After being criticised through much of 2020 for announcing measly fiscal support packages despite stringent lockdowns, it appears that the budget performed a volte-face and turned to fiscal activism. To be sure, the higher fiscal deficit partly reflects the government’s move towards greater transparency, as higher loans of the Food Corporation of India are now counted above-the-line. Yet, even if the move towards transparency had not materialised, the fiscal deficit would have been higher, at around 8.1 per cent of GDP in FY21 and 6.1per cent in FY22, by our estimates.
The revised targets suggest government spending will be frontloaded and rise by 55-60 per cent, year-on-year, in the final quarter of FY21. After adjusting for the higher food-subsidy, revenue expenditure will be elevated at around 12.5 per cent of GDP in FY22, 1-2 percentage points higher than the historical average, while capex is slated to inch up to 2.5 per cent of GDP in FY22 — levels last seen in the early 2000s. No matter how one slices the budget, elevated government support is the key message.
A number of factors may have resulted in this change in strategy. First, spending more during lockdowns would have resulted in smaller multiplier effects, given higher precautionary savings in the private sector. With the economy now normalising, government spending is likely to have a greater bang for the buck. Second, the government has likely shed its sovereign rating-related caution. The Economic Survey had argued that higher growth is a pre-condition for debt sustainability, not vice versa. The budget walked this talk.
Yet, even as the government plans to spend more, this is not a universal fiscal stimulus. The composition of spending is skewed more towards higher capital expenditure than revenue expenditure. In particular, the push on growth is targeted towards the more productive infrastructure sector that adds to both demand (in the short term) and supply (in the long term).
We know that capex has higher multiplier effects. According to a past study by the RBI, the short-term (one-year) multiplier of capex (general government) is around 0.47, while the longer-term multiplier is 2.41. Taken at face value, the higher-than-expected capex spending could boost GDP growth by 0.1-0.3 percentage points (pp) in the short term and by 0.7-1.3pp over the medium term, relative to the baseline.
The idea behind this strategy is that higher public investment will crowd in private investment, boost consumption and form the foundation for a more durable growth recovery over the medium term. In turn, this will buoy nominal GDP growth and tax revenues, and enable fiscal consolidation and debt sustainability over time — a pet peeve of rating agencies. Will this strategy work?
It may be hard to please the rating agencies, given their focus on medium-term fiscal finances, but the budget will give a booster shot to growth. With COVID-19 in check, the economy has already normalised at a faster-than-expected pace. Front-loaded and higher government spending, the lagged impact of easier financial conditions, faster global trade and ongoing vaccinations should all combine to lead to a sharp pickup in cyclical growth; we expect real GDP growth to rise by 13.5 per cent, year-on-year, in FY22. The multiplier effects from higher capex should also spill into FY23.
Beyond that, there is greater uncertainty, as a durable cycle requires the corporate sector to shed its focus on debt deleveraging and hunt for growth. This animal spirit, in turn, requires many initial conditions to fall in place that are much harder to predict.
The role of monetary policy will also change. Through 2020, the burden of uplifting growth had largely fallen on monetary policy, while fiscal policy had taken a back seat. This appears to be changing with fiscal policy taking a more proactive role in driving growth. For now, with growth still in the early stages of a recovery and demand-side price pressure low, monetary policy mainly needs to nurture the nascent green shoots of growth and ensure smooth government borrowing. However, as growth improves, the easy liquidity conditions will need to be normalised; we expect early steps in this direction later in the year.
Policy normalisation is often feared, but it is, in fact, a good sign that the economy is returning to normal after the pandemic-inflicted shock. The hope is that this is not the old slow normal, but a new, and brighter, normal.
This article first appeared in the print edition on February 4, 2021 under the title ‘A change of strategy’. The writer is chief economist for India and Asia ex-Japan at Nomura