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India’s fiscal outlook: flattering to deceive
India’s FY11 fiscal deficit is likely to print below the budgeted 5.5% of GDP on account of higher revenue and significantly higher nominal GDP growth
Net of asset sales, however, fiscal consolidation was minimal (0.2% of GDP), far less than the budgeted target of 0.8% ppts of GDP
The February FY12 budget is likely to announce a deficit target of 4.8 %, with an implied net borrowing of around Rs3.8 trillion, larger than in FY11
With potential asset sales in FY12 far less than in FY11, the budget target will be hard to achieve exerting upward pressures on bond yields, especially if private credit picks up, thereby forcing more OMOs by the RBI
An opportunity squandered
Back in July when inflation was in double digits, the private investment cycle had yet to pick up, and the current account deficit first threatened to break above 3% of GDP, the one undiluted bright spot on the horizon was the fiscal outlook. Revenues from the 3G spectrum auction had exceeded budget targets by a whopping 1% of GDP and the expectation was that this would further aid the process of fiscal consolidation and consequently that the FY11 fiscal deficit target of 5.5 % of GDP would be significantly bettered.
More importantly, the medium-term outlook had brightened significantly. The Goods and Services Tax (GST) seemed on course for an April 2011 implementation, the Direct Tax Code had not been diluted and the Securities and Exchange Board of India (SEBI) had just ruled that all listed companies would have to raise their public shareholding to 25%, effectively forcing PSUs to disinvest 0.5-0.75% of GDP every year for the next 3 years. Given all this, reducing the fiscal deficit to 4.8% of GDP in FY12, as per the recommendations of the 13th Finance Commission, appeared realistic. Fiscal policy has consistently been India’s Achilles heel, and for once it seemed that a confluence of events had conspired to ensure that India was finally getting its fiscal house in order.
In the months that followed the script got rewritten for the worse. Supplementary budgets in August and November ensured that all the extra proceeds from the 3G revenue (Rs 750 bn) were allocated to be spent. What’s more, none of this money was allocated for this year’s oil subsidies! Only Rs 31 billion has been allocated for oil subsidies in the February budget, and even conservatively assuming an average crude price of $80 per barrel for this year, the government’s share of the oil subsidy bill is expected to exceed Rs 300 billion (see table below), none of which has been allocated as yet. Furthermore, higher crude prices are likely to push the Indian Oil Corporation (IOC) disinvestment into the next fiscal and the uncertainty regarding the subsidy sharing mechanism is threatening to jeopardize the prospects of ONGC being disinvested this fiscal year. If both these get pushed back to FY12, disinvestment proceeds this year could fall below the budget target. But this would not be a bad thing at all as this would force FY11 spending to be curtailed.
More significantly, however, the continuing disagreement between the Center and States on the modalities of the GST have meant that it will not be implemented in FY12 and, at best, could come into force from FY13. If that’s not enough, the aforementioned SEBI ruling on public shareholding will now not be applicable to PSUs. All this means that the ability of the government to realistically reduce the central government fiscal deficit to 4.8% of GDP in FY12 and therefore to 4.2 % in FY13, as per the recommendations of the 13th Finance Commission, appear very improbable.
In sum, the fiscal euphoria that existed back in July has evaporated at a rapid rate, and the unpleasant fiscal arithmetic that has existed over the last two years has now come a full circle.
FY11 fiscal deficit will flatter to deceive
Despite the fact that all the extra 3G revenue has been allocated to be spent, the FY11 budget deficit is still likely to print below 5.5% of GDP as targeted (JPM forecast 5.3%, see table below). However, this is not because the government has been able to achieve any further fiscal consolidation but primarily because higher-than-expected inflation is likely to result in nominal GDP printing significantly higher than what was assumed in the budget. Another reason the fiscal deficit may better the target is the inability of the government to spend the extra revenue fast enough, resulting in a likely positive cash balance of at least Rs.100-200 billion at year-end.
Despite this, in nominal terms, the fiscal deficit is likely to print higher than what the budget projected. While tax collections are expected to come out higher than budgeted (in part, because higher-than-expected inflation has resulted in higher nominal incomes and profits), this will be largely neutralized by the fact that the government, in keeping with past practice, will need to shoulder at least half the oil-subsidy burden, and half of this amount is likely to be disbursed before the end of this fiscal.
At first pass, a fiscal deficit of 5.3 % of GDP in FY11 suggests significant fiscal consolidation from the 6.8 % level last year. This is, however, extremely deceptive because it includes asset sales (3G, disinvestment) and excludes subsidy bonds. Standard definitions of the fiscal deficit exclude asset sales and include subsidy bonds. Viewed in that vein, the fiscal deficit of the central government has gone from 7.4 % of GDP in FY10 to 7.2 % in FY11 – an effective fiscal consolidation of only 0.2% pts of GDP, much less than the 0.8% pts of GDP that was budgeted.
Good news: FY12 budget likely to announce 4.8% fiscal deficit next year; Bad news: achieving this is highly improbable
Buoyed by achieving or bettering the 5.5% target set out in the budget for FY11, the Central Government is expected to announce a fiscal deficit target of 4.8% of GDP for FY12 in the February Budget.
However, moving from 5.3 % of GDP in FY11 to 4.8% in FY12 will not entail a fiscal consolidation of 0.5% but instead an effective fiscal consolidation of 2 % of GDP because the Centre will not have the 3G revenues (1.5 % of GDP) as its disposal next year (assuming that disinvestment proceeds are neutral across both years which seems reasonable if IOC and ONGC are pushed to next fiscal). This would appear overly ambitious, to say the least, because an effective fiscal consolidation of 2% of GDP has never been achieved in the last two decades.
What’s more, with GST pushed to the following year, revenue buoyancy is expected to be limited, and the entire fiscal consolidation of 2% would need to be achieved on the expenditure side – again unprecedented in recent history.
Subsidies: same tune; different lyrics
The likelihood of significant expenditure compression in the next fiscal appears extremely unlikely particularly because subsidies are likely to stay high and potentially even rise further in the next fiscal.
In particular, the Right to Food Security Act is likely to be passed in FY12 and if the version propose by the National Advisory Council is adopted, which appears likely, it is expected to add Rs 150 billion to the food subsidy bill in FY12 in the first stage of implementation and another Rs 80 billion in FY14 when the final stage is expected to be implemented. With food inflation continuing to surge post-monsoon, the political imperative to enact a broad-based Food Security Act that provides protection to a significant section of society appear more urgent than ever.
Like this year, the FY12 Budget is expected to allocate only Rs 31 billion to oil subsidies but, like this year, the central government’s oil subsidy bill is again expected to be an order of magnitude higher even if crude were to average $80 per barrel, absent further retail price deregulation. With inflation continuing to be high and sticky and not reducing despite the year-end base effect (we expect December WPI inflation to climb back up to above 8% driven by food inflation) the likelihood of significant retail price deregulation for petroleum products in the near future appears remote. Twice in two weeks, the Group of Ministers expected to discuss the issue of limited administered price increases for diesel and LPG issue has been deferred – suggesting that the political appetite for retail price increases does not exist in the current inflationary environment. Oil subsidies seem here to stay!
Furthermore, if crude prices continue to stay elevated or rise, the expected disinvestment of IOC could be pushed back even further, potentially affecting even FY12’s disinvestment targets.
As such, the risks to a fiscal deficit target of 4.8% of GDP next year are firmly to the upside. In the absence of any significant subsidy reform next year, we expect FY12 fiscal deficit to print closer to the 5.5% mark (5.9% net of asset sales) than the 4.8% mark.
Gross borrowing could touch Rs 5 trillion but OMOs and higher FII investment limits will cap bond yield
Even with a 4.8 % fiscal deficit target expected to be announced at the February budget, the government’s net borrowing requirement is expected to be Rs 3.8 trillion – about Rs 350 billion higher than this fiscal. However, with lower redemptions in the next fiscal, the central government’s gross borrowing requirements for FY12 are expected to be about Rs 4.5 trillion – almost identical to that of this year.
All this, however, is under the assumption that a 4.8% fiscal deficit is achievable. If, instead, the fiscal deficit prints close to 5.5%, as we expect it will, the government’s borrowing requirements could increase by as much as Rs 600 billion, and gross borrowing could exceed Rs 5 trillion.
The higher borrowing is likely to exert upward pressure on bond yields, especially if private sector credit growth picks up as the investment cycle gathers steam. However, authorities have several tools in their armory to counter this. We have already seen that the RBI’s decision to engage in Rs 480 billion of OMOs over a month has push the 10-year yield down by almost 20 basis points. More OMOs could be the order of the day next year as a means to cause reserve money to grow at 14-15% and ease the liquidity situation. In addition, once liquidity conditions stabilize, the SLR requirement for banks could potentially be increased back to 25% during the course of next fiscal. Finally, FII limits for government bonds could be increased again next year if another avenue of demand needs to be created. In sum, enough tools exist to keep yield-range bound in the 7.75-8.25 range over the next year. In contrast, continuing tight liquidity and stubbornly-high inflation resulting in 4-5 more rate hikes next year could result in a bear flattening of the yield curve.
A key risk to this scenario, however, is a sharp pick-up in the private investment cycle and non-food credit off-take. Given that several banks are holding government bonds well in excess of current SLR requirements, a sharp-pick in credit – in the wake of tight liquidity conditions – would force banks to accommodate the credit pick-up by either selling or reducing their incremental demand for government bonds causing yields to rise.
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