Global Research | 16 February 2016
· Government’s decision on the FY17 fiscal deficit target is a close call
· Adherence to the original fiscal deficit target of 3.5% of GDP will require slashing productive expenditure
· Growth headwinds may be partially addressed by adopting alternative policies
· Rates market concerned about a likely wider FY17 fiscal deficit target
Watching the fiscal deficit target
Will the finance minister adhere to the original fiscal consolidation plan or slow the pace of consolidation on ? This is a close call. India’s government originally targeted a fiscal deficit of 3.5% of GDP for FY17 (year starting April 2016) and 3.0% in FY18. However, with increased claims on central-government finances (pay increases for public-sector employees) and a gradual growth recovery, pressure has increased to slow the pace of fiscal consolidation. We expect the government to target a fiscal deficit of 3.7% of GDP. However, with the Reserve Bank of India (RBI) strongly advocating the merits of adhering to the original plan even if it slows growth in the short run, we think the likelihood of the government deciding to stick to its fiscal consolidation plan despite all odds has increased.
We agree with the merits of adhering to the original fiscal consolidation plan. The need to maintain and enhance policy credibility is strong given current global market volatility. We believe revising the fiscal consolidation plan for a second straight year will erode investor confidence in the government’s commitment to implementing such plans. A slower pace of fiscal consolidation may also result in a negative impact on the aggregate fiscal deficit and public debt, if states, which have been fiscally prudent so far, decide to follow a similar path.
However, the 0.4% of GDP reduction in productive expenditure necessary to achieve the 3.5% fiscal deficit target in FY17 may lead to growth headwinds. We do not rule out a further reduction in such expenditure in FY18 as the government attempts to narrow the fiscal deficit to 3.0% of GDP that year. Public investment has driven the country’s economic recovery in the past 18 months, and this will likely be curtailed to achieve this reduction. With private-sector investment unlikely to come to fruition soon, we believe the nascent recovery may suffer serious setbacks.
If the government adheres to its original plan, adopting alternative policies could mitigate growth headwinds, in our view. First, we believe that if the government taps its existing funding arrangements (with the largest public-sector insurance company focused on railway infrastructure development), it could meet at least half the reduction in production expenditure. Second, new alternative sources of funding, such as the National Infrastructure Investment Fund (NIIF), could be made operational to meet at least a fourth of the reduction.
Third, we believe the central government needs to further streamline its expenditure. According to the Fourteenth Finance Commission (FFC), with a higher tax devolution to state governments, the majority of more than 30 centrally sponsored schemes with a total allocation of INR 1.2tn (0.9% of GDP) should have been transferred to state governments. However, the central government last year decided to continue with most of these schemes to facilitate a smooth transition. We believe that after a year of FFC implementation, further streamlining of the expenditure-sharing plan between the central and state governments is necessary. This should enable the central and state governments to be more disciplined in fiscal management.