New daily cases of COVID-19 have fallen 80 per cent in three months, the economy is at 94 per cent of its pre-pandemic levels, and the Sensex is near the record 50,000 mark. Against this positive backdrop for India, what role could the government’s budget on February 1 and the RBI’s policy meeting on February 5 play?
To answer this, we first need to put India in a global context. As fiscal spending falls gently in the rest of the world, we expect it to remain unchanged and at elevated levels in India. And with inflation north of the 4 per cent target, we think India may be amongst the first to gently start raising interest rates.
With that, there is likely to be a changing of the guard between policymakers. Central bank officials may have been the key players in 2020 as they slashed interest rates. But the government will likely play a more prominent role in setting the contours for a growth recovery in 2021.
To explain why, we believe four large shifts are needed to sustain the recovery, and a closer look suggests each of these will need fiscal support.
One, while demand for goods is back to healthy levels, demand for services is still 30 per cent below normal and needs to catch up. A successful roll-out of the government’s vaccination drive will be necessary for this important shift to take place.
Two, as more activity restarts, there is likely to be a shift from rural spending to urban spending. The labourers who went back to their village homes during the lockdown may want to return to their city jobs, but some may find those jobs do not exist anymore. As a result, welfare benefits may need to be extended for a longer period.
Three, large firms and high-earners have fared much better than small companies through the pandemic, but it’s these tiny and informal enterprises that make up 85 per cent of the labour force, and whose health will be instrumental for a sustainable recovery. Again, a continuation of social welfare spending, particularly to support those at the bottom of the pyramid, will be important.
Four, a move from consumption to capital spending is important to raise the economy’s capacity to create jobs. But it may not come easily at a time when many private factories are idle. Public capex and structural reforms may need to take the lead here.
Can the budget accommodate all of this, and yet show some responsible fiscal consolidation? We think it can.
We expect government expenditure to remain elevated at 15.4 per cent of GDP. This will enable Delhi to spend generously on the vaccination rollout, social welfare schemes and capex. In particular, we forecast the capex outlay to rise by 0.5 per cent of GDP. That’s because with 2020 mired in a lockdown, 2021 could see two years’ worth of replacement capex.
And despite elevated government spending, we expect the fiscal deficit to fall gradually to 5.8 per cent in 2021-22 from 7 per cent in 2020-21. That’s thanks to a sharp rise in tax revenues — around 30 per cent (year-on-year), double the year’s nominal GDP growth. A disproportionate amount of business is moving to the larger and listed firms. The formalisation underway can lift tax revenues in the short run. Higher income from disinvestments could also help, particularly in view of the buoyant capital markets.
As growth continues to rebound and gets increasing support from fiscal policy, attention is likely to turn to inflation. If 2021 turns out to be a year when pent-up demand for services is released, it could come with a negative side effect of rising services inflation. Service providers tend to raise prices once a year. Given that this wasn’t possible in 2020, they may double the increase in 2021.
Also, inequality can be inflationary. High-earners, who have done well through the pandemic, tend to consume more services, like travel and education, than goods. Add to this elevated commodity prices, and high inflation could well be a problem. We see inflation averaging 5.0-5.5 per cent in 2021-22, above the 4 per cent target but below the 6 per cent upper limit of the tolerance band. How would the RBI react to above-target inflation?
Perhaps, one way forward for the RBI would be to differentiate between a short-term cyclical recovery and medium-term potential growth. The RBI could manage liquidity in line with the cyclical recovery. As pent-up demand leads to an economic rebound, the RBI can gradually draw some of the excess liquidity out of the system. The aim would be to gradually nudge overnight lending rates up and closer to the benchmark repo rate of 4 per cent. This would also help push real rates out of negative territory, which in our view is an important step to keeping inflation contained.
But, perhaps, the RBI will not tinker with the benchmark repo rate yet. We believe that India’s potential growth has fallen throughout the pandemic. As long as investment remains low, the RBI may want to keep the repo rate at the current benign level of 4 per cent.
Just as inflation forecasts are critical for an inflation targeting regime, growth forecasts will become important for fiscal and monetary policy as the country navigates its way out of the pandemic.
This article first appeared in the print edition on January 29, 2021 under the title ‘Navigator in chief’. The writer is chief India economist, HSBC Securities and Capital Markets (India) Pvt Ltd.
