Only magic can help the Modi government contain India’s fiscal deficit

Arduous task.
Arduous task.
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The Schlieffen Plan is the most celebrated of military blueprints and also an interesting example of how magical thinking can clash with hard reality.

From 1897 to 1905, German Field Marshal Alfred Graf Von Schlieffen gamed out a plan for fighting Russia, France, and Britain all at the same time. By using Germany’s excellent rail system, the plan assumed, 88% of the country’s forces could invade France via Belgium, defeat it, and return to face the slow-mobilising Russians. Von Schlieffen calculated that there would be a decisive battle near Paris in the fifth week of the invasion.

If the British reinforced the French, he estimated that the German army would be 24 divisions—roughly 400,000 men—short of assured victory. This is where magical thinking came into play. The plan envisaged a “ghost force” that would appear from nowhere and win the decisive battle for the Germans.

Von Schlieffen died in 1913. On Aug. 04, 1914, the Germans invaded Belgium. On Sept. 06, they faced an Anglo-French army, just 70 km from Paris. The late field marshal’s calculations had been exact. But his “ghost divisions” were not there and so the Germans lost.

What does this have to do with the Indian economy? Just as the success of the Schlieffen Plan relied on ghost divisions, balancing India’s budget seems to rely on ghost revenues.

Subhash Chandra Garg, economic affairs secretary, recently said the Narendra Modi government will restrict India’s fiscal deficit to the targeted 3.4% of the GDP, as stated in the revised estimates of the February 2019 interim budget. Ghost revenues are needed to meet that commitment.

In February, the fiscal deficit hit 134% of the revised budgetary estimate for 2018-19. The deficit was Rs8.51 lakh crore as against the revised estimate of Rs6.34 lakh crore, as per data from the Controller General of Accounts. That’s 4.5% of the GDP, assuming the GDP meets the revised target.

The data also shows central revenue receipts totalled Rs12.65 lakh crore by February, or 73.2% of the revised estimate. The bulk of India’s revenue comes from taxes.

In the interim budget, the estimate for the Goods and Services Tax (GST) collection for 2018-19—central GST plus the central government’s share of Integrated GST—was revised down by Rs1 lakh crore to Rs6.43 lakh crore. The collection target for customs duty was set at Rs1.3 lakh crore and for excise duty at Rs2.59 lakh crore.

Still, even with a record GST revenue of Rs1.06 lakh crore in March, the central GST collection fell short of the revised estimate by around Rs46,000 crore while other indirect taxes are likely to be short by about Rs50,000 crore. There is estimated to be a shortfall in direct tax collections as well, of nearly Rs50,000 crore in the target of Rs12 lakh crore.

Juggling money

The only revised estimates target likely to be met is the revenue from disinvestment. As against the target of Rs80,000 crore, the collection is set to exceed Rs85,000 crore. To achieve this, the Power Finance Corporation was made to acquire another public sector company, the Rural Electrification Corporation. The government is squeezing public sector companies for a second interim dividend even though this puts pressure on their balance sheets and cheats minority shareholders.

Putting it all together, the fiscal deficit for the year 2018-19 will be higher than the revised estimates since revenue collection is well short of the target. In fact, even the GDP may be lower than the revised estimate.

Magical thinking aside, what does a higher fiscal deficit mean? More borrowing, for one. The central government as well as public sector companies and institutions like the Food Corporation of India will have to borrow to balance their accounts. It also means the government will have less room to spend.

Most of the borrowing will be from the bond market. This will likely push up interest rates and crowd out private corporate borrowers, making it harder for them to implement their expansion plans. A certain proportion of new capital expenditure for high-rated corporations must be raised from the bond market. Hence, corporates cannot even rely on equity markets for capex.

There’s another negative implication: lower tax collections indicate slower growth. This implies that the GDP estimates will be revised downwards. That is no surprise since most other high-speed indicators also suggest that GDP growth in 2018-19 has been considerably lower than the official estimate of 7%.

If the GDP is less than estimated and the fiscal deficit is higher, it is simple arithmetic that the deficit will be higher as a share of the GDP. It could approach or even exceed beyond 4% of the GDP, despite all the magical thinking.

India’s current account deficit was around 2.5% of GDP by the end of December, an improvement on 2.9% at the end of September but well above the 1.8% for the year 2017-18. Given moderate oil prices, there is not much to worry on this front, even though the deficit is also worse than the 2.1% recorded in the first three quarters of last financial year.

The rupee has recovered sharply after the Reserve Bank of India’s (RBI) swap auction late last month received an enthusiastic response. The central bank cut interest rates in April, but the buoyancy created by lower rates might be balanced by the expectation of higher government borrowings. A strengthening rupee means exports get more expensive while imports could rise as they become cheaper. This could put more pressure on the current account deficit.

Indian governments have always gamed the fiscal deficit data, but never on the same scale as in 2018-19. There are several ways to understate the deficit. One is to simply delay payouts until the next financial year. This is why the Food Corporation of India, for instance, is perpetually borrowing cash.

Raiding reserves

Another way is to raid the reserves of public sector companies and create cross-holdings by ordering them to “buy” the stakes in other government-owned companies. This mode of transferring money from one government pocket to another has been elevated to an art form in the past two years with mega deals such as the Oil and Natural Gas Corporation “buying” the Hindustan Petroleum Corporation Limited and the Power Finance Corporation “buying” the Rural Electrification Corporation. Then, there are enforced subscriptions by the Life Insurance Corporation, 100% owned by the government, to Initial Public Offers and Follow on Public Offers of public sector companies.

The Modi government has added new wrinkles to the art of understating the fiscal deficit by arm-twisting “independent institutions”, such as the RBI and the Securities and Exchange Board of India, into releasing reserves. It is now indulging in magical thinking by asserting that the fiscal deficit target will be met.

A high fiscal deficit is a poisoned legacy for the next government, which will need at least two years to pull the deficit back to 3%.

This post first appeared in Scroll.in. We welcome your comments at ideas.india@qz.com.