On May 31, important updates regarding India’s GDP growth and the Centre’s budget results for 2020-2021 became available. According to NSO provisional estimates for 2020-2021, the annual contraction in real GDP turned out to be 7.3 percent, an improvement from the previous estimate of 8 percent. Real GDP growth of 7.8% would be needed in 2021-2022 to return to real GDP levels of 2019-2020.

The old GDP growth projections for 2021-2022 are being reviewed to take into account the negative impact of the second wave of the pandemic. The RBI has downgraded its real GDP growth forecast for 2021-2022 to 9.5%. Other recent estimates (ICRA) indicate the feasibility of 9% growth. At the bottom of the scale, growth of 8.5% is projected by Societe Generale and 7.6% by Moody’s. We consider that with appropriate policy interventions, real GDP growth of 9% may still be possible if the blockages end by the end of July. It is also important to take into account nominal GDP growth for 2021-2022, as this would be a key determinant of the fiscal outlook. In light of supply side pressures and rising costs, the RBI has projected CPI inflation at 5.1%. Given recent trends in inflation rates based on the CPI and the IPD (implicit price deflator), the latter may be somewhat lower, say 4 percent. Thus, nominal GDP growth can be projected at 13.4 percent, which is 1 percentage point lower than the Centre’s budget assumption of 14.4 percent.

Data from the Comptroller General for the Centre’s fiscal aggregates show gross tax revenue (GTR) of Rs 20.2 lakh crore and net tax revenue of Rs 14.2 lakh crore for 2020-2021. The probable growth in RWG for 2021-2022 can be derived by applying a buoyancy of 0.9 – the average buoyancy for five years before 2020-2021 – to the projected nominal GDP growth of 13.4% (the budget assumed a buoyancy of 1.2). This gives tax revenue growth of 12%, which means that the gross and net tax revenue forecast for 2021-2022 would mean Rs 22.7 lakh crore and Rs 15.8 lakh crore respectively. This implies additional net tax revenue for the Center amounting to Rs 0.35 lakh crore compared to budgeted amounts. The main expected deficit could still lie in non-tax revenues and non-debt capital revenues. According to CGA figures, their 2020-21 levels are respectively Rs 2.1 lakh crore and Rs 0.57 lakh crore. By applying a growth rate of 15% to these, a deficit in 2021-22 of up to Rs 1.3 lakh crore could arise in non-tax revenues and non-debt capital revenues.

Historically, the growth rates of non-tax revenue and non-debt capital inflows have been volatile, but together they have averaged just under 15% in the five years leading up to 2020-2021. In any case, the strong budgeted growth of 304% in non-debt capital revenue for 2021-2022 seems rather unlikely given the challenges posed by the second wave. Considering the recently announced RBI dividend of Rs 0.99 lakh crore at the Center, the main shortfall could lie in non-debt capital inflows. Together, the overall deficit in total non-debt revenue can be limited to around Rs 0.9 lakh crore, or 0.4% of estimated nominal GDP. This indicates that a possible slippage in the budgeted budget deficit of 6.7 percent of GDP, as revised in light of recently released GDP data, could be limited.

Given the economic challenges associated with the second wave, three expenditure items must be prioritized. First, an increase in the supply of income support measures for the vulnerable rural and urban population. This would require an amount of Rs 1 lakh crore which can be partly provided by the expenditure restructuring. Second, in light of the recent decision, the budgeted expenditure for immunization of Rs 0.35 lakh crore should be increased, at the very least, doubled. Third, additional investment spending for certain sectors, in particular health care, should also be foreseen. This can be another crore of Rs 1 lakh. Together, this additional expenditure would amount to Rs 1.7 lakh crore, or about 0.8 percent of the estimated nominal GDP. Thus, we need to forecast a budget deficit of around 7.9% of GDP composed (a) of a budgeted budget deficit of 6.7% (b) of 0.4% to fill the deficit of total non-debt revenue and (c) 0.8 percent for additional stimulus measures.

The Center announced loans of Rs 1.6 lakh crore to cover the deficit in the GST compensation tax. This amount should not be counted as its deficit, although it is in addition to the borrowing program. In view of the higher budget deficit, it is expected to add another crore of Rs 2.6 lakh to its borrowing program, bringing total borrowing, including GST compensation, to around Rs 16.3 lakh crore, against Rs 12.05 lakh crore now. State loans would be added to this. The net result will be an unprecedented borrowing program by the Center which may require support from the RBI. This, in fact, is happening now. The RBI injects liquidity into the system through various channels. Banks have sufficient liquidity to take out new debt. It is an indirect monetization of debt. This is nothing new, but the scale is much higher. It is better to avoid direct monetization.

The government and the RBI are keen to keep interest rates low despite this heavy borrowing. The household sector’s appetite for financial assets may not increase. External sector demand for Indian sovereign bonds could also be lukewarm. The success of the Centre’s borrowing program depends on the support provided by the RBI. The support does not have to be direct. It can be indirect, as is currently the case. The RBI massively injects liquidity into the system. According to the latest monetary policy statement, the reserve currency growth rate is 12.4% (as of May 28). So far, the cash injection has been benign. Money supply growth (M3) is modest at 9.9% and credit growth is only 6% (as of May 21). What these numbers show is that the money multiplier is low. This can be attributed to two reasons: weak credit expansion and larger leaks in the form of foreign exchange. The growth potential of the money supply is significant. The discussion in the monetary policy statement on inflation focuses entirely on supply availability and bottlenecks in commodity distribution. The output gap is certainly relevant. But just as relevant in an analysis of inflation is the liquidity of the system and its impact on output and prices with lags. The liquidity injection has its limits. Even though we insist on expanding public spending, it is necessary to keep in mind the implications that expanding liquidity will have on inflation.

Rangarajan is the former Chairman of the Economic Advisory Council to the Prime Minister and former Governor of RBI and Srivastava is Chief Policy Advisor, EY India and former Director of the Madras School of Economics. Opinions expressed are personal