India’s budget deficit to remain more vulnerable: Moody's

A  new report by Moody's Investor Service, “India's Fiscal Deficits: What past trends portend for the future”, investigates why India's government finances have failed to improve despite high economic growth, and what this implies for fiscal policy reform in the future.

According to the report, India's budget deficit will remain more vulnerable than rating peers to every growth slowdown until the tax base is substantially expanded. Policy proposals to expand the service tax to all but a specific negative list of services is an effort in this direction. However, it will take years before service tax revenue becomes as important to revenues as manufacturing currently is, it adds.

Moody's say, the Indian economy has tripled in size over the last decade. Its GDP growth, savings and investment rates have reached historic highs, and now far exceed the average rates for emerging markets. Yet, the general government's budget deficit ratio is close to levels of a decade ago, and far higher than that of similarly rated countries.

The report finds that while annual budget statements were important indicators of the government's policy preferences, actual deficit outcomes were constrained by the structural attributes of the Indian economy and dependent on GDP and inflation trends.

For instance, during its strongest periods of GDP growth, India's tax revenue to GDP ratio did not rise to levels of similarly rated countries due to the structural constraints of a low tax base and administrative limitations that impact compliance, explains the report.

The report further mentions that a modest decline in India's GDP growth widened its fiscal deficit more significantly than observed elsewhere. This was partly because taxes on corporate profit and manufactured goods output and consumption dominate Indian government revenues, and both are highly growth-elastic. Also, India's subsidy spending is exposed to commodity price and exchange rate trends, and has inflated expenditures during the last few years.

Moody's say that India's Baa3 rating incorporates these fiscal drawbacks as well as credit strengths such as its high GDP growth and savings rates which allow large government deficits to be absorbed by the economy. Over time, however, the failure to narrow persistent government deficits could endanger these very credit strengths.

Loose fiscal policy nourishes inflation, says Moody's adding that persistent inflation, in turn, erodes the value of accumulated savings. It also raises capital costs and discourages investment.

Moreover, high domestic interest rates prompt the private sector to seek leverage abroad, widening the current account deficit and increasing economic vulnerability in times of global financial volatility, add the report.

Moody's stable outlook on India's rating is anchored by a view that fiscal metrics will remain in their current range over the next twelve to eighteen months. Stabilizing India's deficit at lower levels is a medium term project that an annual budget statement can set in motion, but cannot accomplish. In addition to persistent policy efforts to shrink long term claims on government expenditures, reduce subsidies and expand the tax net, it requires a return to a more benign growth and inflation environment.

Please find attached Moody's issuer comment titled “India's Fiscal Deficits: What past trends portend for the future”.