The State of the Economy & Budget 2020-21 Recommendations

India suffered 6 consecutive quarters of de-growth, culminating in a 4.5% GDP growth, in Q2 FY20 & is optimistically expected to clock a 5% GDP growth in FY20 & a 5 - 5.5% growth next year. Incorporating the former Chief Economic Advisor – Arvind Subramanian’s – claim that the growth rate, as per the new GDP series, overstates growth by 2.5%, reveals a shocking  growth rate of 2.5% only, requiring “antibiotics & not painkillers” as per the former head of the Prime Minister Economic Advisory council (PMEAC), Rathin Roy.

With nominal GDP at 7.5% & borrowing rates around 10%, there is no economic logic to seek credit for expansion. Furthermore, with capacity utilization trending between 72-76% (68.9% only in Q2FY20, 73.7% in Q1 FY20, 76% in Q4 FY19 as per RBI – Reserve Bank of India) there is no incentive for expansion, especially when assets are available at a steep discount, vide the Insolvency & Bankruptcy code (IBC).

Crony capitalists raided the banking network till 2014, & after Governor Raghuram Rajan instituted the Asset Quality Review (AQR), in Dec 2015, & put 11 PSU Banks under Prompt Corrective Action (PCA) - effectively debarring them from lending - they started raiding the Non-Banking Financial Companies (NBFCs) instead & the party ended with the Infrastructure Leasing & Financial Services (IL&FS) crisis, in 2018, prompting de-growth. This, perhaps, is a bigger root cause to decelerating growth as compared to Demonetization or a “faulty GST”. The Indian Banking, Finance Services & Insurance (BFSI) sector is thus fragile & “Loan melas” & “mudra loans” could only kick the can down the road.

The Periodic Labour Force Survey (PLFS), conducted by the National Sample Survey Organization (NSSO), pegs unemployment at 6.1% in FY18, a 45 year high. However, new jobs generated, as per NSSO, during FY2000 - FY2005 was 6 crore while FY 2005 - FY2012 was 1.5 crores only, indicating that India has been facing a problem of lack of good employment opportunities for quite some time, perhaps, because Indian Industry is more keen on putting up capital intensive rather than labour intensive industries, raising the spectre of the “demographic dividend” turning into a “demographic curse”, with the attendant consequence of social strife.

Faced with such a bleak economic commentary, RBI opened up the monetary policy tap, with a 135 point reduction in repo rate, in 2019, but faces issues of transmission; with current Repo rate at 5.15 % & inflation at 7.35%, in Dec 2019, RBI will be forced to pause. Furthermore, savings rate dropped form 37.8% in Mar 2008 to 30.5% in  Mar 2018 & hence the need to maintain a  Real interest rate of 1 - 1.5% - a good compromise between the needs of the depositors & the borrowers, even while the latter could demand a negative / zero real rate of interest.

Sector wise Health Matrix

The auto sector is facing stress with de-growth in sales starting, Oct 2018, roughly coinciding with the onset of the IL&FS crisis, impacting consumer credit to auto sales; this is also in line with the global secular trend of reduction in auto sales because millennials’ prefer ride hailing apps over auto ownership. Rajiv Bajaj, of Bajaj Auto, avers that increased insurance costs implemented from Sept 2018, making of additional safety features like Anti Braking System (ABS) mandatory, since Apr 2019 & the proposed leap from BSIV to BSVI, from Apr 2020, leading to at least a 30% hike in vehicle costs explains slowing sales in 2 wheelers. It is probable that the weak economic sentiment coupled with job losses & a wait for better electrical vehicle offerings are other causes forcing customers to postpone purchase. Auto sector contributes 15% to GST & 7.1% to GDP. While manufacturing contributes 15% to GDP, Auto at about 47% of manufacturing is critical to the health of the economy, impacting derived demand products: steel, tyre, paints, carbon black etc.

While the rise in protective tariffs & the resolution of stressed assets like Essar & Bhushan steel, vide Insolvency & Bankruptcy Code (IBC) has somewhat helped alleviate suffering of the steel industry, the pain in the power, aviation, telecom, BFSI, Real Estate  etc. sectors persists.

With states like AP dishonoring Power Purchase Agreements (PPAs), in lieu of buying solar power, at discounted rates, power plants running on fossil fuels, like coal, are seeing low utilization & could emerge as the next Non- Performing Assets (NPAs). The centre mandated opening of a bank guarantee/Letter of credit by discoms, in favour of power generating companies, since Aug 1^st 2019, to avoid addition to Rs 41,747 crores of outstanding dues, is impacting demand & generation. In the aviation industry, Jet & Indian Airlines are on the block while Indigo is facing headwinds. In the Telecom industry, Vodafone-Idea is threatening to throw in the towel. As per Knight Frank, India’s top 7 cities have 42 months of unsold stock of flats, end Q2FY20, an indication of the precarious situation in the real estate industry; while the govt. has announced a Rs 25,000 crore real estate fund, the quantum of unfinished projects in the top 7 cities alone is worth 4.6 lakh crores. The sordid list continues indicating that the economic recovery, with so many industries in the Intensive Care Unit (ICU), is way off.

With traditionally heavy capex spenders, like Reliance, busy deleveraging their balance sheets, expecting Indian industry to revive with a rise in private investment is foolhardy. Creating a “bad bank” as advocated by some, to accelerate credit,& hence investments, could actually be counterproductive when capacity building on project appraisal skills or erection of Chinese walls, between the govt. & the BFSI sector – to prevent “phone banking”- an euphemism for cronyism - have not been implemented yet. With low capacity utilization & with a weak demand scenario, characterized by diminishing consumption, the Indian private sector will be loath to invest, forcing the govt. to do the heavy lifting, for at least the next 4-8 quarters. Unless domestic demand rises, foreign investors too would prefer a “wait & watch” mode & hence foreign direct investment (FDI) too cannot come to the rescue.

Perhaps, because of the listed headwinds, the govt. increased custom duties, during the last few years, emerging into a “protectionist avatar” - maybe for some time - to increase capacity utilization.

Against this bleak economic scenario, it is important that the center release pending dues to the states so that states are not forced to cut expenditure which otherwise would accentuate a negative spiral of de-growth. This is critical since the combined budgets of all states is more than the central budget. Suggest the following further for reviving the economy:

(1)Revive Consumption:

Ideally a loose monetary policy is complemented by a tight fiscal policy but the current extraordinary situation, perhaps, demands a Keynesian stimulus. However, Sajid Shenoy, of JP Morgan, estimates the fiscal deficit of the centre (3.3% of paper but could be closer to 4.4% as per Rathin Roy), states (2.6% budgeted but could rise to 3% this year) & off balance sheet items at 9% leaving little fiscal space. However, a higher fiscal deficit, if used for capital spending, is still defensible. Fiscal & monetary taps opened up simultaneously, without structural reforms, though, would invite stagflation – high inflation & low growth. Hence the need for a loose monetary & fiscal policy with structural reforms, to prime growth, to be slowly moderated after 4-8 quarters. As structural reforms yield results only in the medium term, demand & consumption revival is the immediate ask by placing money in the hands of the citizens of the lower quartile of society who would perhaps, spend the entire amount on consumption, unlike others who shall have a greater propensity to save, more so during times of economic distress.

During the last 5 years, with investment & exports being weak, consumption emerged as a saviour which has since started weakening; Consumption has dropped to 57% of GDP & hence a need for revival. Rural demand can he enhanced by spending more under Mahatma Gandhi Rural Employment Guarantee Scheme (MNREGA) but knowing Modi’s disdain towards the scheme, it is unlikely to be approved. He could very well spend under “Har Ghar Nal”.

Modi had promised tap water, to all households, as part of his 2019 manifesto. Bringing river water vide canals to all villages/cities is capital intensive & the govt. – of all hues - record on relief & rehabilitation of the displaced has been pathetic.  Furthermore, climate change has led to the emergence of extreme climates. To address both the objectives, lakes can be dug, on govt. land, in the outskirts of villages/cities from where piped water can be provided to the nearest catchment under “Har  Ghar Nal”. The presence of these new water bodies shall serve as sinks to rain water/floods & moderate climate. Suggest a spent of Rs 50,000 crores, every year for the next 3 years, under this head.

Ideally, Direct Benefit Transfer (DBT), of the Rs 75000 crores, currently spent as fertilizer subsidy, directly into farmers accounts could help but transfers under PM Kisan have been tethered to clean up the database of beneficiaries; likewise, DBT of the 1.84 lakh crores spent as food subsidy. However, since the political economy was kept greased vide these subsidies, interest groups would torpedo moves towards DBT.

(2)Revive Investment: Investment rate dropped from a peak of 41.2% in Q2FY12 to 29.7% in Q2FY20. With Indian BFSI sector fragile, either FDI or govt. spending has to come to the rescue since the Indian private sector is unlikely to display the appetite for reasons explained earlier.

The govt. can raise revenues vide divestment with the promise that the entire proceeds of asset sales shall be used, entirely, for building new assets to avoid the accusation from the opposition of selling “family silver”; it is a case of selling one asset to erect another with the bonus of creating additional employment, they could reason. The Govt. has never achieved divestment target beyond Rs 1 lakh crore but needs to target an ambitious fig. of at least 1.5 lakh crores, during FY 21.

The reduction of taxes for manufacturing to 17.17%(15% basic Tax+10% Surcharge+4% education cess) for companies incorporated started after 1^st Oct 2019 & starting production by 31^st Mar 2023, meant to attract new supply chains from abroad, taking advantage of the US-China trade war, would be a slow burn, especially due to investor caution on slowing demand & news regarding social strife, in India, courtesy issues, like CAA-NRC & states like AP reneging on contracts.

It is important to learn lessons from Vietnam - the greatest beneficiary of shifting supply chains from China. Vietnam- with a GDP 1/12^th India’s, has exports 75% of India’s in 2018 against 6% in 1960 & 34% in 2000. The Prime Minister should task his commerce minister with a one point agenda: bring supply chains to India -a "once in a generation" opportunity" as per Dr Arvind Virmani.

(3)Exports: While an export policy comes under the realm of the Commerce Ministry, the FM should arrange for zero rating of exports, under GST, to prevent working capital lock up due to delayed refunds. However, this too shall come under the remit of the GST council & outside the budget.

GST revenues at around 1 lakh crores per month against 1.2 lakh crores target – about 20% shortfall. Arvind Subramanian recommended a revenue neutral rate of 15.5% while the average realization, at launch, was 14.4% which has progressively dropped to 11.6% (~20% shortfall), since govt. reduced GST rates for interested parties, for short term gains, before state elections – 5% on food before Gujarat elections etc.; Increase in GST rate to 15.5% - with 3 slabs –could be a recommendation to the GST council, to be implemented, only after the economy has started looking up.

(4)Infrastructure Focus: The govt. has already announced, in Dec 2019, that they plan to spend $102 lakh crores during the next 5 years on infra – 25 lakh crores in power, 20 lakh crores in roads, 14 lakh crores in Railways etc.; the FM could explain in the budget how she plans to raise resources for funding the same. Budget FY20 announced a capital spend of Rs 0.64 lakh crores for Railways & Rs 0.68 Lakh crores for Roads & Highways; this can be increased to Rs. 1 lakh crore each.

The govt. should announce a spend of Rs 25000 crores, with a matching contribution by the states, to buy new electric buses which shall not only help the auto sector but also the  steel, tyre & carbon black revival; better public transport & last mile connectivity shall also have positive environmental consequences.

(5)BFSI Reforms: With bank mergers announced, integration of all PSU general insurance companies the next step; listing of Life Insurance Corporation (LIC) could net additional revenues but since LIC is forced to emerge as a white knight to rescue the govt. in its divestment targets, impacting valuation, listing may be delayed.

It is time to clean up the mess in private banks like Yes bank; reforms in the shadow banking network – NBFCs – co-operative banks should happen over the next 5 year.  Announce Rs 25000 crores as a financial sector safety fund. Perhaps, additional allocations would be needed in the subsequent years too to nurse the sector back to health.

That Banks are reluctant to lend is buttressed by about 4 lakh crores lying under reverse repo. To address the issues of “phone banking” & Asset liability mismatches encountered by banks in project finance, suggest the following options:

(a)Revive Developmental Financial Institutions (DFIs) like the erstwhile ICICI, IDBI, IFCI etc. suggests Sajjan Jindal; Vinayak chatterjee, of Feedback Ventures,  suggests govt. contribute 2 lakh crore equity & raise 8-10 times that amount vide debt to achieve the purpose. Moneylife’s Sucheta Dalal, however, reminds us of the run on DFIs, in the 1990’s, by companies like Essar, Jindal, Usha etc. & challenges its viability

(b)Encourage creation of private DFIs with stakes held by international pension funds, sovereign wealth funds etc. to deter “phone banking”. Hopefully, they display more professionalism.

(c)Deepen corporate debt market & debar PSU banks from subscribing to corporate debt beyond 20% (say) of issue size.

(6)Encourage FDI:  The “dirty dozen” firms that were the first to be brought to the IBC, for resolution, were all run by Indian promoters, who caused Indian banks much harm unlike foreign firms, like HUL, Nestle etc. India attracted $61 billion of FDI last year – about 2% of GDP; perhaps time to increase it to 4% of GDP by Increasing FDI limit in Insurance from 49% to 74% & 100% under automatic route for all sectors except sensitive ones like defense.

(7)Reduce PIT: Reduction of corporate tax has led to a clamor for reducing personal income taxes (PIT) to ensure parity. As per an IMF paper, only 20% of tax savings, post reduction in corporate taxes in US, to 21%, has flowed into investments & the scenario is unlikely to be different in India; perhaps, the govt announced the measure as a hedge against joining Regional Comprehensive economic Partnership (RCEP).

Reducing personal income taxes, especially, during these times when tax collection is under stress is generally, thus, not a recommendation. However, reduction of taxes in the lower slab & compensation by introducing 35% & 45% slabs could be attempted; however, GOI would prefer continuance of surcharge & cess since they are not part of the divisible pool with the states.

With a rebate of Rs 12500, on incomes between 2.5 – 5 lakhs, no citizen with an income under 5 lakh pays tax while the 5-10 lakh slab attracts a 20% tax, which could be reduced to 10% to spur consumption. Promise a road map of reducing the tax, on incomes between 10 - 25  lakhs, from 30% to 20%, next year & recover losses by introducing higher tax slabs. Direct Tax Code, could be a better alternative, at simplification & removal of exemptions,  but since all governments, want to play God, on budget day & having experiencing the loss of power, post indirect tax reform with GST launch, no central govt. is likely to play ball. Therefore the proposed slabs

Income Tax Slabs	Current	Proposed
2.5-5 lakhs	5%; Rebate of Rs 12500/- ensures zero tax	Retain
5-10 lakhs	Rs 12,500 + 20% of income over 5 lakhs	Rs 12500 +10% of income over 5 lakhs; to be announced for FY21
10-25 lakhs	Rs 1,12,500+30% of income over 10 lakhs	Rs 1,12,500+20% of income over 10 lakhs; to be implemented from FY22
25-50 lakhs		Rs 4,12,500+30% of income over 25 lakhs; to be implemented from FY22
50-100 lakhs	Rs 1,12,500 +33% of income over 50 lakhs. 33% is due to a 10% surcharge over 30%	Simplify with a  35% slab
100 -200 lakhs	Rs 1,12,500 +34.5% of income over 50 lakhs. 34.5% is due to a 15% surcharge over 30%
200-500 lakhs	Rs 1,12,500 +37.5% of income over 50 lakhs. 37.5% is due to a 25% surcharge over 30%	Simplify with a 45% slab
500 lakhs & above	Rs 1,12,500 + 41.25% of income over 50 lakhs. 41.25% is due to a 37.5% surcharge over 30%
Currently a 4% Health & Education cess is applicable on all the slabs which needs to be eliminated

With no "wealth tax/Estate" tax in India, the 45% tax slab is not quite as regressive as it is generally made out to be.

Conclusion: India is facing a “silent fiscal crisis” as per Rathin Roy & the next 4-6 quarters are going to be a trial by fire; the Finance Minister can emerge victorious by unleashing steps, at demand revival, in the short run - vide DBT, spent of Rs 50,000 crores under "Har Ghar Nal", Rs 1 lakh crore each under Railways & Roads & Highways (against 0.64+0.68 Lakh crores budgeted last year), Rs 25000 crores for buying electrical vehicles with a matching contribution by the states etc. - & allowing, structural reforms - lower corporate taxes, opening up of FDI, factor market reforms etc. - to fire in the medium to long term. Adroit handling, is a prerequisite, & that shall determine if India emerges as a global powerhouse like Japan, South Korea or China or an “also ran” like Turkey, Brazil, Thailand or South Africa.