Before our ancestors figured out why solar eclipses happened, their “explanation” was mostly some evil creature swallowing the sun: the rakshasa Rahu in Hindu mythology, dragons in China, and the wolf Hati among the Vikings. Reasons concocted to explain why India’s economy suddenly stalled from January this year seem to be similar: “The government isn’t reforming enough” and “undercapitalised PSU banks” are inappropriate explanations, even if they sound credible. Some, like “corporate India is not investing deliberately to spite the government”, border on the ridiculous.
So what explains it? In our view, the slowdown was catalysed by sharp spending cuts by a Central government facing empty coffers. It would be worth outlining the complete story before we start pointing fingers.
The Union government doesn’t really have much control on its finances, at least in the short term. Most of its expenditure is non-discretionary — interest payments, salaries, defence, and subsidies like food and fertiliser, which sound discretionary but are not. Worse, more than a third of its revenues are corporate taxes, which by definition depend on corporate profits, which are hard to predict.
So when the Central government embarked on its ambitious fiscal consolidation plan four years ago, it seems to have bitten off more than it could chew. By January of fiscal year 2011-12, that is, with two months still left to go, the accumulated deficit had already breached the full year’s target. I remember rushing to Delhi to understand what the government would do: Would it raise the deficit target? I was naïve. The government met its deficit target, but by delaying its cash payments to the month of April. As the government of India does cash accounting, if it doesn’t cut the cheque by March, even though it has used services of its suppliers, the payment doesn’t go into that year’s deficit. This is too convenient a loophole for the government not to use.
With no change in underlying dynamics, the shortfall started building up. The fiscal deficit target for the next year, 2012-13, was even lower, and now the spilled over payments from the previous year also had to be made. Soon, the government wasn’t just pushing out expenditure but seemed to be pulling in revenues too, collecting excess taxes in the last few months of the year and then issuing refunds early the next year.
As the years passed, the fiscal deficit pushed to the next year kept ballooning, so much so that in the recently concluded fiscal year, 2014-15, the full year’s fiscal deficit had been exhausted in just the first eight months. The government was thus forced to sharply curtail expenditure from December to March in order to meet its deficit target. The pace of spending contraction was 2.5 to 3 per cent of the GDP — a brutal spending crunch that likely slowed economic growth by at least 1.5 to 2 per cent.
This was just at the Central level. As Central transfers are a meaningful part of state budgets, a revenue shortfall at the Centre hurts state budgets as well. Moreover, when the Centre sees fiscal stress, one of the easiest expenditure items to postpone is transfers to states. An aggregation of state budget data suggests that even in February, that is, with just one or two months left in the fiscal year, state governments expected the Centre to send Rs 85,000 crore more than they eventually got. One can only imagine the fiscal chaos in the states as this large quantum of cash was delayed.
No wonder the economy seemed to hit a wall around January; growth in sales of cement, paints, automobiles and most discretionary items came down sharply. In the absence of credible reasons, incredible explanations were engineered, and a “lack of reforms” became the favoured “explanation”.
Evidence of successively higher amounts being pushed to the following year is visible in the share of full-year expenditure spent in the March quarter, or the January to March period. Historically, that has been the strongest period of government spending, as departments pick up activity towards the year-end deadline in the fear of missing targets. In the last year before fiscal consolidation started, 2010-11, 34 per cent of full-year expenditure was spent in the March quarter. This fell steadily in subsequent years, dropping to just 24 per cent in 2014-15. And, as one would expect, the share of the June quarter, or the April to June period, has been rising steadily over the years.
Not surprisingly, therefore, once the new fiscal year started in April, the shackles were off, and Central government spending seems to have picked up strongly, rising 28 per cent over April last year. This momentum is likely to have continued into May. While state governments do not release monthly budgetary data, one can safely surmise that their spending is up, too. As a result, early signs of economic revival are already visible. The phase of a precipitous drop in monthly cement sales seems to have ended, with May showing an increase. Sales of some discretionary items seem to be picking up. In the next few weeks and months, the signs of revival are likely to become stronger and more widespread, like they did in the June quarter last year.
This begs the question: With the government clearly front-loading spending again, shouldn’t we fear a government-spending-driven slowdown in the second half of the fiscal year again? That is possible, as the monthly deficit in April was nearly a fourth of the full year target. But it is unlikely for two reasons. First, the spillover of the deficit seems to be much lower, and revenue targets seem credible, so much so that in the first two months, indirect taxes are growing much faster than budgeted, even though direct taxes are a tad weak. Second, the government, through a prudent increase in taxes on petrol and diesel, has retained more than half of the benefits of lower oil prices, improving its finances.
But this untidy fiscal management creates unnecessary economic volatility and, by introducing unpredictability in growth, impedes investment. The most damaging is the impact on state government activity. Going forward, it would be advisable to reduce reliance on tactics like pushing out expenditure or pulling in revenues, and instead work with more credible fiscal targets.
The writer is India Equity Strategist for Credit Suisse