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India’s pesky twins
India’s fiscal and current account deficits have been a chronic stigma on its
macro. Investors and Indian policymakers selectively and occasionally get
worried about them, depending on whether the size complicates macro
management and/or financing becomes a worry. The improving trend in
fiscal deficit reversed due to the counter-cyclical measures to soften the blow
from the global financial crisis, but the consolidation in the post-recovery
phase has been too slow. Higher government borrowing has also made the
transmission of the aggressive monetary tightening by the RBI less effective.
Despite the chronic fiscal worries, India has avoided a crisis since 1991, partly
because of declining government’s debt/GDP and the absence of foreign
currency borrowing to finance the fiscal deficit. India has had to calibrate
macro policies taking into account the flip-flops in capital inflows. Lower
crude oil price will have a favourable impact on the deficits but higher risk
aversion could also lower capital inflows. India has continued to liberalise
capital flows despite global uncertainties. Overall, the deficits warrant close
tracking so that they don’t slip into unsustainable territory, especially in the
current topsy-turvy world of global finance.
Twin deficits at play
India is unique in Asia for posting chronic shortfall in the fiscal and the current
account balances. Indeed, the sum of the consolidated (centre + states) fiscal
deficit (FD) and the current account deficit (CAD) was almost 10% of GDP in
FY11 (Figure 1). The CA deficit is significantly affected by India’s dependence
on crude oil, which accounts for almost 30% of total imports
The two deficits are related to each other according to the accounting identity
shown below:
(G - T) = (S - I) - (X - M)
In the above identity, G is government spending, T is government revenue, S
and I are private sector saving and investment, respectively, and (X - M) refers
to net exports. Thus, the government budget deficit, (G - T), must be equal to
the surplus of savings over investment plus the trade (or current account)
deficit, - (X - M).
CAD AND FD ARE RELATED
Under floating exchange rates, any deficit or surplus in the current account must
be balanced by an equal and opposite surplus or deficit in the capital account. Thus,
G - T = (S - I) + net capital inflows
Consequently, a budget deficit must be financed either by an excess of saving
over investment (S - I), or by borrowing from abroad. A large FD also
adversely affects India’s ambition of higher sustainable economic growth.
Posting chronic twin deficits increases the dependence on foreign capital,
which in turn can make the economy vulnerable to swings in global capital
flows. Importantly, the Indian government does not borrow internationally by
issuing foreign currency sovereign bonds, but it has been liberalising the
capital account of the balance of payments so as to attract more foreign savings
for the non-government sector.
GOVERNMENT DOESN’T
BORROW INTERNATIONALLY
TO FINANCE FISCAL DEFICIT
It is common for growing emerging economies to have saving-investment gaps,
but what constitutes sustainable thresholds for FD and CAD vary across
countries. Still, the Indian economy is exposed to swings in foreign capital and
hence the need to ensure that the CAD does not exceed 2.5-3% of GDP and
that there is a sustained reduction in the FD.
Both deficits are partly affected by changes in global price of crude oil. The
impact on the fiscal is a policy choice to live with higher subsidy bill by
avoiding a higher pass-through to local fuel prices. On our sensitivity analysis,
a USD10/bbl increase (decrease) in crude oil prices widens (narrows) the FD
and the CAD by around 0.2ppt of GDP and 0.5ppt of GDP, respectively. The
impact of the recent decline in crude oil price will be favourable provided the
decline is more than the depreciation of INR against USD. So far, Brent and
CRB index have corrected by around 20% from their respective peaks while
INR has depreciated by around 11%.
BOTH DEFICITS ARE PARTLY
AFFECTED BY CHANGES IN THE
PRICE OF CRUDE OIL
Fiscal consolidation is a must
Weak fiscal dynamics have always been India’s Achilles’ heel. The weakness
has been aggravated by the emergence of coalition politics at the national level
that have prompted various governments to adopt a more myopic view of
public finances. Unlike other Asian economies, the states in India enjoy a lot of
fiscal autonomy and the federal government normally cannot enforce any
discipline directly. Further, the ruling UPA government appears to favour using
the fiscal pump for political advantage, often under the banner of “inclusive” or
“redistributive” initiatives, some of which have been announced despite the
concerns about their impact on macro management.
There are two key issues with India’s FD: (1) slippage following the global
finance crisis (GFC) and the disappointingly slow post-recovery pace of fiscal
consolidation (Figure 2); and (2) sustainability of government debt
Since early 2000s, the trend in India’s FD has had three phases:
Phase 1 - Pre-GFC: Fiscal indicators were improving until the GFC erupted
(the full impact of the hit from the GFC was captured in FY09). High
economic growth, some spending restraint and the federal government
adopting fiscal responsibility legislation allowed the federal government’s
fiscal deficit to shrink to 2.6% of GDP in FY08 from 5.7% in FY01. The
consolidated FD improved to 4.1% of GDP from 9.5% over the same time
period, partly helped by states adopting a state value-added tax, which boosted
their revenues.
FISCAL DEFICIT-GDP WAS
IMPROVING UNTIL GFC…
Phase 2 - Response to GFC: This covered the period FY09 to FY10. Two
factors played an important role in the reversal of the improving trend in the
FD during this phase: (1) the payout of the Sixth Pay Commission (SPC)
beginning late 2008; and (2) counter-cyclical fiscal measures to cushion the hit
to the economy from the GFC. The combined impact raised the federal
government and the consolidated FDs to 6.4% of GDP and 9.5% of GDP,
respectively, in FY10.
…FISCAL RESPONSE TO GFC
PUSHED UP THE FISCAL
DEFICIT…
Phase 3 - Post GFC: This phase, which began in FY11, marked the post-GFC
effort to consolidate the fiscal position as the Indian economy recovered from
the fallout of the GFC. However, the government’s efforts towards fiscal
consolidation have been weak and the fiscal laxity has contributed to the
subsequent inflation challenge. In FY11, the government enjoyed a one-off
windfall of around INR650bn (0.8% of GDP) from the 3G/WMA auction,
which allowed the final FD to come in at 4.7% of GDP, lower than
government’s revised forecast of 5.1%. In the coming years, India will have to
show more spending discipline and also undertake reforms to boost revenue.
The FY12 FD of 4.6% of GDP that was announced in February (CLSA: -5.2%
of GDP) was ambitious to start with as it was under-budgeted for subsidies, as
is typically the case with India’s budgets when they are announced. Figure 3
shows how the monthly FD has evolved over the course of the fiscal year. Of
importance is that the reported federal government’s FD in April-August of
66.3% of the full-year target announced in the FY12 Budget is partly biased
because of exceptionally high tax refunds that were packed in the early months
of FY12. This lowered the net tax intake of the government, but should iron out
over the course of the year, although the government will miss its FD target.
Lower divestment and higher subsidy bill will be negative for the FY12 FD,
but there will also be areas, such as NREGA, where spending will be much
lower than budgeted. Also, the hit to revenue collection will be less pronounced
than is typically expected as the FY12 Budget was based on a conservative
14% growth in nominal GDP, while the actual outcome is likely to be around
17%.
SPENDING WILL BE LOWER IN
SOME AREAS BUT OVERALL
FISCAL SLIPPAGE STILL LIKELY
Gross direct tax collection in April-August rose by an impressive 25.9% YoY,
and indirect tax collection increased by nearly 24%, while the Budget assumed
growth in gross tax revenue of 18.5%. While growth will surely moderate
owing to the slowing economy, tax collection has been favourably affected by
higher imports, still-high inflation and moderation in economic growth that is
not as severe as what the industrial production suggests.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
India’s pesky twins
India’s fiscal and current account deficits have been a chronic stigma on its
macro. Investors and Indian policymakers selectively and occasionally get
worried about them, depending on whether the size complicates macro
management and/or financing becomes a worry. The improving trend in
fiscal deficit reversed due to the counter-cyclical measures to soften the blow
from the global financial crisis, but the consolidation in the post-recovery
phase has been too slow. Higher government borrowing has also made the
transmission of the aggressive monetary tightening by the RBI less effective.
Despite the chronic fiscal worries, India has avoided a crisis since 1991, partly
because of declining government’s debt/GDP and the absence of foreign
currency borrowing to finance the fiscal deficit. India has had to calibrate
macro policies taking into account the flip-flops in capital inflows. Lower
crude oil price will have a favourable impact on the deficits but higher risk
aversion could also lower capital inflows. India has continued to liberalise
capital flows despite global uncertainties. Overall, the deficits warrant close
tracking so that they don’t slip into unsustainable territory, especially in the
current topsy-turvy world of global finance.
Twin deficits at play
India is unique in Asia for posting chronic shortfall in the fiscal and the current
account balances. Indeed, the sum of the consolidated (centre + states) fiscal
deficit (FD) and the current account deficit (CAD) was almost 10% of GDP in
FY11 (Figure 1). The CA deficit is significantly affected by India’s dependence
on crude oil, which accounts for almost 30% of total imports
The two deficits are related to each other according to the accounting identity
shown below:
(G - T) = (S - I) - (X - M)
In the above identity, G is government spending, T is government revenue, S
and I are private sector saving and investment, respectively, and (X - M) refers
to net exports. Thus, the government budget deficit, (G - T), must be equal to
the surplus of savings over investment plus the trade (or current account)
deficit, - (X - M).
CAD AND FD ARE RELATED
Under floating exchange rates, any deficit or surplus in the current account must
be balanced by an equal and opposite surplus or deficit in the capital account. Thus,
G - T = (S - I) + net capital inflows
Consequently, a budget deficit must be financed either by an excess of saving
over investment (S - I), or by borrowing from abroad. A large FD also
adversely affects India’s ambition of higher sustainable economic growth.
Posting chronic twin deficits increases the dependence on foreign capital,
which in turn can make the economy vulnerable to swings in global capital
flows. Importantly, the Indian government does not borrow internationally by
issuing foreign currency sovereign bonds, but it has been liberalising the
capital account of the balance of payments so as to attract more foreign savings
for the non-government sector.
GOVERNMENT DOESN’T
BORROW INTERNATIONALLY
TO FINANCE FISCAL DEFICIT
It is common for growing emerging economies to have saving-investment gaps,
but what constitutes sustainable thresholds for FD and CAD vary across
countries. Still, the Indian economy is exposed to swings in foreign capital and
hence the need to ensure that the CAD does not exceed 2.5-3% of GDP and
that there is a sustained reduction in the FD.
Both deficits are partly affected by changes in global price of crude oil. The
impact on the fiscal is a policy choice to live with higher subsidy bill by
avoiding a higher pass-through to local fuel prices. On our sensitivity analysis,
a USD10/bbl increase (decrease) in crude oil prices widens (narrows) the FD
and the CAD by around 0.2ppt of GDP and 0.5ppt of GDP, respectively. The
impact of the recent decline in crude oil price will be favourable provided the
decline is more than the depreciation of INR against USD. So far, Brent and
CRB index have corrected by around 20% from their respective peaks while
INR has depreciated by around 11%.
BOTH DEFICITS ARE PARTLY
AFFECTED BY CHANGES IN THE
PRICE OF CRUDE OIL
Fiscal consolidation is a must
Weak fiscal dynamics have always been India’s Achilles’ heel. The weakness
has been aggravated by the emergence of coalition politics at the national level
that have prompted various governments to adopt a more myopic view of
public finances. Unlike other Asian economies, the states in India enjoy a lot of
fiscal autonomy and the federal government normally cannot enforce any
discipline directly. Further, the ruling UPA government appears to favour using
the fiscal pump for political advantage, often under the banner of “inclusive” or
“redistributive” initiatives, some of which have been announced despite the
concerns about their impact on macro management.
There are two key issues with India’s FD: (1) slippage following the global
finance crisis (GFC) and the disappointingly slow post-recovery pace of fiscal
consolidation (Figure 2); and (2) sustainability of government debt
Since early 2000s, the trend in India’s FD has had three phases:
Phase 1 - Pre-GFC: Fiscal indicators were improving until the GFC erupted
(the full impact of the hit from the GFC was captured in FY09). High
economic growth, some spending restraint and the federal government
adopting fiscal responsibility legislation allowed the federal government’s
fiscal deficit to shrink to 2.6% of GDP in FY08 from 5.7% in FY01. The
consolidated FD improved to 4.1% of GDP from 9.5% over the same time
period, partly helped by states adopting a state value-added tax, which boosted
their revenues.
FISCAL DEFICIT-GDP WAS
IMPROVING UNTIL GFC…
Phase 2 - Response to GFC: This covered the period FY09 to FY10. Two
factors played an important role in the reversal of the improving trend in the
FD during this phase: (1) the payout of the Sixth Pay Commission (SPC)
beginning late 2008; and (2) counter-cyclical fiscal measures to cushion the hit
to the economy from the GFC. The combined impact raised the federal
government and the consolidated FDs to 6.4% of GDP and 9.5% of GDP,
respectively, in FY10.
…FISCAL RESPONSE TO GFC
PUSHED UP THE FISCAL
DEFICIT…
Phase 3 - Post GFC: This phase, which began in FY11, marked the post-GFC
effort to consolidate the fiscal position as the Indian economy recovered from
the fallout of the GFC. However, the government’s efforts towards fiscal
consolidation have been weak and the fiscal laxity has contributed to the
subsequent inflation challenge. In FY11, the government enjoyed a one-off
windfall of around INR650bn (0.8% of GDP) from the 3G/WMA auction,
which allowed the final FD to come in at 4.7% of GDP, lower than
government’s revised forecast of 5.1%. In the coming years, India will have to
show more spending discipline and also undertake reforms to boost revenue.
The FY12 FD of 4.6% of GDP that was announced in February (CLSA: -5.2%
of GDP) was ambitious to start with as it was under-budgeted for subsidies, as
is typically the case with India’s budgets when they are announced. Figure 3
shows how the monthly FD has evolved over the course of the fiscal year. Of
importance is that the reported federal government’s FD in April-August of
66.3% of the full-year target announced in the FY12 Budget is partly biased
because of exceptionally high tax refunds that were packed in the early months
of FY12. This lowered the net tax intake of the government, but should iron out
over the course of the year, although the government will miss its FD target.
Lower divestment and higher subsidy bill will be negative for the FY12 FD,
but there will also be areas, such as NREGA, where spending will be much
lower than budgeted. Also, the hit to revenue collection will be less pronounced
than is typically expected as the FY12 Budget was based on a conservative
14% growth in nominal GDP, while the actual outcome is likely to be around
17%.
SPENDING WILL BE LOWER IN
SOME AREAS BUT OVERALL
FISCAL SLIPPAGE STILL LIKELY
Gross direct tax collection in April-August rose by an impressive 25.9% YoY,
and indirect tax collection increased by nearly 24%, while the Budget assumed
growth in gross tax revenue of 18.5%. While growth will surely moderate
owing to the slowing economy, tax collection has been favourably affected by
higher imports, still-high inflation and moderation in economic growth that is
not as severe as what the industrial production suggests.
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