterly forecasts, the turnaround to a positive real GDP growth is seen only in 4QFY21 as per Deutsche Bank while the RBI’s Professional Forecasters Survey predicts a positive turnaround in 3QFY21.

The annual projections also indicate the strong likelihood of even the nominal GDP growth showing a contraction in FY21. If we take OECD’s real GDP growth projection for India at (-)10.2% and a deflator-based inflation of about 5%, the implied contraction in nominal GDP comes to about (-)5.0%. A contraction in nominal growth also indicates a contraction in the tax revenues of the central and state governments. This highlights that the key instrument available with the central government for turning around the economy in the current and the next year is an exceptionally high fiscal deficit.

Fiscal deficit prospects: finding resources for next round of stimulus

Current fiscal trends indicate that the main route through which fiscal stimulus can be injected is augmentation of fiscal deficit of the central and state governments. The states have been allowed an increase in their aggregate fiscal deficit from 3% to 5% of GDP. The additional borrowing of 2% of GDP can be divided into two parts. Up to 1% is linked to incentive-based borrowing with respect to four conditions. The balance of 1% of GDP has been linked to GST compensation cess where the states have been given two options. In option 1, if all states opt for it, the upper limit of borrowing would be INR97,000 crore which may be marginally less than 0.5% of estimated FY21 GDP. Individual states can exercise this option and their borrowing may amount to about 0.5% of their respective GSDP depending on their share in the aggregate amount under option 1. Any state going for option 1 will be allowed another 0.5% of GSDP as unconditional borrowing. In option 2 also, states can access up to 1% of their respective GSDP related to four incentive linked conditions. Further, they can opt for borrowing their full share of the aggregate shortfall of INR2.35 lakh crore. If all states go for this option, their aggregate borrowing would be slightly in excess of 1% of estimated FY21 GDP. However, states going for this option will not be allowed the additional unconditional borrowing and bonus tranche together amounting to 1% of their respective GSDP. 21 states[1] have opted for option 1. Other states have rejected both the options and called for Prime Minister’s intervention. The situation will become clear in due course. For the time being we can consider 5% as the upper limit of the state borrowing in FY21. In both the options, the borrowing related to the shortfall in the GST compensation cess will be reimbursed to the states by the extension of the cess beyond the transition period.

As per center’s borrowing program announced on 8 May 2020, the targeted borrowing amounts to INR12,00,000 crores. This would be about 5.9% of GDP if we keep nominal GDP at the FY20 level implying a nominal growth of 0% in FY21. If the year ends in a contraction in nominal GDP, center’s fiscal deficit to GDP ratio would be higher.

Any additional stimulus will call for further increase in center’s borrowing. A combined borrowing by center and states of 12.5% of GDP or above may require a substantive portion of the borrowing being monetized by the RBI directly or indirectly, thereby increasing pressure on inflation.

Concluding observations

Being a pandemic year, FY21 should be considered as an exceptional year outside of the normal growth path of the Indian economy and the path of fiscal consolidation. A combined fiscal deficit of more than 12% of GDP would need to be corrected afterwards. But the pandemic’s shadow may last for one or two more years. The fiscal correction should be gradual so that growth is slowly nursed back to India’s potential. In FY22, combined fiscal deficit may be kept at 9% of GDP and FY23 onwards, it may be sustained at 7% of GDP. The combined debt-GDP ratio would take much longer to be brought down from its anticipated level of about 90% by the end of FY23 (World Bank). It may also be worthwhile recasting India’s fiscal and monetary policy frameworks, an issue that was discussed at length in the ‘In focus’ section of August 2020 issue of Economy Watch.

Summary

Once the impact of the pandemic slows down, the fiscal correction from FY21 should be gradual so that India’s growth is nursed back to its potential.

About this article

By D. K. Srivastava

EY India Chief Policy Advisor

A noted economist, D.K. Srivastava is an Honorary Professor at Madras School of Economics and Member of the Advisory Council to the 15th Finance Commission.

Related topics Tax COVID-19