India’s Financial Economy: Post 3

This week we will evaluate India’s fiscal condition and I hope to bring out a few facets that I have learnt about recently and are not as widely discussed.

I will start with the central government and then proceed towards the state government and other off-balance sheet entities.

When looking at the central government’s finances these are the major drivers. I have specifically called out the impact of COVID for each of them:

1. Direct Taxes[55%]:The three main components of direct tax are Corporate Tax(32%) and Income Tax(23%). As you know the corporate tax rate was cut in the 2020 budget. The impact of this tax cut was estimated to between 15–20% of the corporate tax pool, but now we are also dealing with lower corporate profits owing to the lockdown. So the best case assumption for 2021 would be a 20% cut on 2019 corporate tax revenue. Income tax collections would be more stable.
2. CGST: We now have the data for GST collection for some period of the lockdown. Against an average total GST collection rate of about 1 Lakh crore, the March CST collection fell to 30,000 crore but has subsequently risen to 90,000 crore in May. The May figure likely includes some filings that couldn't be done in March/April hence the recurring rate is still lower. Gross GST collection in Q1 this year is down 40%. The pace of GST collection recovery is directly linked to the recovery in the real economy.
3. Customs and Excise[17%]: These are levers where the government has a lot more flexibility. Domestic industry lobbies are petitioning the government for hikes on customs duty on imports in order to support domestic industry. Similarly the government has increased excise on fuel in light of the sharp fall in crude. This is the online tax source that will go up this year.
4. Devolution to States: The devolution is done as per the formula defined by the 14th Finance commission which comes is prescribed at 42% post cost of collection. On an actual basis it comes to about 30–35% of the gross tax revenue. The 15th Finance commission has submitted its first report to the government but the process will likely get delayed until there is stability on tax collections.
5. Central Govt Revenue: This constitutes of the center's share of the tax collected and non-tax revenue sources. The primary non-tax revenues are dividend income from PSU’s, dis-investment proceeds and dividend from RBI.
6. Pay Allowances: This constitutes about 30% of the central govt’s total revenue.
7. Planned Revex: I have classified all subsidies, central govt plans, health and education programs into this. Cumulatively it works out to about 60% of the Govt’s income in a regular year. For FY21 this will go up, as much of the fiscal support provided by the government will accrue on this part of the income statement. Cumulatively they come to around 1.2–1.5% of GDP.
8. Capital Expenditure: This will likely remain within 18–20% of the central government’s income. So far it seems that this is the place where the government might have to curtail some spending. The impact of the rising tension with China on the defense spending is still not clear.
9. Interest Expenditure: This is a function of interest payment on existing debt stock and interest payment on fresh debt issued. It is evident that the central govt’t net borrowing would increase in a very large way (7–8% of GDP). RBI’s role in bringing down rates would play a role in reducing the yield at which this additional borrowing is raised. At 35% Interest Cost to Revenue is one of the highest amongst larger emerging markets.

In normal years the total tax revenue of the country normally stands between 10–12% of GDP. Here I’m talking about the tax collected the central govt’s tax mechanism. The share of this in today’s vertical devolution formula would come to around 7–8%. Adding Non-Tax revenues takes this to about 8–9% of GDP. Typically in periods of stress tax collection falls more than the contraction in nominal GDP but that is somewhat offset by the sharp rise in excise and customs duties. On the expenditure side the non-interest revenue expenditure stands at about 7-8% of GDP. This can potentially expand by upto 2% out of which 1.2–1.5% has already been announced. Capex is about 1.5% to 2% of GDP. Assuming that the lower end of Revenue Collection at 8% of GDP this leads to a 3.5% primary deficit. Interest payment will likely go up as a fraction of GDP to around 3.5–4% of GDP. This takes us to overall fiscal deficit of around 7% for the central government.

State Finances: The main components of state finances are Central Transfers [48%], S-GST [20%], State Level Taxes [20–25%] and Non-Tax Revenue [8%]. Post the implementation of the FRBM Act, states had brought down their fiscal deficits and it was consistently being maintained at sub 3% levels. This year the states have sought a relaxation of that limit to 5%, which has been granted by the central government subject to some conditions. States are fighting COVID at the frontlines and are bearing the bulk of the expenditure (healthcare and logistics) even though they have limited fiscal levers to increase revenues. Thus we expect that the states would borrow as much as possible and hit the 5% limit for this year.

Off Balance Sheet borrowing and contingent liabilities: As many of you are aware, the central government has many off balance sheet entities which borrow from the markets and NSSF and operate at the behest of the government. The largest of these entities are FCI, Indian Railway Finance Corporation, NHAI amongst others. Observers should pay extra attention to revenue expenditure being routed through entities like FCI, who do not report their financials in a timely manner. Now we come to contingent liabilities. The central government will likely have to infuse capital in PSU banks and PSU General Insurance companies since the equity capital at both places are below the regulatory minimum. The State Governments on the other hand are dealing with mounting losses at the power DISCOMs owing to the lockdown which affected revenues from high tariff industrial users. For the moment the central government has arranged for financing from PFC and REC to the tune of 90,000 crore against an implicit guarantee from the state governments.

Financing the Deficit

Next we have to consider how this deficit will likely be financed. National Income Accounting teaches us a simple equation: Savings + Current Account Deficit(CA) = Pvt Investment + Fiscal Deficit. The current account dynamics are not entirely at the hands of the government and at volatile times like this one can argue that countries are better off running a smaller current account deficit. Therefore if you ignore that component, this equation dictates that the overall savings of the economy has to be divided between the Government Sector and the Private Sector for investment. India’s financial savings rate was about 17% in FY19. This had come down from 20% in FY16 since the economy has been slowing down. Out of this 17%, 10% comes from corporations and 6–7% is from households. Corporations will certainly have less savings this year as they have lost about 2–3 months of revenue but had to meet most of their expenses. Households savings is uncertain at the moment, some categories of households will save more owing to risk aversion but there will be dis-saving at the bottom of the pyramid since since there has been a significant rise in unemployment. Thus it is safe to say that the overall savings rate would come down. Assuming that it ends up at 16% and the overall fiscal deficit (excluding off-balance sheet entities and contingent claims) stands at 12%, this implies simplistically that the government this year will ask for 75% of the financial savings of the economy. So far, we have not considered the role played by the RBI. RBI comes into the equation in two ways. First of all, the RBI holds about 15% of the Govt Bond outstanding and they have the capacity to expand the base money and buy more govt bond from the market. This has two effects, the RBI ends up holding more share in the outstanding govt bond and second this enables the RBI to bring down the G-Sec yields which enables the Govt to issue debt at lower yields and thus optimize their interest payments. The other channel is that when Banks are risk averse, instead of expanding their loan book by lending out incremental deposit inflows, they tend to park that money either in Govt Bonds (thus increasing SLR) or by parking that money with RBI in reverse repo. The Reverse Repo transaction requires the RBI then to provide collateral in the form of Govt bond, thus increasing RBI’s own appetite for Govt Bonds. These are some inbuilt counter-balancing mechanisms that naturally enables the govt to mop up more savings from the economy in crisis times such as these. The limit to RBI’s ability is imposed by inflation. As per the terms of the MPC, the RBI is duty bound to maintain inflation at 4–6% which would limit their ability to expand the base money.

Debt Dynamics

Even though most people tend to agree that the Government's fiscal situation is precarious, a common argument that people resort to: is that that doesn't matter since most of the government’s borrowing is in the domestic currency. Even if we buy that approach we would have to think about Debt Sustainability. A very optimistic view of Debt sustainability would be to argue that any level of debt is sustainable as long as the Debt to GDP is expected to come down. I’m enclosing below a simple accounting identify that gives us the relationship between Debt to GDP(d) of two periods with Primary Deficit(pb) and the differential between nominal growth rate(g) and interest rate on debt(r).

Debt Sustainability Formula

Lets understand where we stand on both these two fronts. Primary deficit in India on an average (post 1991) has been sub 1% and the 3–3.5% that it is likely to hit this year would the highest we have seen thus far. This number can only come down if the tax revenues increase, which are broadly dependent on higher collections of GST. Despite the G-Sec yields coming down, the gap between nominal growth rate and government interest rate is the highest in the post-91 era. As of December 2019, the weighted average yield on G-Sec outstanding stock was 6.7 %. The nominal growth rate pre-crisis was 7.2%. Moody’s expects the the FY21 Debt to GDP to hit 84%. This again is the highest level that India has seen so far. Therefore from then onwards the Debt to GDP ratio would have to come down. Even if growth and tax revenues come back, the government would have to limit expenses to create a Primary Surplus to bring the Debt to GDP to manageable levels.

I wanted to summarize this article with two high level observations. Firstly I think we must all recognize that as a country we have very limited fiscal space and therefore the clamor to demand more fiscal outlay from the government is self-destructive. At this point I want to critique a widely held belief that India is somehow better off because there is limited debt. This is another one of “This Time is Different” kind of arguments. All the financial crisis that we have had in India, and we have roughly had one every decade, has happened because of Fiscal Profligacy and we simply cannot ignore that hard evidence. In the past this used to be shrug under the carpet, because the RBI would automatically monetize the fiscal demand of the government leading to repeated Stagflation like conditions. Many of us may not understand this today, but take the time to talk to your parents and grandparents to understand how that feels like. The final and related point I wanted to make is that we need to restart the conversation around economic reforms and indeed that is the only way to bring India back to a sustainable growth path that will in turn stabilize our debt levels.