As we come closer to the annual ritual of India's central budget the biggest dilemma facing the finance minister would be how to strike a balance between continuing on the aggressive fiscal deficit contraction program as per plan -  3.9% in F16, 3.5% by F17 and 3% by F18- and, taking an audacious approach in an attempt to recharge the economy which is badly in need of pump priming from investments.
Make no mistake, F16 deficit target can comfortably be achieved with prudent policies followed by the government on distribution of gains from crude oil price drop. However deficit figures for F17, and possibly for F18 seem to be under pressure.

 The pinch points….

Ironically, low inflation, which is distorting nominal GDP estimates (pulling the nominal GDP lower than the estimated figure due to diminished inflation applied to calculate nominal GDP) is emerging as a threat to India’s fiscal deficit currently by denting the denominator for fiscal deficit. For every 300 bps decline in inflation the fiscal deficit can be higher by about 10 bps.
Pay commission impact on wages will cause a hit of about Rs 1000 b for the government in F17. Add the impact of OROP and one can estimate about 60 bps upward impact on the fiscal deficit.
Thus these two factors – which may not be easy to mitigate- may inflate the fiscal deficit by 60- 70 bps in F17.

and the vents

Although the government is set to miss out on its divestment target by a massive Rs 400b the fiscal deficit target for F16 does not seem too daunting due to large gains owing to oil price reduction.
Even in F17 oil price is the most obvious pressure vent here as it may average about US$8-10/bbl lower in F17 than in F16 which will mean a gain of about Rs 650b ( about 0.45% of GDP) for the government.
On the other hand proceeds from divestment in F17 seem set to be subdued given the near term market prospects.

The need for sticking to the fiscal roadmap ….. 

Apart from the risk of sovereign rating downgrade any further slippage versus the fiscal deficit road map also presents the possibility of loss of credibility for the government since the latter had already postponed this roadmap once earlier.
More importantly reckless increase in fiscal deficit will open up the spectre of inflation which will create its own demons. In that sense, some industry leaders that have been calling aggressively for loosening of fiscal deficit targets to initiate a massive stimulus in the shape of government spending, will do well to remember that the concomitant inflation may force the RBI to reverse the rate cycle.

….And the case for augmentation of investments 

Amid low capital expenditure, poor industrial growth and depressed job creation India’s economy seems to be missing the zing that is expected in the fastest growing developing economy in the world. As exports remain muted investments need to be magnified to reinvigorate the economy. Now, private sector is unlikely to take the initiative in investments given the low capacity utilization in the economy which leaves government investments as the only way to pump prime the economy. Indeed there is a risk that contagion - in the shape of shrinking exports- of global slowdown may start pulling down the economic growth if domestic bolsters are not put in place quickly.

Is the balance so difficult?

In the gloomy global macroeconomic environment prevalent currently the merits of disciplined approach to fiscal management cannot be overstated. Sticking to the plan will bring kudos from international rating agencies, multilateral lending institutions, and general observers.
However if GDP growth slumps then fiscal deficit will have at least some tendency to expand. Hence the government cannot afford to lose sight of the GDP growth imperative too – even if controlling the fiscal deficit is taken as the primary objective.
Private sector investments are at least 6-8 quarters away and in this scenario if the government spending does not pick up the growth may nosedive by end of F17. This is even more relevant now due to two consecutive years of poor monsoon which has pressurized the rural economy.
Some areas where the government needs to work on urgently from the deficit perspective are –
  1. Curb revenue expenditure aggressively – While the pay commission related expense is unavoidable due to political compulsions there are some areas where revenue expenditure can be cut by 25-30 bps (of GDP). Especially, assistance and grants to states can be curbed now that share of states’ in tax collection has been enhanced from 32% to 42%. Even on pay commission related impact at least some pressure can be postponed to F18.
  2. Rework the subsidies – Even as there is an urgent need to upgrade the budget for MNREGA and other rural schemes like pension yojana, gram jyoti, surakhsa bima, and Jeevan jyoti yojana - the government needs to eliminate the kerosene and cooking gas subsidies altogether and work on shifting at least some part of fertilizer subsidy to direct transfers. Overall subsidies may not shrink in F17 from the budgeted 1.7% of GDP in F16 due to continued need of food subsidy. However if repackaged to make it more focussed the subsidy program may actually aid GDP growth thus bolstering the fiscal deficit figure at least to some extent. In addition, for F18 actually subsidy bill should be brought down even in absolute terms.
  3. Give a massive push to road construction, railways, urban development and defence (capital spending) – Spending on these areas will not only buttress industrial activity and create urgently required jobs, but also improve the basic infrastructure for citizens. It may be prudent to allocate 30-40% more Y-o-Y on the above heads – even if it causes upward pressure of 65-70 bps on fiscal deficit.
  4. Front load recapitalization activity of banks – As the RBI continues with its efforts to clean up banks’ balance sheet the government may have to aggressively recapitalize some of these banks so that credit growth starts reviving by F18. The Rs 700b that the government has set aside to recapitalize PSU banks over five years may need to grow at least 2x. This should need spending - in F17- of about 15-20 bps of GDP more than in F16.
While the last two factors may nudge up the deficit -and the second one may be neutral- these factors will also boost the GDP growth thus to some extent preventing a wide surge in the deficit as a % of GDP.

Nothing ventured nothing gained

Looking at the above factors and the potential pay commission impact in combination with the potential Rs 650 b gain (about 0.45% of GDP) from crude oil prices in F17 and amid well controlled inflation, it does not look difficult to strike a balance between the two extreme positions. Summing up the impact of all the above factors, 30-40 bps expansion in the deficit - versus targets for F17 and F18, seems what the doctor has ordered for the Indian economy. It won’t bring down the skies on the deficit front, and at the same time will give enough boost to the economic growth. In any case, for a growing economy like India’s if some balanced and calculated aggression is not used to spur growth then the medium term targets for poverty alleviation and improvement in general quality of life too may get clouded.