India: The two faces of FY22 budget

India publishes its Q3 GDP figures on 26 February, ending the catastrophic 2020 calendar year. Based on our nowcasting model (figure 1) we expect a fiscal Q3 GDP figure of -1.8% (y/y). There are clear signals of economic recovery, with a continued improvement of the manufacturing PMIs and consumer sentiment as well as higher electricity production. The increasing mobility (figure 2) seen in Q3 also underscores that the Indian economy is getting back on track.

On 1 February, Finance Minister Nirmala Sitharaman presented the Budget for FY2021/22. One of the Budget highlights is the major increase in health expenditures from INR 945bn to INR 2.2tn. This increase includes additional expenditure on vaccines (INR 350bn). Another key take-away is the increase in capital expenditure from INR 4.2tn (USD 56bn) as budgeted in FY21 to INR 5.4tn (USD 76bn) in FY22, an increase of over 34%. The government is clearly aiming at speeding up investment in infrastructure, which we think is a good thing. Investing in productive assets increases the long-term growth potential and strengthens the ‘Make-in-India’ agenda by increasing the country’s attractiveness to global manufacturers.

The government expects the fiscal deficit to be around 9.5% of GDP, which is bigger than our expectation of 7.9%. The accumulation of spending also results in a deficit of 6.8% of GDP in FY22, slightly higher than our expectation of 6.3%. The government will keep the deficit elevated for the coming years with the ambition to slowly reduce it to below 4.5% in FY25. Minister Sitharaman aims to achieve this in two ways: by increasing the tax base to bolster revenues and by privatizing government assets. With respect to the latter, the government estimates to receive INR 1.75tn in FY2021/22 by selling a few national banks.

However, the recent track record of selling government-owned assets raises the question whether it is realistic to expect substantial government receipts from the privatization of state-owned banks this year. Although the 6.8% deficit is already an ambitious target, we think it could increase towards 7.5% if the government fails to meet the ambition to privatize some government assets this year.

Higher deficits result in a heavier government debt burden, which at 80% of GDP is already high for an emerging market. Part of the impact is quantified in the Budget: interest payments are projected to rise to 45% of government revenue receipts in FY22 compared to 36% in FY21. If the government is unable to increase its revenue base, this higher interest burden will have a negative effect on future government investments. On the flipside, we do not expect India’s debt to become unsustainable in the short term. The abundance of liquidity in global markets supports capital inflows to India, FX reserves import cover has increased over the last period, and government debt in foreign currency is low at 2.3% of GDP.

Inflation has been levelling off substantially over the last few months, dropping below the RBI’s upper band target range for the first time since March 2020. Most of the decline in inflation can be attributed to lower food prices. We expect these to stabilize in the short term with a good rabi harvesting season in mind. However, we expect inflation to increase later in the year driven by higher global commodity prices (which increase input costs for manufacturers), increased fiscal spending by the Indian government, and expansionary monetary policy by the RBI to foster economic growth.

Despite lower inflation, the RBI did not act on the window of opportunity to cut rates during their meeting on 5 February. Nevertheless, the RBI remains active in the bond market, buying 10yr government bonds in an attempt to keep the yields at 6% in order to support government borrowing. This will increasingly put pressure on the RBI as bond yields rise on the back of recovering economic growth and interest rates bottom out. This adds to our expectation of higher inflation, also keeping in mind the downside risks of such policies.

All of the above would normally bode ill for the value of the INR. However, amid abundant global liquidity, investors are looking for higher yields, forcing them into EM assets. This is resulting in appreciating pressure on the INR, although India is being outperformed by most of its Asian EM peers, which may be a reflection of the risks highlighted above. Looking ahead we expect the INR to strengthen in 2021 on the back of risk-on sentiment, ending the year at 71.55.