The Economic Survey 2015-16, which was tabled in the Parliament today, the 26th of February 2016, enumerates the challenges faced by the Indian economy in a period of high global economic turbulence. While India’s economic growth, at 7.6% for fiscal 2015-16 against growth rate of 7.2% seen in fiscal 2014-15, stands out among its peers with China growing at below 7% and Russian and Brazil going into recession, outlook for growth is muted as world aggregate demand is down on weak global economic growth. India too has had a few years of weak monsoons that has impacted rural demand. The government is facing challenges in fiscal consolidation even as banks are reeling under bad loans given to a highly leveraged corporate sector that is unable to service its debt.
Economic growth is expected to stay in a 7% to 7.5% range in the coming year with an outside change of higher growth if monsoons are normal and government employees spend their bounty on the back of 7th pay commission recommendation of higher salaries.
The survey calls upon the RBI to undertake many tasks to revive economic growth. Benign inflation outlook given low global commodity prices and weak aggregate demand, widening output gap (difference between capacity and capacity utilization, which is determined by demand), growth uncertainty and high corporate sector leverage calls for monetary easing. RBI has brought down the Repo Rate by 125bps in 2015 from 8% to 6.75% and the government expects it to ease the rate further.
The survey also talks about the need to address the Twin Balance Sheet Challenge (TBS), which are the stressed assets of public sector banks that have grown to such alarming levels that many of the banks market capitalization is less than the bad loans of the banks and the high leverage of large corporate entities that have caused the stress in the banking system. The result of the TBS is that banks loans have dried up and corporate sector has stopped investing and this is impacting economic growth.
Four R’s, Recognition, Recapitalization, Resolution and Reform are necessary for the banks and corporates to get back on track. Recognition is providing for stressed assets, repaitalization is infusing equity into banks, resolution is weeding out stressed assets through sales or rehabilitation and reform so that the same issues do not occur again.
The question of recapitalizing banks has thrown up two answers. One is government pumps in the equity, which is ideal since the government owns the banks. Government can sell its other assets to recapitalize banks.
The second is more radical and needs much more debate. RBI can recapitalize the banks by lowering its shareholder equity to assets ratio, which is the highest in the world. RBI’s capital is to be used for recapitalization of banks but this has far reaching implications.
On the fiscal deficit front, the government will meet its target of fiscal deficit of 3.9% of GDP despite the revision of nominal GDP from 11.5% to 8.6%, Read our note on Understanding Union Budget 2016-17 -Fiscal Deficit. However in fiscal 2016-17, the government faces higher expenditure on government salaries if it implements the 7th pay commission recommendation in full. Given the need for growth impetus, government may want to spend more to kick start the economy but this could lead to the government not meeting its fiscal deficit target of 3.5% of GDP for fiscal 2016-17.
Higher fiscal deficit will lead to higher government borrowing and banks being the largest buyers of government bonds may not participate in the government bond auctions given that they are already running excess government bond investments over statutory levels (SLR or Statutory Liquidity Ratio is 21.5% of Net Demand and Time Deposits, NDTL and will go down to 20.5% of NDTL in March 2017). Banks SLR holdings is around 29% of NDTL. Banks not participating in government bond auctions will push up borrowing costs for the government leading to further strain on the fiscal deficit as interest outgo increases.
Survey has suggested that RBI could step in to buy government bonds to fill the void left by banks, which would mean back door deficit financing that is inflationary in nature.
The survey expects CPI inflation to come in at 5% in March 2017 as per RBI target given weak aggregate demand, rising output gap, low oil prices and falling food prices if monsoons are normal. The survey does not expect higher government salaries through 7th pay commission recommendation to impact inflation.
Current Account Deficit (CAD) is expected in a 1% to 1.5% GDP range on the back of lower trade deficit. Trade deficit is down on falling oil import bill, which is down 41% in the first ten months of fiscal 2015-16.
The survey highlights that tax breaks on investments in small savings schemes and tax free bonds and subsidies on Railways, Power, ATF, Cooking Gas, Gold and Kerosene benefit the rich more than the middle class and the poor. The tax breaks could be phased out in the forthcoming budgets. The survey has not mentioned that long term capital gains tax could be tampered with, as feared by markets.
Rollout of GST that will not happen as scheduled in April 2016 is seen as a disappointment but the survey hopes that it will be implemented quickly.