India's fiscal deficit: Morning after blues?

A lot has been said about India’s focus on controlling fiscal deficit over the second half of FY 13. Indeed, via a single minded effort on expenditure control, the new finance minister was able to control what till then looked like a run-away train. In fact as we now know, the final deficit for FY 13 came in at 4.9%; even better than the guidance provided at the time by the new minister(which was initially looked upon quite suspiciously). A large brunt of the expenditure control was borne by plan spending. This is the less difficult one to manage given that much of non plan is sticky in nature on account of fixed subsidy, interest costs etc. To put this saving in perspective, plan spending turned out to be 80% of budgeted amount; a saving of more than INR 1 lakh crore or 1% of GDP. Obviously such a squeeze in plan spending is neither desirable nor sustainable. Reflecting this, the budget estimate for plan spending for FY 14 is up 34% from the provisional estimate of FY 13. Indeed the finance minister has clarified recently that the focus this year will be on getting stronger revenues rather than on cutting expenditures.

At this juncture both local and global investors are fairly confident of the renewed fiscal credibility in India; given the large exercise in balancing that we have recently undertaken. The purpose here is not to second-guess intent that the finance minister has to plug deficit at 4.8% of GDP in current financial year. The purpose only is to highlight potential trends that may pose risks to the fiscal consolidation effort in the year ahead. Alongside, we will also touch open future potential bond supply which may have implications on the shape of the yield curve in the times ahead.

The chart tracks plan, non plan and total expenditure between April 12 – April 13. There are some points of interest here. First, the lull in plan spending especially in the months of October, November, January, and February is quite evident. Alongside, the lack of control on non plan is equally evident. What is additionally noteworthy is the jump in total spending in April 2013 versus April 2012 (16% growth). This validates our expectation and policy guidance that government expenditure growth is back. It can also be inferred that the substantial drag on GDP growth from lack of spending in the October – March 2013 half year is unlikely to be in play any further now that government spending is picking up. Although numbers for May are not yet available, tracking government surpluses with RBI one can reasonably deduce that spending was relatively strong in the month of May as well. On the subsidy front, there is genuine effort towards compressing fuel subsidy by gradually hiking diesel prices. However, savings here may be more than taken away from additional spending on food, if the food security bill becomes reality. In fact, if the government were to stop practice of partly paying current year subsidy in the next, then after accounting for INR 45,000 crores to be paid for last year’s fuel subsidy there is only INR 20,000 crores left for the current one.

The chart  tracks the revenue patterns for the government over the same period. Specifically, tax, non tax and total revenues are presented. The ‘humps’ in the months of June, September, December and March represent the advance tax collection cycle. However, what is noteworthy is the sudden collapse in total revenues in the month of April (total receipts are only 40% of that collected last April). While this is too early to call this a trend, a slowdown in collections is to be expected in a slowing growth environment. The government has budgeted for a 22% growth in total receipts this year over the provisional numbers for last year (the corresponding growth last year was 17%). Apart from slowdown in tax revenues, potential stress may also emerge on non tax items. Telecom receipts are budgeted at INR 41,000 crs; twice of last year’s realization. Normal disinvestment receipts are pegged at INR 40,000 crores (apart from divestment of government stake in non government companies of another INR 14,000 crores). A large part of the normal disinvestment would have been Coal India. However, that has run into trouble with employees protesting further stake sale. Apart from this, market appetite for this much paper is always an underlying question.

The net result of the above readings on revenue and expenditure for April is that the fiscal deficit for the month is the highest for the period under review and almost 40% higher than last April. Again, we would hesitate to call this a trend. However if some of the pressures analyzed above fructify, then fiscal risks may become a renewed reality towards second half of the year. This is especially so as the kind of expenditure compression that the finance minister could manage last year may not be possible in the run up to the general elections next year. This represents the grim side of the same growth slowdown story. While rate markets are now focused on the positive aspect of slowdown (in terms of expectations of further rate cuts), we may have to soon reconcile to the negative aspect as well ( in terms of higher fiscal deficit and higher bond supply).

While on the subject, a related point needs mention as well. This has to do with gross supply of government bonds in a year (net borrowing plus maturity). Starting the next year, we are entering a phase where bond maturities in a given year will rise significantly. From INR 95,000 crores in the current financial year, bond maturities will rise to INR 168,000 crores in the next year and INR 197,000 crores the year after. This means that all other things remaining constant, the gross supply of government bonds will be higher by INR 70,000 crores next year. This is significant as, even though net supply remains the same, the net supply of duration to the market goes up to the extent of additional gross supply. Indeed, the government had budgeted for INR 50,000 crores extra this year for bond switching and thereby smoothen forward maturity profile of its borrowings. This is an additional amount that the market (as well as the government !) seems to have forgotten about for the time being. We would highlight the following conclusions and investor takeaways:

1. While recent developments on the fiscal front have given much confidence to investors, it is not necessary that the same confidence extends to the year ahead. While it is too soon yet to sound doom and gloom on this front, there are incremental developments that bear close watching and that may have implications later on in the year.
2. The market will soon enter a phase where, all other things being equal, gross bond supply will go up over multiple years on account of higher bond maturities. This may have implications for shape of the yield curve as well the spread over the repo rate at which the bond curve deals. Again, all other things being equal, the spread over repo rate should widen reflecting the higher bond supply.

The purpose of writing this note and the one before (refer ‘Can aggressive monetary easing create a funding problem in India?’ dated 29th May) is not really to second guess the market’s current bullish momentum. The attempt is to merely highlight some of the risks that often get overlooked in the midst of a near term strong bullish momentum but which nevertheless have important implications for overall market returns over the medium term. Alongside, the purpose also is to caution that India’s macro-economic story is by no means as inevitable as some of the straight-line bullish forecasts currently in the market seem to suggest. For those forecasts to be proven correct and more importantly to be sustainable, a lot of triggers have to first fall in place. Else, even if the RBI turns to being a risk taker and drives market rates lower in the near term, these rates will not sustain and will soon realign to the underlying macro-economic reality.