As Finance Minister Nirmala Sitharaman rose to present the Union budget for 2022-23 on Tuesday, she faced several competing demands. For one thing, the government’s budget deficit (or total market borrowing) was a concern. On the other hand, there were demands for continued support for the weaker sectors of the economy.
If it spent more to provide direct financial support to various sections of society, the budget deficit, which was already more than double prudential standards, would worsen. If she tried to drastically cut spending, it could hurt large swathes of the economy that are already struggling as a result of the Covid-induced disruptions.
In the end, she chose a strategy that considerably accelerates investments or capex (i.e. expenditures spent on manufacturing new productive assets) while largely retaining revenue expenditures (i.e. expenditures to meet day-to-day expenses).
While prioritizing spending on capital construction is a macro-sound strategy in normal times, it remains to be seen whether it will work for India as it emerges from the Covid-induced setback with significant scars.
What were the challenges facing the economy?
India’s GDP growth rate has been slowing since 2017-18 as unemployment hits its highest level in four decades. Data released on January 31 showed that GDP growth in 2019-20 was just 3.7%. That’s when the Covid-19 pandemic hit.
Between a sharp contraction and an equally sharp recovery, the following two years (FY21 and FY22) essentially resulted in the loss of two full years of income and employment. Moreover, the recovery in aggregate GDP masks the suffering of large parts of the economy. Most surveys and data point to a K-shaped recovery, meaning the economically weaker sections still have significant scarring.
As the second chart above shows, while overall GDP has recovered, the largest component of GDP – private final consumption expenditure (PFCE), or the money that people spend individually – which represents 56% of the entire GDP, is below the level before the Covid pandemic.
The picture appears darker when we look at the levels of GDP and CCTB per capita (graph 3). The average CCTB (or expense) is lower than 2018 levels. Moreover, these are still arithmetic average figures. They suggest that a large part of the population is even below this average level. People are spending less because employment levels have seen a secular decline since 2016 (Chart 4); Covid only made it worse.
A weak CCTB meant that the other big driver of GDP growth – investment or gross fixed capital formation – would remain weak. Indeed, weak demand has led to low capacity utilization (Chart 5) and this removes any incentive for private companies to invest in new capacity, create new jobs and new sources of income for people.
The only other driver was the money the government spends. But too much spending here was excluded because the budget deficit was already double prudential standards.
The question posed to the Minister of Finance was: what would be the trigger for growth in the coming year?
So what was the Budget strategy she chose?
The salient feature of the 2022-23 budget is that the government has chosen to significantly increase capital spending while largely restraining revenue spending. This surge in capex will be reflected in the “investment” component of GDP. The main advantage of capital spending is that it gives much higher returns to overall GDP.
According to different studies, one rupee spent on capital expenditure can yield between Rs 2.5 and Rs 4.8 (over periods ranging from 1 to 7 years), while money spent on the revenue account, such as direct cash transfers to the poor, tends to give returns between Rs 0.54 and Rs 0.98 (i.e. less than one rupee).
Capital expenditures provide greater returns not only by creating new jobs, but also by creating new productive assets that boost future productivity.
Here’s how the government hopes this surge in investment will materialize and lead to India’s economic recovery: new roads, new ports, and more. will not only create new jobs, but will also reinvigorate several other industries through backward and forward linkages. For example, besides new workers, a new bridge will need cement, iron and steel, etc. This will increase the demand for engineers and other technical and management professionals.
When done on a large scale, these expenditures will leave people with more income and this, in turn, will stimulate aggregate demand – the CCTB component. This new demand will further incentivize the private sector to stimulate its own investments and, in fact, take the lead in future investments.
So, according to the budget strategy, a push for investment by the government can lift India out of the current crisis and create a virtuous circle of growth. Over time, as tax revenues from new economic activity increase and private sector investment becomes self-sustaining, the government will withdraw from its investment leadership role, thereby reducing its borrowing requirements.
How does this strategy differ from what has been done by countries like the United States?
Countries like the United States have triggered a massive fiscal response to the Covid crisis. This meant that a lot of money flowed from government coffers into people’s accounts. In India, most aid has come in the form of free food grains, the rural employment guarantee scheme and credit guarantees (no real money paid to struggling small businesses; just guarantees on the loans they can take out). As such, there is no comparison between the direct financial assistance provided by developed countries (even in percentage terms) and that provided by India.
It is for this reason that most estimates suggest a sharp increase in poverty and inequality in India after Covid. On the other hand, the United States was among the countries that experienced a true “V” recovery, returning to the pre-pandemic growth path, and not just on the level.
But countries like the United States also ended up facing a problem: inflation. When lots of money flowed into people’s hands, aggregate demand recovered far too quickly even as supply disruptions persisted, creating historic levels of inflation.
It is another matter that even with depressed demand, India has also experienced quite high inflation over the past couple of years.
Similar to the investment push in India, in the United States, President Joe Biden has pushed for an ambitious $1.9 trillion plan called Build Back Better, aimed at growing the US economy “from the bottom up. and in the middle”.
Will the capex push in the budget succeed?
Few would argue with the merits of increased government capital spending because of the obvious benefits, especially at a time when all other engines of growth are struggling. Moreover, several elements suggest that such an investment cycle will continue.
In a recent research note, Nomura analysts observed: “At first glance, a number of preconditions appear to be in place. The government has announced various reforms, including the National Infrastructure Pipeline (NIP), the system of incentives linked to production, lowering of corporate tax and privatization. Companies have deleveraged their balance sheets during the pandemic. The corporate debt ratio decreased overall across all sectors, from 0.79 in FY19 and from 0.82 in FY20 to 0.63 in FY21.
Add to that the creation of a bad bank, which will allow the banking system to be ready to grant loans when the private sector asks for them.
But there are reasons why it may not be successful. It’s because these are not normal times. There are deep scars in the economy, particularly in the informal sector (which accounts for 90% of all jobs), and aggregate demand is still quite weak. Capacity utilization levels are well below the point where companies might consider increasing their investments.
Economists such as Ravi Srivastava of the Institute for Human Development and Radhicka Kapoor of ICRIER believe that the success of this strategy will depend on how these projects are implemented. The two economists pointed out that these capital assets have long gestation periods and that the expected benefits for ordinary people may take time to materialize.
To the extent that these projects are local in nature – rural roads instead of a major highway – they can be more effective in relieving weaker sectors of the economy. “Given the extent of the economic difficulties, this budget had to rest on two legs. Capex is good, but the government also needed to provide more direct help here and now,” Srivastava said.
It was the ninth budget under Prime Minister Narendra Modi. Is there a pattern emerging?
Over the past eight years, the Modi government has employed very different economic strategies, without suggesting an established ideological anchor. Prior to 2017, he chastised agricultural loan waivers, but just before the UP elections, he took it upon himself to promise them. Similar reversals have been observed with respect to programs such as MGNREGA, the removal of the Land Acquisition Act or the recent repeal of the Agricultural Acts. Ahead of the 2019 elections, direct cash transfers were paid to farmers under PM-KISAN – a compensation policy of the kind he had long criticized.
Similarly, in last year’s budget, privatization and divestment were the main themes — but this year they are completely absent.
And, if the Prime Minister believed in a growth strategy driven by government investments, it is not clear why this was not done in 2019-20 itself instead of giving a tax cut on the companies worth Rs 1.5 lakh to companies, who simply pocketed the money – either to pay off their debts or to improve their bottom line.
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