There is limited scope for the Modi government to undertake drastic measures to reduce expenditure to GDP ratio, and the only credible way to reduce spending is by cutting subsidies, mainly oil subsidy, says Morgan Stanley

The Narendra Modi-led National Democratic Alliance (NDA) government, in its preparation for the FY2015 fiscal accounts will need to consider adjusting the FY2014 reported fiscal deficit for one-off measures taken in March to make a better assessment of the starting point. "We believe there is limited scope for the government to undertake drastic measures to reduce expenditure to GDP. In this context, we believe the only credible way to reduce spending is by cutting subsidies (mainly oil subsidy). We expect that the government’s approach will be to maintain a moderate pace of expenditure growth at around 9.5% year-on-year (Y-o-Y) even as growth picks up to ensure sustainable fiscal consolidation," says Morgan Stanley in a research note.

"However," the report says, "We do not expect the new government to take drastic measures to reduce expenditure to GDP, as the present run rate at 14.2% of GDP is towards the lower end of the historical range of 13.9-16.5%. We believe the government could contain overall spending growth to around 9.5% compared with an average of 16.7% seen in 2009-2013. In other words, we see the government aiming to keep expenditure growth slightly below nominal GDP growth."
 

Source: Budget Documents, Morgan Stanley Research

* F2014 central government fiscal deficit adjusted to show underlying trend at 5% of GDP vs. government’s reported number of 4.5% of GDP

"We believe that the new government will need to clarify that the starting point of the underlying fiscal deficit trend as of FY2014 is 5% and not 4.5%. This, we think, would allow the government to have a credible target for FY2015," says Morgan Stanley in a research note.

Since the credit crisis, India’s fiscal deficit has remained high, in the range of 7.5-10% of GDP due to bad growth mix and reduced productivity in the economy. While the fiscal deficit trend has improved since FY2012, the deficit remains high at 7.6% of GDP in FY2014. This includes the central government's deficit at 5% of GDP (adjusted for underlying trend compared with 4.5% reported) and the state government's deficit at 2.4% of GDP.

Morgan Stanley says, it believes that reducing the fiscal deficit and increasing investment are critical steps towards improving the growth mix and raising productivity, because fiscal consolidation is one of the key elements of the reform agenda for the new government. "The state governments’ deficit is closer to the trend line, and more importantly their mix of spending is better placed with revenue in surplus. Hence, we believe that the bulk of the reduction in the fiscal deficit needs to be at the central government level," the report said.

By the time the new government presents the budget for FY2015, the first quarter will already be over. Morgan Stanley says, it believes there is limited room for reducing the fiscal deficit for the year. "We expect the fiscal deficit to be cut to 4.5% from 5% in FY2014. We believe the new government will maintain a gradual path towards fiscal consolidation by adopting a twofold approach: 1) maintaining a moderate pace in government expenditure and 2) improving the tax revenue to GDP ratio through an improvement in the growth outlook," it added.