How fiscal pressures on state budgets are more pro-cyclical and weak imports push up bond yields
Neelkanth Mishra | Last Updated at December 4, 2019 01:00 IST
(This was published in the Business Standard: link)
Economies are complex systems, with inter-linkages that usually do not get adequate attention, but which can have a strong effect on economic momentum and the severity of economic cycles.
Let us start with state government spending. In popular imagination, “government” stands for the Union government in Delhi, and when companies complain of delayed payments, everyone looks to Delhi for recourse. However, not only do state governments on a net basis spend 90 per cent more than the Centre, they have much more discretion on their spending than the Centre. Nearly a fourth of central government spending, for example, is interest payments, and another fifth is salaries and pensions — delays to these are unlikely, if not impossible. Add to that defence spending, transfers to states and subsidies (this year fertiliser and food subsidy payments appear to have been made thus far), and three-fourths of the Centre’s expenditure is accounted for.
The probability of state governments delaying payments is much greater, however, and not just for political reasons as seen in some large states where the ruling party has changed recently. Aggregating state budgets, one finds that they are budgeted to spend Rs 38 trillion in this fiscal year, 19 per cent higher than last year’s expenditure, and nearly 1 per cent higher as a share of GDP. Capital expenditure is budgeted to grow 21 per cent over the prior year to Rs 6.3 trillion. But these numbers are subject to significant downward revisions. States miss receipt and expenditure targets set in their budgets in most years: While there are execution challenges, as shown by states borrowing less than what they are allowed to in recent years, lower-than-expected receipts also constrain spending. In recent years, a meaningful part of the slippage in receipts has been due to weaker-than-budgeted tax transfers from the Centre. This year, the problems could be much worse than usual. We estimate that total spending growth could slip to as low as 7 per cent year-on-year, implying a drop in the state spending-to-GDP ratio compared to last year.
As the Controller General of Accounts (CGA) releases monthly data for the central government, analysts track the slippages on central taxes and the impact on central deficits and spending. However, given that 42 per cent of central taxes automatically flow to states, and account for 40 per cent of total state spending, their impact on states is very significant too. More so as states have no flexibility on their fiscal deficit targets. This is hard to track however, as monthly data on all states is not available on the CGA website. As a slowing economy hurts states’ own receipts, in addition to central transfers, states with a budgeted deficit close to the permitted threshold of 3 per cent of GSDP will be forced to cut spending. Even those where the deficit is budgeted to be below 3 per cent of GSDP would be constrained by the quantum of borrowing approved for them, as this is set by December, whereas the extent of central tax shortfall would be disclosed only in February 2020.
The issue of goods and services tax (GST) compensation may worsen the situation. When GST started, states had been promised 14 per cent annual revenue growth for five years: Any shortfall in collections would be made up by the Centre through payments from the compensation cess being collected (mainly a surcharge on coal, cars, tobacco and fizzy drinks). Until last year, states were beneficiaries of GST, as the slowing economy did not affect their revenues meaningfully, and they saw a substantial improvement in GST-subsumed taxes as a share of GSDP. But their assumption of 14 per cent growth in GST collections every year could be challenged this year, as GST collections have been so weak that the compensation requirements are far in excess of the compensation cess budgeted. The slowdown in coal (thermal power generation was down nearly 20 per cent versus last year in both October and November) and auto demand in particular has hurt cess collections too.
If the Centre is unable to make the compensation payments fully this year, and quite possibly next year as well, the resulting negative surprise in receipts is likely to force a curtailment of state spending. With the states having implemented the seventh pay commission recommendations, they too have seen a sharp increase in committed expenditures: Their pension bill, for example, is already 10 per cent of total expenses. Therefore, cuts to spending are likely to be in discretionary capital spending, which possibly explains some of the delayed payments that companies complain about. Over the past few years aggregate state capex has risen in importance, offsetting to some extent the slowdown in private household sector capex. They increased from 1.2 times the central government capex six years ago to 1.8 times last year. Cuts to state government capex could have a negative impact on economic growth going forward, further vitiating the cycle.
A second unrelated but equally important inter-linkage is the impact of the slowdown on interest rates. As the economy has slowed, so have imports, and the merchandise trade deficit has fallen sharply. Given that India’s services net exports are about $130 billion, the annualised goods trade deficit of just $125 billion in the last two months suggests that the country is running a current account surplus. This may be temporary, because gold import volumes are running well below normal levels, but during this period, given continuing capital inflows, India has had a significant balance of payments surplus. As the central bank has intervened to absorb this, reserves have gone up by $15 billion in the last two months.
Interestingly, local bond traders view this as a reason to push up yields on government bonds. The rationale being that the Reserve Bank of India injects durable liquidity either through open market purchases of government bonds, or by intervening in the currency market, where it buys dollars and sells rupees. If the pace of dollar absorption is so high, it has no need to buy government bonds, and this creates a shortage of demand for government bonds. Thus, counter-intuitively in a weakening economy with weak imports, effective interest rates are not falling even for government bonds.
It is important for market participants as well as policymakers to track these inter-linkages in the economy, and act to limit the damage they can inflict on economic momentum.