Rational Expectations: GDP growth will fix debt, so spend now

And assuming a 25% investment rate—it is lower right now—this means India’s potential growth falls by 1.5% or so.And assuming a 25% investment rate—it is lower right now—this means India’s potential growth falls by 1.5% or so.

Those advocating Finance minister Nirmala Sitharaman should not spend too much more to stimulate the economy as this will raise both deficits and debt are positing a false alternative. While they warn the likely jump in bond yields—as the Centre borrows more—will raise costs and so depress India Inc’s investment, this assumes that, were the FM to restrict spending, neither debt nor deficit will rise.

In April to August, tax collections fell by a fourth (y-o-y) instead of, as budgeted, rising by 12%. Assuming that this will hold for the rest of the year, and GDP falls by 7% in nominal terms (that’s a 10% real fall with a 3% inflation level), taxes will fall short by Rs 5.3 lakh crore and the FY21 deficit will rise by a whopping 2.6 percentage points.

This is what JP Morgan’s chief India economist Sajjid Chinoy argued (bit.ly/2FvprrZ) in this newspaper some months ago (see graphic for an updated chart). If this year’s consolidated deficit widens by 4.5% of GDP but the trend nominal GDP growth settles at 8%, debt levels will rise towards 100% of GDP over the decade. But even if the deficit increases by 7% of GDP this year while trend nominal GDP settles at 10%, debt/GDP stabilises around 90% and then begins to come down; trend growth matters critically for debt sustainability.

Interestingly, with the IMF’s latest WEO report talking of global debt levels at 100% of GDP, it is unlikely an increase in India’s debt levels to 90-95% of GDP will get credit-raters to downgrade India. Indeed, the latest Moody’s statement on India talks of “the small scale of the stimulus … to support the economy during a very sharp contraction” being “a credit negative”. It goes on to add, “in total, the two rounds of stimulus bring the government’s direct spending on coronavirus-related fiscal support to around 1.2% of GDP. This compares with an average of around 2.5% of GDP for Baa-rated peers as of mid-June”.

In a fundamental sense, the real issue is about the damage to the economy if the FM doesn’t spend enough; this will take the shape of millions of firms shutting shop and that, in turn, will depress GDP revival. That is what the latest IMF report calls ‘scarring’. How much the economy has got scarred already is difficult to estimate, but there are ways to try and approximate the damage.

Demonetisation, for instance, would have hit lakhs of producers as 86% of the cash got sucked out— Covid-19 will have an even deeper impact—though, believe it or not, the official data shows India’s growth picked up post-DeMo! A possible explanation, assuming the data was not massaged, was that lakhs of firms window-dressed their accounts to show higher sales in order to be able to deposit their black money in the bank, and that is what the data captured.

Though the government later rubbished it, the NSS Periodic Labour Force Survey showed unemployment jumping from the historic 2-2.5% to 6.1%; this suggests a massive shutting down of enterprises due to demonetisation.
In the current Covid-19 context, the sharp jump in NPAs suggests the same story is being repeated. RBI sees NPAs rising from 8.5% in March 2020 to 12.5% in March 2021 in a baseline scenario, and to 14.7% in a severe stress situation. Higher NPAs lower credit availability as banks repair their balance sheets. Assuming an ICOR of around 5 right now, the rise in NPAs—to 14.7%—will raise the ICOR to around 5.6. And assuming a 25% investment rate—it is lower right now—this means India’s potential growth falls by 1.5% or so.

Another way to estimate the Covid-19 ‘scarring’ is the dip in potential output over the next 4-5 years. If FY21 GDP falls from 100 to 90, the lower base will mean recovering to the old trajectory will take several years. And growth rates from FY21-25 can also change due to the loss of productive capacity as firms shut down, workers go back to villages, etc. The latest IMF report doesn’t get into which of the two factors is at play—maybe both are—but says India’s GDP will be 12-13% lower than it would have been in FY25 due to the ‘scarring’.

But if bond yields do rise as the government borrows more, surely the impact of the extra spend will lower private sector growth? Chinoy argues this is unlikely—Credit Suisse India Strategist Neelkanth Mishra makes much the same point (bit.ly/2FA0DPK) in a recent column in The Indian Express—as the likely FY21 BoP surplus of 3.5% of GDP implies India has excess savings of this magnitude. This extra saving, Chinoy argues, is not only keeping bond yields from spiralling, it is ensuring RBI doesn’t have to buy that much of government debt. In April to September, Chinoy says, the government borrowed Rs 9.5 lakh crore more than last year by way of GSecs, SDL and T-Bills, and yet RBI bought just Rs 1.6 lakh crore of this.

But, and here’s the next question, even if the government spends, what does it spend on? Apart from the fact that there could be much higher cash transfers to the poor and greater bank recapitalisation— especially with more NPAs piling up—most suggest a bigger infrastructure rollout. The latter sounds good, but there aren’t too many ready-to-roll-out infrastructure projects right now; and why would firms, for instance, invest in new power plants while the SEBs are too broke to even pay their dues on time?

One quick way, though, is to extend concessions to sectors that have the ability to invest immediately. Slashing spectrum prices—either for 4G or 5G—could result in large expenditure; around $15-16 bn for each operator over 2-3 years in the case of 5G. Abolishing licence/spectrum charges would also stimulate capex immediately. Sharply reducing levies on oil and gas—or allowing market prices to be charged for all production, not just the new ones—would give firms enough cash to be able to invest quickly in new fields or to simply ramp up existing production. Selling PSUs would have the same impact; just see what Vedanta did to raise HZL’s investment and output to understand this.

The short point is India needs to spend a lot more if it wants to fix the permanent damage to the economy that will occur if lakhs of producer firms shut down; when this happens, it will both raise deficit/debt levels and even be inflationary as supply chains break down. As it happens, the BoP surplus presents a golden opportunity to keep the costs down for an expansionary fiscal policy. Given this, it is not clear why the government is hesitating.

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