Getting More Bang For The Buck From India’s Limited Fiscal Bullets

Last week, India’s Finance Minister started testing the stimulus waters with a fiscal move, going beyond sole-dependence on interest rate cuts to do the trick. In a world that is crawling back to quantitative easing and negative interest rates, albeit only in highly-rated sovereigns, this move by the Finance Minister could not have come a day sooner. Whether India should at all remain tied to an austere fiscal deficit target of 3 percent, adopted from more developed European nations, is another debate, given the observed ineffectiveness of fiscal austerity in Europe.

What’s important to understand right now is that this recent move is likely to have a lesser-than-anticipated impact in FY20. While it does not meaningfully restrict future fiscal stimulus moves, the fiscal bandwidth is not unlimited, and judicious use of the same is required for higher and immediate economic impact.

Limited Immediate Impact

The importance of a simplified corporate tax structure and low rates, to the cause of ease of doing business, cannot be overstated. However, as corporates have been provided an option under which they may continue with the extant tax rates along with a plethora of exemptions, the number of businesses that will shift to the new regime in this fiscal year itself will be limited. A significant number of large corporates already pay effective tax rates that are either close to, or below 25 percent.

It also implies that the benefits of the move, in terms of fresh capex and job creation are unlikely to play out, at least in the next two quarters.

Make The Fiscal Deficit Count

While it’s unwise to gauge the effectiveness of national economic policy by solely looking at the market reaction, the signals emanating from the relatively more measured bond market offer a sense of the macro-prudential and systemic vulnerability.

Let’s take a purely hypothetical scenario. Assume that a different choice of a specific fiscal tool had triggered an immediate positive economic impact and/or a rate cut would have spurred consumption and investment. Then, the consequent revival of nominal GDP would have kept the fiscal deficit in check and bond hawks happy, while revival in capex and job growth would have kept equity doves in blithe spirit. However, that is unlikely to happen in the current scenario.

A previous column by this author earlier this month showed how India Inc.’s current capacity utilisation (around 76 percent), and soft de-leveraging, is unlikely to trigger immediate investment. To the extent that some companies in the automobile, mining, commodities and broader manufacturing sectors are struggling with slim margins, the corporate tax cut may provide them a breather. While it may not create jobs immediately, one hopes that this will check job losses in the short-term.

Real Interest Rate And Fiscal Deficit Tango

There are other, perhaps tangential aspects, to the government’s decision to consider as well. Remember, that this move comes alongside continued monetary policy easing.

A high real interest rate keeps the rupee stable while a low real interest rate increases the vulnerability of the domestic currency to foreign currency shocks. On the other hand, an increase in the fiscal deficit typically causes the bond market to seek higher yields.

For starters, it exposes the economy to aversion among foreign portfolio investors, if not capital flight. Additionally, the impact of an external shock is more debilitating in such a scenario.

Lending rates have fallen by 150-250 basis points between 2013 and 2019, however there has been no robust pick-up of corporate debt. So, one needs to re-consider the approach of calibrated rate cuts. The upside of a capex or consumer growth revival is not obvious, while the forex vulnerability associated with a lower interest rate is more certain. A fiscal stimulus is likely to be more effective but the risk associated with a higher fiscal deficit requires to be mitigated with a reasonable real interest rate.

Timing The Fiscal Deficit

But there are factors balancing some of the potential concerns around forex vulnerability at this stage.

With much of the world undertaking stimulus measures again, it may be difficult to argue why, in this interconnected world, India should be a beacon of an unsuitably-austere fiscal policy. Given the trajectory of global growth and interest rates, a ‘taper tantrum’ is unlikely in the next 2-3 years.

For starters, it reduces the risk of external forex events. So even though the vulnerability of a forex threat increases because of a higher fiscal deficit, the likelihood of a global forex event is currently low. Under this scheme of things, the chances of an Indian revival in the next two-three years are much higher.

On the contrary, continuing with a yet-to-be proven monetary push paired with fiscal discipline may lower nominal and real growth further. The former will increase the fiscal deficit number anyway. The route of a fiscal push in a QE world, while keeping real interest rates reasonable, may increase India’s chances of going back to the 7-8 percent growth channel.

Reform Without Fiscal Load

In India, crises have been the biggest drivers of reforms. The government must use the opportunity to push reforms such as land acquisition and archaic labour laws. Along with a rationalised tax structure, this set of reforms can actually attract a meaningful portion of global manufacturing that is trying to find a home outside China. As such, just tax reforms may not be sufficient for that.

Where To Spend

That’s the easy and well-known part.

1. Infrastructure. If the government delivers on the much-awaited land and labour reforms, direct spending on infrastructure would possibly have a much higher multiplier effect than without these reforms.
2. Social Spending. Fine-tune and broad-base the distributive policies to support consumption. Alongside labour reforms, the government needs to adopt a calibrated social safety net.
3. TARP, Indian Style. Fund a bad bank which will clean up Indian banks’ balance sheets and help them to go full-throttle on funding the next round of growth, with better-managed risks this time!

Lastly a word on debt. Debt is inevitable in a modern economy and its growth. What can be managed is whether that debt is used for creating long-term social assets i.e.; real assets and human resources or whether it ends up funding short-term consumption. The latter could yield a sugar-high, but isn’t sustainable.

Deep Narayan Mukherjee is a financial services professional and a visiting faculty on risk management at Indian Institute of Management, Calcutta.

The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.