November 2019 issue of Economy Watch highlights emerging policy challenges both because of the continued economic slowdown and issues of resource sharing in India’s federal fiscal transfer system due to Jammu and Kashmir’s reorganization.
Recent data highlight continuing slowdown
In spite of multiple fiscal and monetary policy initiatives, the Indian economy has continued to slow down. The September 2019 core sector Index of Industrial Production (IIP) data shows a contraction of (-) 5.2% which appears to be the worst in the history of the new IIP series which started in 2011-12. Manufacturing Purchasing Managers Index (PMI) fell to a two-year low of 50.6 and services PMI fell to 49.2 in October 2019. The automobile sector remains in deep contraction with September 2019 motor vehicle sales showing a contraction of (-) 23.3%. According to the capacity utilization data released by the RBI, the capacity utilization is at a seven-quarter low of 73.6 in 1QFY20, which is the lowest since 3QFY18. These trends indicate that the recent fiscal measures announced by the government including the sharp reduction in the Corporate Income Tax (CIT) rates and incentives for automobile, housing and export sectors have not yielded much result as yet. The repo rate reduction of 135 basis points during the period from February to October 2019 has also not elicited any significant positive response. The key question is whether it is only a matter of time before growth starts to pick up or are there still some tools available to the government which may be used to accelerate the recovery process. In the November 2019 issue of EY’s Economy Watch, we highlight emerging policy challenges both because of the continued economic slowdown and issues of resource sharing in India’s federal fiscal transfer system due to Jammu and Kashmir’s reorganization.
India’s Finance Commission (FC) to consider Jammu and Kashmir’s (J&K) new status
India’s FC is a constitutional body which examines the mechanism of resource transfers from the center to states normally every five years. The Fifteenth Finance Commission (FFC) is presently deliberating on its Terms of Reference (ToR), which have been recently supplemented by some additional ToRs. The first one was issued on 29 July 2019 that relates to the need for recommending a funding mechanism for defence and internal security. Another ToR is linked to the Jammu and Kashmir Re-organization Act, 2019 (J&KRA) which has resulted in the formation of the erstwhile state of Jammu and Kashmir as a union territory (UT) with legislature and the formation of Ladakh as a UT without legislature. Consequently, India will have 28 states instead of 29 and three UTs with legislature instead of two and six UTs without legislature. The key issues for the FC are to whether to consider J&K as equivalent to state for the purpose of determining transfers to states or treat J&K as other UTs with legislatures such as Delhi and Puducherry. In the latter case, the fiscal needs of J&K would need to be considered entirely by the central government from out of the allocation for it by the FC.
Funding of defence and internal security
In the case of defence and internal security, it is easily seen that these conditions are met to different degrees. In the case of defence, there are unanticipated shocks that arise from time to time due to the imposition of wars and conflicts arising from external sources. It is also difficult to anticipate the expenditure requirements when such shocks arise.
In respect of internal security, the joint involvement of center and states may be of considerable practical value and therefore, some of the spending from the proposed fund may be through the state governments.
Non-lapsability is also a significant issue in the case of defence expenditure particularly for defence capital expenditure where due to various procedural rigidities, the allocated budgeted expenditures remain unspent and eventually they may be released for other ministries. There may thus be a case for creating a funding mechanism for expenditure on defence and internal security. However, there is no need for such a fund to meet all the requirements of defence and internal security. Some expenditures can easily be kept out such as defence pensions and possibly defence salaries. It is possibly most relevant for purchase and maintenance of defence goods particularly defence capital goods and for development, research and innovation. It has been observed that it is mostly defence capital expenditure, where actuals tend to be lower than the budgeted amount.
Importance of government expenditure restructuring for combating slowdown
One clear policy option to hasten the recovery process could be a direct and strong demand push injected into the economy through the augmentation of government’s expenditure, particularly capital expenditure. Over the longer-run expenditure side reforms should be undertaken, aimed at reducing the share of revenue deficit in fiscal deficit so as to create additional fiscal space for capital expenditure. India’s policymakers have been constrained by a sharp reduction of tax revenue growth accompanied by the Fiscal Responsibility and Budget Management Act (FRBMA) limits on government borrowing. Center’s tax revenue during 1HFY20 has shown a growth of only 1.5%. This situation is likely to worsen further as the revenue depleting effect of the CIT rate reduction manifests itself in the short-term. Various estimates of the impact of CIT rate reforms on fiscal deficit, which we had reviewed in the October 2019 issue of Economy Watch, indicated that the slippage for center could be in the range of 0.5 to 0.7% points of GDP for FY20. There may also be an impact on state’s fiscal deficit, which may be about 0.6% points of GDP. Furthermore, states will also be at the receiving end of the lower growth of center’s gross tax revenues. Together this means that neither the center nor the states may not be able to inject additional purchasing power into the system through a direct demand stimulus in the near future. The government may be able to increase its expenditure only if it is willing to permit a large slippage in the fiscal deficit target prescribed by the FRBM. To reach a size of US$5 trillion by FY25, clearly more countercyclical and structural policy initiatives would need to be added to the long list of policy initiatives already undertaken to uplift current and potential growth. In particular, a large investment is needed in India’s infrastructure sector. The FY20 Union Budget had envisaged an annual investment of about 10% of GDP for the next five years. However, the method of financing such a large investment has not been specified yet.
Long term growth prospects
India slipped 10 ranks to 68 in 2019 from 58 in 2018 in the Global Competitiveness Index prepared by the World Economic Forum released in September 2019. India has decided not to join the RCEP, at least for the time being, as its substantive concerns have not been met. India is particularly concerned with regard to the RCEP’s impact on sectors such as textiles, milk, steel and more broadly small and medium sized industries. On its own part, India has to substantively increase its competitiveness while the RCEP has to make specific provisions addressing India’s concerns.
There is some positive news as well. India has shown an improvement in the Ease of Doing Business ranking by climbing 14 ranks in this index to 63, making it the one of world’s top 10 most improved countries for the third consecutive time. With the push given by the sharp CIT rate reduction, investment should start picking up in due course. The longer-term prospects for India’s economic growth remain intact.