Pay Commission, Election Spend Pose Major Risks For India: Lehman

MUMBAI: The Sixth Pay Commission and populist election spending pose major risks for India, says Lehman Brothers in its Global Weekly Economic Monitor dated October 12.

Progress on the fiscal front has been one of India’s recent hallmarks. The state and central budget deficit narrowed from a peak of 9.9 per cent of gross domestic product in 2001-02 (Apr-Mar) to an estimated 5.7 per cent in 2007-08, the largest improvement in the past quarter-century. The improvement has been driven by fiscal reforms and robust economic growth. But in FY09, despite strong revenue growth, we expect the fiscal deficit to rise to 6 per cent of GDP on populist spending ahead of elections, the report says.

Moreover, if the outcome of the Sixth Pay Commission is anything like that of its predecessor, the deficit could be larger still in FY10, the investment bank says.

SUMMER OF ‘09

In India, an impending election is nearly always a trigger for populist fiscal spending. Most of the past peaks in the expenditure cycles have occurred close to national elections. The upcoming election, which must be held no later than May 2009, will likely be no different. The government looks set to focus on increased education, health and rural spending. Already, news reports suggest that the party has sought to extend the national rural employment guarantee scheme to all districts, at a projected annual cost of $4.6 billion. A number of other schemes likely to be introduced include the Aam Aadmi Bima Yojana (insurance for rural landless workers), Health Insurance Scheme for Below Poverty Line Workers, National Old Age Pension and the National Policy for Farmers, Lehman says in its report.

The government is also granting more subsidies. From this month, sugar mills will receive subsided loans and many export-oriented sectors reeling from the pressure of an appreciating rupee have recently received extended export credit, service tax exemption and other tax breaks. The government estimates that revenue foregone as a result of export-related concessions was close to $14 billion in FY07 and looks set to grow in FY08.

Off-balance sheet government subsidies are also likely to rise. Domestic fuel prices have remained unchanged despite the surge in the international price of oil – and India imports most of its oil. With elections round the corner, the probability of a fuel price hike looks slim; the government will compensate the loss-making oil marketing companies through the issuance of oil bonds worth Rs 235 billion, much lower than the estimated total loss of Rs 540 billion in FY08 from under-recoveries due to subsidised selling of fuel products, the report adds.

COMMISSIONED TO PAY?

The Sixth Pay Commission poses a more medium term, but serious, risk to the fiscal outlook. The SPC, an administrative mechanism set up by the government, recommends an increase in pay of central government employees only once a decade, the investment bank says.

India has had five pay commissions so far and the last one – the Fifth Pay Commission in 1997 – had a devastating effect on India’s fiscal finances. The fault lay not with the FPC. The FPC had recommended large pay hikes, but also advised that the hikes should be linked to downsizing of pay scales and the workforce, abolishing vacant posts and adopting a performance-linked pay structure. The government in power at the time accepted the recommendation related to pay hikes, but ignored the implementation of the other politically sensitive recommendations.

This had twin effects. First, it resulted in a massive one-shot 30 per cent increase in salary for all the central government employees. Second, it impelled state governments to implement similar hikes. The net result was a sharp rise in the share of general government wages and salaries from 5 per cent of GDP in FY96 to 6.4 per cent in FY00, a doubling of pension payments from 1 per cent to 2 per cent of GDP and a sharp surge in the fiscal deficit from 6.5 per cent to 9.5 per cent of GDP during the same period. Some states were unable to meet these commitments and had to borrow to pay salaries.

The jury is still out on the SPC, which will submit its report in April 2008. If the SPC recommends similar hikes as the FPC – and they are implemented – the total wage and pension bill of the combined central and state governments could increase from 5.8 per cent of GDP in FY08 to 7.6 per cent by FY12. The impact is likely to be spread over 2-3 years as the hikes will be effective FY09 for central government employees and FY10 for state government employees and a number of salary arrears will be cleared only in a phased manner. In this scenario, we estimate that the total general government fiscal deficit could surge to about 7.5 per cent of GDP by FY12.

We expect pre-election spending to widen the consolidated fiscal deficit in FY09 to 6 per cent of GDP, but our base case is that this deterioration will be temporary and that robust GDP growth and further fiscal reforms will narrow the deficit to 5.2 per cent of GDP by FY12, Lehman says in its report.

However, the SPC poses a major risk to our base line. India cannot afford the serious fiscal slippage that would reverse many of the positive dynamics that have been helping to raise the economy’s potential growth rate. It could reduce the much-needed public financing for infrastructure investment and crowd out private investment as higher budget deficits push up interest rates. It could also raise the risk premium perceived by foreign investors, thereby slowing the much-needed FDI. The SPC will be an important test of the government’s resolve to adhere to fiscal prudence, the report concludes.