HSBC- India Perspectives- Fiscal food for thought

 Revenues are running well-below

budgeted levels and spending above

 As a result, the H1 budget deficit has

reached 80% of the annual target

 Spending will, therefore, have to be

squeezed in H2 to hit the deficit target

A spending squeeze please

Despite the last couple of months of relative calm, India has

not completely shaken its vulnerabilities to Fed tapering. It

will, therefore, be important to further guard against spillovers

by sticking to monetary and fiscal policy tightening, and

stepping up implementation of structural reforms. This is not

an easy task at this juncture, given the soft economy and

upcoming elections.

Delivering fiscal tightening will likely be a challenge. Revenues

commanded just 35% of the full-year budget target during the

first half of FY2014 (April-September) against the roughly 40%

normally achieved. Meanwhile, expenditure execution has been

faster than normal. As a result, the cumulative fiscal deficit has

reached 3.8% of GDP midway through the fiscal year, around

80% of the full-year target of 4.8% of GDP.

To address this, the government has announced expenditure

rationalisation measures. Steps to mobilise more dividend

payments have also been flagged. Despite this, we believe there

will be a need for further spending compression to meet the

deficit target. Ideally, high-quality steps such as deregulation of

diesel prices would be introduced, but that is not feasible in a

pre-election year, in our view. However, an ad hoc hike in

diesel prices is possible. In addition, the government will have

to take broad-brushed steps to rein in spending and will likely

also resort to postponing payments to the following fiscal year.

However, the Minister of Finance has put a line in the sand

when it comes to the deficit and he last year delivered on his

promises. We, therefore, believe that the deficit will end up

quite close to the target, but slightly higher at 5.1% of GDP.

This figure even factors in spending compression worth around

1% of GDP during the latter half of the fiscal year, which will

shave at least 0.5-0.7% off GDP growth and, therefore, make it

difficult for GDP to recover further in annual terms near term.

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Slipping relative to targets

The Minister of Finance Chidambaram faces the

difficult task of having to pull back on the fiscal

reins during an election year.

This is necessary to bring fiscal policy on a

sustainable path, help contain inflation and the

current account deficit, and to crowd in private

sector investment. Moreover, external factors are

adding to the need for tightening. Rating agencies

have fired a warning shot and markets are less

forgiving with Fed tapering just around the corner.

The Minister of Finance has drawn a line in the

sand when it comes to this fiscal year’s 4.8%

deficit target and has promised to deliver. He has

a lot of credibility to hang his promises on, which

he has earned over the years and also last year

when the deficit reached a lower-than-budgeted

4.9% of GDP. This followed significant spending

compression during the second half of the fiscal

year, including some postponement of spending to

this fiscal year.

We believe this effort will have to be repeated this

year, but the task has been made more difficult by

the slowdown in growth and, therefore, cyclical

weakening in tax revenue collections. Moreover,

the targets set for divestment, spectrum sales, and

subsidies were ambitious, and will likely prove

difficult to achieve.

This is already evident from the fiscal

performance so far this year. Midway through the

fiscal year, tax revenues have risen by just 4.7%

y-o-y versus 15.3% at the same time last year and

the 19.2% assumed in the budget for the full year.

Tax revenues from customs, excise duties and

corporate taxes have been particularly poor.

Moreover, a significant portion of non-tax

revenues have yet to be realised and the prospects

for catching up are not good, in our view.

On the back of this, revenues have reached just

35% of the full-year budget target during the first

half of the fiscal year. This is below the 40%

typically achieved mid-way through the fiscal

year (Chart 1).

Meanwhile, expenditures are rising faster than

normal. Expenditures during the first half of the

fiscal year reached 49% of the total annual

budget, which is above what is typically seen at

this time of the year (Chart 2).

Moreover, the execution of spending has been

uneven across spending categories. For example,

plan capital expenditures have only reached

around 38% of the full-year target so far, while

non-plan current expenditures are at 52%.

The result of all of this is that the fiscal deficit for

the first half of the year has already reached 3.8%
of GDP1
, around 80% of the full-year budget
target of 4.8%.
Even factoring in a pickup in tax and non-tax
revenues during the second half of the fiscal year,
we expect total revenues to rise by just 8.6%
y-o-y against the 23% assumed in the budget. This
implies that the deficit target will not be met
without significant spending cuts relative to the
budget. Not an easy task at this point in the
election cycle, in our view.
A need for spending squeeze
While not an easy task, the Minister of Finance
has some options and he has executed some of
these already.
On 18 September, the Ministry of Finance took
measures to rationalise selective expenditure
items. Some of these measures include a 10% cut
in certain non-plan expenditure items, which
would partly be achieved through bans on holding
conferences abroad, purchases of vehicles, and on
creation of posts. Also, expenditure in the final
quarter will be capped at 33% of budget
allocation. In addition, a cap of 15% of total
budget will apply for the last month of the fiscal
year – March 2014.
______________________________________
1
Calculated as cumulative fiscal deficit for April-September as a
percentage of annual FY 2014 nominal GDP forecast by HSBC
Deregulating diesel prices would help reduce the
subsidy bill, but it is highly unlikely at this point
in the election cycle, in our view. Even with a
continuation of the monthly INR0.50/litre hike in
diesel prices, we estimate that the fuel subsidy bill
will be INR300bn (0.3% of GDP) higher than
budgeted, absent further steps.
Also, if the rupee depreciates further, it could
quickly raise the subsidy bill in the absence of
diesel price hikes (Chart 4). Every one rupee
increase in the rupee-dollar exchange rate (rupee
depreciation) will increase the under-recovery by
INR80bn and the subsidy bill by INR40bn on a
full-year basis, assuming that the government
pays for half of the under-recovery incurred by oil
marketing companies.
However, it is highly likely that a significant
portion of the subsidy payment will be pushed to
the following year, which means it will not hurt
this year’s cash deficit. However, this is an
accounting manoeuvre and the government is
essentially building up arrears.
If the government instead bites the bullet and
makes an ad hoc INR5/litre adjustment to diesel
prices in December, the deficit can be lowered by
around INR60bn in the current fiscal year, around
0.1% of GDP. On a full-year basis it will be four
times as much. It is possible the government mayresort to this, although this is far from a “slam
dunk” with election fast approaching.
Cuts in non-essential current spending, other than
subsidies, and capital expenditure are more
realistic options. In the latter case, this can partly
be achieved through delays to projects or to
payments. However, the economy is supply-side
constrained, which means that investments are
desperately needed, especially when it comes to
infrastructure. This makes this an unfortunate
choice from a growth and inflation perspective.
Nevertheless, we expect that the government will
have to scale back capital outlays quite notably
and would also not be able, in any case, to fully
execute the budget envelope as we have seen in
previous years. However, the government should
try to be selective about which projects to push
back and focus on non-essential current and
capital expenditures to limit the growth impact.
Limited revenue options
The cyclical downturn limits the ability of the
government to raise tax rates, other than taking
steps to improve tax administration and, through
this, tax collection.
The divestment targets set at the beginning of the
year will be difficult to achieve, as mentioned
earlier. So far, the government has only collected
INR13.25bn against the budget target of
INR550bn. Finance ministry officials have
reportedly told news agencies that six firms have
been lined up for stake sales in the current fiscal
year, including 10% of Oil India and Coal India.
However, reportedly these sales could raise
INR240bn, less than half the annual target.
The budget target for spectrum sales of INR408bn
is another tough one, in our view. Two rounds of
auctions held so far have not brought in anything
material. We have a conservative estimate of
INR150bn based on the recurring periodical
licensing fees. Another auction is likely in January
2014. To improve its success, the base price may
be reduced. However, the auction could face legal
challenges, with a case pending in the court. It is,
consequently, difficult to be too optimistic about
any upside from this revenue source.
Lower spending = lower
growth
We believe the budget deficit target will clearly not
be easy to achieve. Taking our revenue assumptions
into account, including the under-performance of
non-tax revenues, the government will have to cut
non-subsidy spending by close to 1% of full-year
GDP. This will shave at least 0.5-0.7% off annual
GDP growth2
. Spending on subsidies is expected to
be higher than budgeted, so this will partly
compensate for the spending compression of other
items. This implies that the net impact on growth
will be around half (0.2-0.4%).
However, this net expenditure compression will
likely be concentrated in the second half of
FY2014. The growth drag will, therefore, fall in
the 0.5-0.7% range during the second half if the
cuts kick in from the third quarter of the fiscal
year. This suggests that it will prove difficult to
achieve a further recovery in annual GDP growth
during the second half. We believe sub-5%
growth is, therefore, still in the cards for FY2014.
It is worth pointing out that this still assumes that
the fiscal deficit will come in at 5.1% of GDP.
Reaching the 4.8% target would, therefore, imply
even deeper spending cuts and more headwinds for
growth. Even if this is partly achieved through the
delay of payments to oil marketing companies or for
infrastructure projects, the companies in question
would likely have to alter their spending plans. It
will, consequently, still have an impact growth.