In this post, Niranjan Rajadhyaksha contends that in the first Budget of the second Narendra Modi administration, Finance Minister Nirmala Sitharaman has made an honest attempt to address some of the stress points in the Indian economy – but a lot depends on the sanctity of her Budget numbers.

The first Budget of the second Narendra Modi administration was presented by Finance Minister Nirmala Sitharaman on 5 July against the backdrop of two dominant macroeconomic challenges. The first challenge was to respond to the sharp cyclical slowdown that has brought economic growth to its lowest level in five years. The second challenge was to rebalance the Indian economy by spurring investment rather than consumption growth. 

Neither is an easy task. The ability to re-energise the economy with a fiscal stimulus was limited given the fact that government borrowing is already soaking up most of the annual financial savings of households. One indication of fiscal fatigue is that the spread between the repo rate and the 10-year government bond yield is several notches above its average level over the past few years, despite the recent liquidity enhancement measures undertaken by the Reserve Bank of India (RBI). 

Domestic economic activity has also been squeezed by the slow recovery in the banking sector combined with the recent crisis in shadow banks. Credit flows have been impaired. The Finance Minister has done well to provide fresh capital of Rs. 70,000 crore (Rs. 700 billion) to public sector banks as well as thrown a six-month liquidity lifeline to financially sound Non-Banking Financial Companies (NBFCs), despite the inevitable moral hazard problems. As an aside, it is not clear how financial soundness can be identified without an asset quality review of NBFCs conducted by the banking regulator. 

The task of reviving the private sector investment cycle is also a tricky one given the balance sheet stress in companies as well as banks. The recent signals offer reason for hope. The latest Financial Stability Report by the RBI shows that bank non-performing assets (NPAs) have finally begun to come down as a proportion of total loans. The corporate sector continues to deleverage. Capacity utilisation as measured by the Indian central bank is still low, but gradually improving. 

The lack of fiscal space for a meaningful increase in public investment means that the Finance Minister has focused on incentivising private sector investment. The cut in corporate tax for all enterprises with an annual turnover of up to Rs. 400 crore (Rs. 4 billion) could be seen, in tandem with lower interest rates, as part of a strategy to bring down the cost of capital over the next five years. The proposals to ease restrictions on foreign direct investment (FDI) are also an attempt to boost investment activity given the current constraints on domestic investment spending. 

The Finance Minister did not outline any overarching macroeconomic strategy in her maiden Budget speech, but one can tease two larger themes from recent macroeconomic policy decisions – an expectation that the stimulus will come from the monetary rather than the fiscal side and the attempt to pull in foreign savings given the recent slide in the domestic savings rate. 

First, the fiscal deficit target has been kept at a conservative level in the hope that this gives enough assurance for the Monetary Policy Committee (MPC) to cut interest rates once again in August. Meanwhile, the RBI has been easing liquidity in the domestic money market by increasing the size of its balance sheet, so that monetary policy transmission improves.

Second, the fall in the financial savings of households as a proportion of gross domestic product (GDP) is apparently being countered with a greater dependence on foreign savings; the two foreign exchange swaps done by the RBI earlier this year as well as the risky plan to float a sovereign bond in the international market should be seen in this context. 

A lot depends on the sanctity of the Budget numbers. There is ample reason to be sceptical. The Finance Minister took the extraordinary decision to leave out any mention of the main fiscal numbers in the Budget speech – but the Budget documents uploaded by her ministry tell us a lot. The Budget seems reasonable at first glance, since the budget estimates (BE) for tax revenues for 2019-20 have been built on the revised estimates (RE) for 2018-19. It looks far less reasonable when the RE are replaced with the provisional estimates for tax collections that have been shared in the second volume of the Economic Survey. 

Tax collections were weak in 2018-19 as a result of many factors, but especially the teething troubles with the goods and services tax (GST). The provisional estimates for gross tax revenue as a percent of GDP in 2018-19 were a percentage point lower than the budget estimates – 10.9% rather than 11.9%. In fact, gross tax revenues in the previous financial year grew slower than nominal GDP growth – bringing tax buoyancy down to 0.8. The decision to hike select direct as well as indirect tax rates could partly be explained by such pressure on revenues, especially since the scope to further expand the tax base after demonetisation and GST seems limited for now. 

The Budget is implicitly assuming a tax buoyancy of 1.6 if we calculate revenue growth based on provisional rather than revised estimates. My quick calculations suggest that there could be a tax shortfall of around Rs. 1 trillion – or 0.5% of GDP – if one assumes a more realistic tax buoyancy of 1.2. That could also be the potential fiscal slippage unless the government decides to compress expenditure later in the year. The problem will likely be exacerbated in case nominal GDP growth is lower than the 11% rate used in the process of budget making. 

Finance Minister Nirmala Sitharaman has made an honest attempt to address some of the stress points in the Indian economy – but a lot depends on the sanctity of her Budget numbers.