Structural reforms bolster India’s macro stability, further fiscal consolidation needed, says Morgan Stanley

India has systematically shifted the way it manages fiscal policy, and the changes so far have helped manage macro stability and reduced inflation differentials with the rest of the world. However, further consolidation is needed to lower public debt ratios, help bring down risk-free rates, and help incentivize investment and job creation, said Morgan Stanley.

One of the biggest macro challenges for India historically has been its structurally higher fiscal deficit, which brings with it elevated public debt ratios.

But policymakers are focused on making structural changes in managing fiscal policy and have reaffirmed their general policy objective to boost investment and jobs in the recent budget, a team of economists at Morgan Stanley said in a report.

The report highlights that the government has systematically addressed the structural challenges with a series of policy reforms in the past decade.

The monetary policy framework was revamped in 2014, partly as a response to the preceding period of high inflation. Then a series of supply-side reforms (industrial policy) have been taken up since 2017. The introduction of a unified Goods and Services Tax (GST), cut in corporate taxes, lifting of public infrastructure spending, and introduction of production-linked incentive schemes have all catalysed investment – in particular, for the manufacturing sector.

“The structural changes so far have helped in macro stability management and reduced inflation differentials with the rest of the world,” the Morgan Stanley report said.

Noting the progress so far, the economists said that the policymakers have been following the path of fiscal consolidation and from a peak of 13.1% of GDP in FY21, the consolidated fiscal deficit is expected to reach 7.7% of GDP in FY25. Moreover, as policymakers focus on boosting the ratio of investment to GDP, the underlying mix of the deficit has also shifted from revenue to capex.

The report also highlighted that India’s fiscal and public debt trends have fared better than most other Emerging Markets (EMs) since the pandemic, but more consolidation efforts are needed.

“At the starting point, India’s public debt to GDP ratio is still very high. At 83% of GDP, it is much higher than its pre-Covid level of 70.5%. Moreover, based on our analysis of other Asian economies, we think this ratio should be at 60% or even lower, when you take into account the age dependency ratio and current stage of development,” the report said.

What needs to be done

Morgan Stanley economists highlighted two issues when thinking about fiscal consolidation. They think that fiscal targets should be introduced and should be based on cyclically adjusted fiscal positions to prevent a pro-cyclical fiscal policy.

“We would, however, go one step further and recommend the usage of structurally adjusted fiscal deficit – the cyclically adjusted fiscal deficit, further adjusted for one-off factors such as terms of trade shocks, large one-time rises in revenue, write-offs related to bank recapitalization, etc,” they said.

They believe that the concept of the structurally adjusted fiscal deficit will give a true picture of underlying fiscal stance while also keeping the target flexible so that policymakers can respond to shocks.

Secondly, the economists believe that policymakers should mandate these targets and only allow for deviations which must be approved by a two-thirds majority of lawmakers with specific provisions or criteria to be invoked (like the event of a significant exogenous shock).

Read all Economy related news here

Disclaimer: The views and recommendations made above are those of individual analysts or broking companies, and not of Mint. We advise investors to check with certified experts before making any investment decisions.