5 minute read 28 Oct 2020
India’s fiscal and monetary stimuli

Why India may face an unprecedented contraction despite the highest fiscal deficit in FY21

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 Oct 2020
Related topics Tax

In our latest issue of EY Economy Watch, we explore why India may witness one of its worst growth outcomes in FY21 despite a historically high fiscal deficit.

World Economic Outlook released by the International Monetary Fund (IMF) highlights differential growth prospects in the pandemic year for different countries. India’s growth is projected at (-)10.3% for FY21, one of the worst among major countries, while some of India’s neighbours such as Bangladesh show a healthier potential for growth. This is in spite of the fact that India’s combined fiscal deficit is likely to turn out to be historically its highest. In the In-focus section of the October 2020 issue of the EY Economy Watch, we explore this in depth and argue that this may be due to the pre-pandemic economic challenges. In contrast, before facing the FY09 crisis, the pre-crisis Indian economy had historically the most robust macro parameters.

India’s FY21 growth: unprecedented contraction at (-)10.3%

Considering growth prospects for different countries, with the exception of nine countries, where positive growth is being assessed by the IMF for 2020, all the remaining countries show a contraction. All the important country groups also show a contraction. The Euro area amongst country groups shows the highest contraction at (-)8.3%. The emerging market and developing economies (EMDEs) group shows a relatively lower contraction of (-)3.3%. The World economy as a whole is predicted to contract by (-)4.4%. There are four notable countries where contraction is predicted to be more than (-)10.0% in 2020. These are Argentina, India, Italy, and Venezuela. While Argentina, Italy, and Venezuela have often experienced severe economic crisis, India has joined their ranks for the first time. This differential in comparative growth performance may be explained by respective sizes of stimulus packages, differences in the pre-crisis conditions, and other country-specific factors.  

India’s fiscal and monetary stimuli: relatively weak in a global context

An important indicator of the fiscal support to the economy relates to stimulus measures announced up to September 2020. These measures include additional spending relative to the budgeted expenditures as also the quantified value of tax cuts. A comparative picture as shown in Chart 1 indicates that for India, in spite of the high level of fiscal deficit expected for 2020 (FY21), the direct fiscal stimulus so far in the fiscal year is relatively quite low at 1.8% of GDP. This is because of the expected increase in fiscal deficit just to make up for the revenue shortfall in FY21 so as to reach the budgeted levels of expenditure although some expenditure restructuring may also happen. The highest fiscal stimulus at 12.5% of GDP is for Canada, followed by USA at 11.8%, Australia at 11.7%, Japan at 11.3%, and the UK at 9.2% of GDP. Most European countries have undertaken substantially large fiscal stimulus measures. China’s fiscal stimulus at 4.6% of GDP is more than 250% that of India. Bangladesh is exceptional in the sense that with a limited fiscal stimulus of 1.1% of GDP, it is able to show a positive growth in 2020.

Monetary stimulus: cumulative policy rate cuts

Source (basic data): IMF
Note: incorporates fiscal measures announced up to 11 September 2020

The IMF also considers some fiscal measures that are undertaken to support liquidity in the system. Comparing the quantified values as percentage of GDP of these liquidity support measures, the leading country in this aspect is Italy, followed by Germany, Japan and the UK. India’s position is somewhere in the middle, amounting to 5.2% of GDP. This is much less than the corresponding magnitudes relative to GDP for some of the developed countries.

In Chart 2, we provide a comparative picture of the relative strength of the monetary stimulus initiated by these countries in terms of the magnitude of the cumulated policy rate cuts since 31 January 2020. In India’s case, the policy rate reduction during this period amounts to 115 basis points. In contrast, quite a number of other countries have relied relatively more on the monetary stimulus measures. Some of the Latin American countries are notable in this respect. For example, Argentina has implemented a rate cut of 1200 basis points, Mexico, 275 basis points, and Brazil, 250 basis points. Canada and USA have implemented rate cuts of 150 basis points each. South Africa and Russia have implemented rate cuts of 250 and 200 basis points respectively.

Direct fiscal Stimulus: cross country comparison

Pre-crisis macro parameters: robust before FY09, extremely challenged before FY21

A comparison between the pre-crisis macroeconomic parameters before FY09 and FY21 highlights the key reasons as to why India’s growth prospects have become so weak for the first time. The extremely challenging situation of the Indian economy in FY21 is due to the weak position of the economy before it entered into the COVID crisis. The real GDP growth during FY06 to FY08 averaged 7.9%. In contrast, the average growth in the three years preceding FY21 was 5.8%. In FY20, in fact, it was much lower at 4.2%. The average saving and investment rates were lower by 5.6% points and 5.4% points respectively in the three-year period preceding FY21 as compared to the three-year period preceding FY09. Similarly, export growth in real terms was lower by 13.0% points and the GDP based deflator was lower by 3.2% points. Lower GDP deflator-based inflation may lead to a lower nominal GDP, having implications on governments’ tax revenues and other fiscal parameters. 

In FY09, India had emerged as one of the few countries showing positive real GDP growth because of the robust macroeconomic parameters in the pre-crisis years. With economic strength characterizing the initial conditions, India was able to undertake effective stimulus measures at that time. In contrast, erosion in tax revenue growth has especially weakened India’s policy options in FY21. The average growth in combined tax revenues of central and state governments considered together was 13.3% points lower in the three-year period preceding FY21 than that in the three years preceding FY09. These trends are required to be reversed if the India is to achieve its genuine growth potential to levels that have already been achieved in the past.

Summary

Robust macroeconomic parameters in the pre-crisis years which had helped India tread the FY09 crisis seem to be missing in the Covid crisis. India will have to reverse these challenging trends to overcome the adverse impact of the pandemic and achieve its genuine growth 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