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India’s latest annual Union Budget for the fiscal year 2020-2021 that finance minister Nirmala Sitharaman presented on February 1 failed to recognize the gravity of the economic problems the country faces, according to experts from Penn and elsewhere. Expectations were high that Sitharaman would find ways to extricate India from its economic slowdown of two years, especially since Prime Minister Narendra Modi has sworn to expand the economy from $2.9 trillion today to $5 trillion by 2024-2025.
The metaphor of an elephant for the Indian economy captured the budget’s shortcomings for Duvvuri Subbarao, former governor of the Reserve Bank of India and a research fellow at the Center for Advanced Study of India (CASI) at the University of Pennsylvania. “As much as I hope the budget will inspire the elephant to start dancing, disappointingly there is little in [it] to get that act going to revive the economy’s growth performance,” he said.
India’s growth slowdown is “deeply structural, requiring a structured response,” according to Subbarao. “What the economy needs for a sustained turnaround is kickstarting private investment.”
Subbarao says structural and governance reforms are vital to boost investor confidence. That entails “a long-haul effort … [but] even a thousand-mile journey has to start with the first step,” he said, recalling the Chinese adage that Mao Zedong had adopted. “That the budget did not launch the journey, and even did not take the first step is a big disappointment. The budget will not do much to engineer a sustained growth reversal of the economy.”
The budget may not be “the best place” to announce structural reforms, according to Devesh Kapur, director of Asia Programs and a professor of South Asian studies at the Johns Hopkins University School of Advanced International Studies, and a former director of CASI. “However, even if it had recognized the magnitude of the challenge the economy faces, and said that the government knows that there are some very serious issues and is determined to address them, it would have sent a strong signal,” he said. (Subbarao and Kapur spoke with Knowledge@Wharton about India’s budget in a recent conversation. Listen to the podcast at the top of this page.)
“The best thing one could say about the budget was it was not an irresponsible budget.” –Devesh Kapur
However, Kapur credited the Modi government for eschewing fiscal profligacy to get past India’s economic challenges. He also praised Sitharaman for providing greater transparency in the budget than in previous years, notably in acknowledging how off-balance sheet borrowings would worsen the fiscal deficit. “The best thing one could say about the budget was it was not an irresponsible budget, in terms of it could have tried to spend its way out,” even as the fiscal deficit targets have been increased, he said. Had the government gone that way, it would have created more inflationary cycles and made economic revival more difficult, he explained.
Stock market investors showed their disappointment over the budget. The leading stock indices — the BSE Sensex and the NSE Nifty 50 — fell some 2.5% on the day of the budget. Kapur said he was not surprised by how the indices reacted, adding that he had low expectations from the budget to begin with. “The Sensex needed a wake-up call. It’s been a little too exuberant given the underlying realities.”
Kapur explained why he had low expectations from the budget. He noted that “over the last year, every economic indicator was going south,” and pointed to investment, growth, unemployment and exports. “[Also], the financial markets and credit markets were at an all-time low,” he added. “What I had not seen over the years was the government recognizing the gravity of the problem. Instead, [it was] in a sense a frittering away the political capital after its massive victory last May in a very divisive social agenda, rather than [bringing] a razor-like focus on the economy.”
Slow Growth and Unemployment
The International Monetary Fund (IMF) had recently sharply revised downward India’s growth forecast by 130 basis points to 4.8% for 2019-2020. Subbarao highlighted the severity of the impasse in which the Indian economy now finds itself. He noted that the GDP growth rate has been less than 5% for the last several quarters, and that “we’ll be lucky if we get close to 5%” this year.
“Not only have we lost our bragging rights as the fastest growing large economy in the world, we are not even in the top league anymore.” –Duvvuri Subbarao
Explaining what stalling GDP growth means for India, Subbarao said: “Not only have we lost our bragging rights as the fastest growing large economy in the world, we are not even in the top league anymore,” he said. “That’s a cause for much despair because hundreds of millions of people’s livelihoods depend on India’s growth reviving.”
Subbarao ran through the economic casualty list: Investment is down. At its peak, when India’s growth story was unfolding, investment was as high as 38% of GDP; it’s now down to 30%. Productivity of investment is low because of poor infrastructure. Agricultural distress is widespread and runs deep. Manufacturing and export indices are also down. Few new jobs are being created. Unemployment is large and growing. “This is not exactly jobless growth but certainly the job intensity of growth is low,” he said. “The list of problems is long. I don’t believe the budget even began to address some of these deep-rooted structural problems.”
The budget did have some positive aspects, such as allocations for agriculture and infrastructure, and some measures to attract foreign capital, including opening up some categories of government securities for non-resident investors. But Subbarao didn’t see those small strokes as an adequate response to the depth of the problems India’s economy faces. He faulted the budget as failing to “do anything much for the MSME (micro, small and medium enterprises) sector, which would create jobs.”
Financial Sector in Trouble
Kapur said he had hoped for the budget “to recognize, be seized of the problem and offer a path forward” regarding the challenges facing the financial sector. Opportunities are limited for fresh investment because of challenges on multiple fronts: For several years now, Indian banks have had stressed balance sheets because of nonperforming loans, the non-banking finance sector has been strapped for funds and corporate borrowers are already overleveraged.
The government has tried to find ways out of that situation, with measures such as the 2016 Insolvency and Bankruptcy Code, Kapur said. But he had expected more resources to recapitalize stressed public sector banks, which would have helped revive the credit cycle. “There’s hardly lending or borrowing going on,” he said. “Unless we have much more credit flowing, we will not have investment. If there won’t be investment, there won’t be growth. And if there won’t be growth, there won’t be any new employment.”
Subbarao agreed that the budget failed to address “the twin balance sheet problem” or the stressed balance sheets of both lenders and borrowers. However, he wondered if the budget should have made more allocations for recapitalizing banks beyond the Rs. 2.1 trillion ($32 billion) it has already allocated for that over the past two years. “I’m sure that is a question that the finance minister and the team would have discussed internally very intensely,” he said. “And they would have thought that we’ve put in enough money for now, so let’s wait and see what this money does. And then, if necessary, we will pump in more capital.”
The government is also cash-strapped and therefore must make tough choices over how it deploys its resources, Subbarao said. “It’s not as if the government is sitting on a ton of money and the twin balance sheet problem is festering and they’re not doing anything,” he said. “The government has very little money, very severe fiscal constraints, and enormous expenditure challenges.”
Governance in Public Sector Banks
Kapur agreed that the government cannot possibly continue pumping money into public sector banks, and he pointed out that “there are severe governance issues” in public sector banking since the government is both the owner and the regulator of those banks. The government would have sent a strong signal that it is aware of those governance issues if it had committed to privatize at least one major public sector bank, he said.
Subbarao noted that India’s public sector banks have outlived their original purpose of going into underserved parts of the country and deepening financial inclusion. “Now, there is a conflict between our growth needs and having public sector banks,” he said. “Instead of owning up to the fact that it’s not possible to keep supporting public sector banks anymore, the government still hangs on to the idea of the public sector banks being holy cows. That’s untenable.”
“The government has very little money, very severe fiscal constraints, and enormous expenditure challenges.” –Duvvuri Subbarao
Steps such as bank consolidation, where weak banks are merged with stronger banks, “are halfway solutions,” Subbarao said. “It would have been good if, for example, the budget or any other government statement outside of the budget had said that we are owning up to the fact that we need to privatize public sector banks, and here is the roadmap to do that. That would have been an enormous sentiment changer.”
Concerns over Divestment
The budget has embarked on an ambitious plan to raise $30 billion by divesting its equity in public sector enterprises, including banks. Those entities include the Life Insurance Corporation of India (LIC) and Air India, the national airline.
Kapur said the plan to privatize Air India was “a no-brainer” and that its sale would stop the continued infusion of public funds to bail out the airline. “Over the last two decades, Air India has accumulated losses and budgetary bailouts in the order of $8 billion to $10 billion,” he said. He recalled how attempts in 2002-2003 to sell the airline were blocked over a public outcry that the government was selling the family silver. “Now the family silver is worthless, less than lead,” he said. However, the Air India sale would not fetch a large amount of money because the government has limited the bidding to domestic investors, keeping foreign investors out. The equity divestment in LIC would take time because it is “a very large company with lots of assets,” he added.
Even after the disinvestment in public sector companies, the government would retain majority control, and that is a cause for concern, according to Kapur. He noted that the government has in the past sold shares in public sector banks, “but that has not fundamentally altered the governance of those institutions, as long as the state still has majority control.”
The government’s program of disinvestment in public sector enterprises has both a good side and a bad side, said Subbarao. Economic reforms launched in 1991 attempted to wean the government away from its investments in almost every industry, which included bread and liquor, he recalled. Disinvestment programs have been a standard feature of annual budgets since then and reducing the size of the public sector was generally seen as a good idea, he noted. “The idea was to yield space to the private sector, yield space for private investment, and allow the government to concentrate on its core functions of law and order, defense, collecting taxes, and concentrate on providing public goods and merit goods.”
At the same time, Subbarao said his concern is the motivation for those divestments. “We are disinvesting not because of a belief that the government needs to get out and to focus on its core function,” he said. “We are disinvesting because we need the money.”
Further, he said he was worried that the disinvestment proceeds would be spent on non-productive expenditures like salaries and pensions, and not on productive investments like infrastructure.
Boosting Consumer Spending
Declining consumer spending over the past year in India has meant severe shortfalls in demand for goods and services. The budget sought to address that with tax breaks for the middle class, aimed at increasing their disposable incomes. The budget announced “a new and simplified personal tax regime” with revised income tax slabs and tax rates, while allowing taxpayers the option of either sticking to the earlier regime or switching to the new one.
“The tax cuts were neither necessary, nor sufficient, if the idea was to boost consumption, and thereby turn around the economy.” –Duvvuri Subbarao
Kapur pointed to two large budgetary allocations that would help boost consumer demand, especially in rural India. The latest budget retained last year’s allocation of Rs. 75,000 crore ($10.7 billion) for PM Kisan, an income transfer program for farmers. That, along with the allocation of Rs. 61,500 crore ($8.8 billion) for programs under the Mahatma Gandhi National Rural Employment Guarantee Act (MGNREGA) “will put more purchasing power, especially into rural India,” he said.
Instead of putting more money in the hands of the middle class, it makes more sense to target the low income and poor segments of the population because their “marginal propensity to spend is higher,” Kapur noted. In any event, “if one is a little sanguine, the two can complement each other,” he said. More important than those measures is the need to boost “consumer confidence about the future,” said Kapur.
In Subbarao’s view, “The tax cuts were neither necessary, nor sufficient, if the idea was to boost consumption, and thereby turn around the economy.” He explained that the tax cuts were “not necessary, because arguably, part of the slowdown of the economy is cyclical, because of a drop in consumption spending.” Further, he said a good monsoon and signs of a revival in manufacturing activity will help. “We will get a recovery, shallow as it might be,” he said. “Once recovery starts, growth will get back to its potential.”
Subbarao also felt that the tax breaks for individuals were insufficient because the income tax base is “quite low.” Personal income tax collections amounted to Rs 4.7 lakh crore ($67.1 billion) last year, or 2.5% of GDP last year. “If the idea was actually to boost consumption, instead of tax cuts, a better way of utilizing that space would have been to increase some allocation for an expenditure program that would have put [more] money in the hands of low-income people.” Incidentally, the allocations for both the MGNREGA and PM Kisan programs were lower than expected.
Focus on Farming?
Even as Sitharaman gave top billing for the farm sector in her budget speech with a 16-point action agenda aimed at doubling farmers’ incomes, she did not seem to recognize its rightful place in the economy, according to Kapur. “In the budget, agriculture is placed along with health, water, sanitation and education in a section called Aspirational India,” he said. “It does not find mention in the section on economic development.”
“The farmer is not seen as a risk-taking entrepreneur. The farmer is seen as someone who needs to be protected, given some things.” –Devesh Kapur
Kapur said that agriculture has received misplaced priority even from previous governments. “Agriculture is seen as almost a part of welfare; it’s not seen as core part of the productive sector of the economy,” he said. “The farmer is not seen as a risk-taking entrepreneur. The farmer is seen as someone who needs to be protected, given some things.” That mindset is rooted in the government’s desire to control all input and output prices in the farm sector. He pointed out that in such a policy regime, “the farmer almost never gets the upside of high prices, [but] he bears most of the downside of low prices.” Government programs such as minimum support prices for crops do little to help because they work only in a few states and for few crops, he explained.
“The performance of the agriculture sector is important not only to the economic wellbeing of India, but even to the emotional wellbeing of India,” said Subbarao. In that context, a top concern for the drafters of the budget should have been “the deep distress in the agriculture sector,” said Subbarao. He noted that although agriculture contributes only about 15% to the country’s GDP, it employs nearly 60% of its labor force.
In addition to that mismatch, India’s agriculture sector faces formidable problems, said Subbarao. “[They include] poor infrastructure, inadequate credit distorted markets, skewed incentives and laws that stifle private investments.” Those problems are many and they run deep, and the budget has failed to even begin addressing them, he added.
Subbarao hoped that the government finds ways to tackle agricultural distress in other policy platforms it has at its disposal. “It is not just an economic problem. It’s a political problem as well, because if you don’t find jobs for the hundreds of millions of people trapped in the agriculture sector, outside of the agriculture sector, they’re going to have deep political problems.” That task cannot be left to central government alone. State governments too must be held accountable for their role in the performance of agriculture, Kapur added.
Fiscal Deficit Challenge
Sitharaman’s budget may also prove to be overly ambitious in its fiscal deficit estimates, according to Subbarao. He noted that she increased the fiscal deficit from 3.3% to 3.8% by invoking an “escape clause” in the Fiscal Responsibility and Budget Management Act (FRBM), a 2003 statute that aims to contain the fiscal deficit by binding the government to improve macroeconomic management and use public funds efficiently. On top of that higher fiscal deficit Sitharaman assumes is the impact of off-budget borrowings by the government, which would add 0.8 percentage points for each of the next two years, taking the total fiscal deficit – which is “already high” – to 4.3%, he said.
That picture gets worse with “unrealistic projections on revenue growth and on disinvestment proceeds,” Subbarao continued. The upshot is that “we have a potentially unsustainable fiscal situation for this year as well as next year,” he said. In that scenario, he was “quite relieved that the finance minister did not succumb to the temptation of a fiscal stimulus.”
Subbarao explained the implications of a high fiscal deficit and the potentially unsustainable fiscal situation. “Fiscal pressures will undermine the Reserve Bank’s efforts to revive investment by lowering long-term interest rates,” he said. “These fiscal pressures can also result in a sovereign rating downgrade, and thereby threaten our effort to get foreign investment. They could stoke inflation pressures. Inflation already is significantly above the Reserve Bank of India’s inflation target rate. At a time like that, a high fiscal deficit can exacerbate those pressures. Most importantly, they can create pressures in the external sector.” He recalled that India “paid a heavy price for fiscal profligacy in earlier years….. We had a very nasty balance of payments crisis in 1991, and a near crisis in 2013. And both those crises were, at their heart, a consequence of extended fiscal profligacy.”
While much of the focus has been on the central government’s fiscal deficit and its fiscal stance, “the big elephant in the room” is the performance of state governments on that front, Subbarao said. He pointed out that together, the states spend 1.5 times more than what the central government spends. “[Further], the development impact of state expenditure is significantly higher than that of central expenditure,” he added. “Therefore, the public finance management of state governments together matters much more to our development outcomes than we tend to acknowledge.”
The reality is “the states are not doing a good job” in managing their finances, Subbarao said. He noted that the Reserve Bank of India in its latest annual report has highlighted “several red flags about states’ fiscal performance, about their inability to increase their own revenue generation, their unsustainable debt burdens, their tendency to cut down on capital expenditure because they’ve got to meet expenditures on loan waivers, power sector loans, and other income transfer schemes.” The report pointed out “the consolidated fiscal position of  states deteriorated in 2018-2019.”
Subbarao and Kapur agreed that the most positive feature of the budget is that it could have been worse. “It was a somewhat stolid [or] prudent budget,” said Kapur. “But [it was] not one that seemed to indicate that it was aware and seized of the magnitude of the problems the economy was facing.” Subbarao felt it was largely ineffectual. “The budget did not do much wrong, but it did not do much right either,” he said. “If you want a balance sheet or report card, I would say the depth of the problems is so intense that the budget does not even begin to address them.”
All said, the policy choices are clear to the finance minister, said Subbarao. “If they’ve not been doing all the right things, it’s not because we don’t know what to do, but it’s because we are unable or unwilling to do them,” he said. He rolled off the long list of aspirations the government has aired: “We want to be a $5 trillion economy by 2024. We want to double farmers’ incomes by 2022. We want to create, or we must create, tens if not hundreds of millions of jobs. We want to engineer a manufacturing revolution. We want to be an export powerhouse. We want to occupy the space vacated by China in this global value chain.”
For sure, the finance minister and the government “to their credit have done a number of things to put India on a growth track,” said Subbarao. What is lacking is a positive sentiment about investing in India, he added. “What needs to be done is to turn around the sentiment. The government has to send out a message that India is a promising place to do business.”
“The government has to send out a message that India is a promising place to do business.” –Duvvuri Subbarao
With the budget, or soon thereafter, the government had the opportunity to lift that sentiment, but missed it, said Subbarao. “What I would have told the finance minister is that soon after the budget, the prime minister must stand up in parliament and make a statement saying, “The economy has deep problems, My government and I are sensitive to that. We know what needs to be done. This is politically difficult. But the people have given us a mandate to do politically difficult things. Therefore, this is my agenda for reviving the economy. I admit that this is not going to turn around the economy tomorrow. This is a long-haul effort. But this is the timetable. And this is what I’m going to do. And these are the milestones by which my performance should be measured.” Had Prime Minister Modi made such a statement, “that would have turned around the sentiment,” he added.
The warning signs are already out there for the Bharatiya Janata Party (BJP) government to shore up its act to revive the economy, said Kapur. He pointed to the defeat the BJP faced in the Delhi state elections two weeks ago, where the previous government led by the Aam Aadmi Party strengthened its hold. “That is a signal that the people have their own priorities about basic bread and butter issues in the economy,” said Kapur. “They are sending a signal that priorities of the government need to refocus very sharply, to a razor-like focus on the economy. It also shows that social agenda issues are divisive, not just distractive, and they can be quite destructive.”