A debate has been under way in India around Covid-19 and its implications for the economy. The RBI has been swiftly and proactively responding to the challenge caused by the crisis; lowering the policy rates and injecting additional liquidity through various instruments in the system over the last two months. With falling oil prices, surplus agricultural production and declining consumer demand, inflation is expected to recede considerably in FY21. With repo rate at 4 per cent and retail inflation at 5.8 per cent, the real interest rate is already negative, and will gradually move into positive territory with a drop in retail inflation forecast.
Therefore, we can expect the RBI to be even more accommodative in its upcoming policy announcements. However, the key would still be the transmission efficiency of the rate cuts and a quick revival of credit demand in the markets. Loss aversion has been steadily rising and will continue to rise till we find a sustainable solution to the pandemic, thus further weakening any chances of fresh credit demand.
Monetary policy measures alone are not sufficient to reverse the large shocks in an economy. At best, they can help mitigate the adverse effects of the shock and only support the recovery process. Thus, in order to reverse the economic fallout of Covid-19 and initiate a recovery, a strong and prudent fiscal solution is needed in addition to the steps taken by the central bank.
Covid-19: fiscal implications
The annualised value of tax collections for FY20 is lower than the revised estimate as per the Budget by about 20 per cent. Taking actual tax revenue collection for FY20 as the base, it would require an approximate 30 per cent increase to reach the budgeted estimate of tax revenue for FY21. However, the irony is that this Budget estimate was prepared with the assumption of a nominal GDP growth at 10 per cent. Now with the deleterious impact of Covid-19, the real GDP estimate for the current year is expected to be in negative territory. and nominal GDP growth is set to be at a mere 4 per cent. The negative market sentiment will make the budgeted disinvestment target of ₹2.1 lakh crore look almost impossible.
With revenue receipts facing a huge downward pressure, the expenditure too is likely to increase disproportionately. The bulk of this increase would accrue due to the urgent need of ramping up health infrastructure, providing social security to the impoverished sections of society, and the economic support needed by the MSMEs. which are fighting for their survival. Possibly, the government would like to push some of the budgeted capex projects, including those on Defence, to later years but the scope is rather limited. Thus, India today faces the risk of breaching the fiscal deficit targets and will likely end up being unable to honour the FRBM mandate.
The higher the fiscal deficit, the higher the rate of interest the government needs to pay on its debt, as it has to compete with other borrowers for the limited pool of public savings. Household net financial savings have been dropping over the last few years with the current pandemic now making the situation even more worrisome. This would further augment the cost of borrowing for the government. As per the latest estimates, the fiscal deficit at the Centre is expected to be around 5.5 per cent of GDP against the FRBM mandate of 3 per cent. Adding to this the fiscal relaxation provided to the States, the gross fiscal deficit could reach an abnormal high of more than 10 per cent of GDP. This might give the advocates of fiscal prudence many sleepless nights. But wait, is there a larger trade off to be made?
Biting the bullet – growth is the panacea
India came into Covid-19 with already high debt/GDP of about 70 per cent, a primary deficit across the Centre and States of about 2.5 per cent of GDP, a weighted average borrowing cost of about 7.5 per cent (on the stock of debt) and an estimated pre-Covid nominal GDP growth of 7.5 per cent in FY20. Research suggests that the higher the difference between the nominal GDP growth and the cost of borrowing, higher is the possibility of debt/GDP ratio declining over the subsequent years. With the backdrop of this difference now being negligible or possibly negative, the fiscal health of the nation would largely be dependent on how the difference plays out in the coming years.
In a war-like situation that India faces today, high fiscal deficit can be allowed only if it can facilitate and sustain high growth in the medium term. However, the caveat is that this growth is contingent on the nature of the fiscal policy adopted and the accompanying reforms. The Union Finance Minister has recently announced the ₹20 lakh crore fiscal package. Only time will tell whether it induces the desperately needed growth or pushes India into a state of fiscal profligacy.
Given the unprecedented challenge the country faces today, both economically and socially, it needs to adopt bold policy initiatives. Had the US been worried about breaching its deficit targets post the financial crisis of 2008, who knows, it may have still been undergoing a period of prolonged recession. Surely, India faces a much bigger crisis than that of the US in 2008 and, therefore, it is time to accept the reality that economic growth in the medium term may only be possible at the cost of a high fiscal deficit.
(Dr. Neelam Rani is Associate Professor in Finance, Indian Institute of Management Shillong; Jasmeet Singh Bindra is gold medallist, PGP (2018-20) from Indian Institute of Management Ranchi.)