Modi’s new Budget shouldn’t break the bank

By Mihir Sharma

Things seem to be falling comfortably into place for Prime Minister Narendra Modi. Yes, he lost seats in India’s recent general election — but he was, nevertheless, re-elected for a third term. Yes, he is dependent upon smaller allied parties for the first time in his political career. But those allies have been complaisant so far, and he has kept them out of major ministerial roles without any blowback.

That period of calm may be coming to an end, however. Next week, India will unveil its tax-and-spending plans for the ongoing financial year, which ends in March 2025 — and, according to Reuters, the allies’ bills will come due.

The two largest regional parties in Modi’s coalition are together apparently asking for Rs 47,628 crore ($5.75 billion) of federal government funds to be transferred to their regions and preferred programmes over the next eight months. Chandrababu Naidu, the chief minister of Andhra Pradesh in India’s south, wants to build a new capital city for his state. Nitish Kumar, who runs India’s poorest state of Bihar, has made a name for himself as a designer of clever but expensive welfare schemes.

Modi is a fiscal conservative. He doesn’t like spending two rupees when one would do, and he won’t spend that rupee when he could make a costless contingent guarantee instead.

Thanks to those instincts, the Indian government managed to control its spending during the pandemic years and has emerged from that crisis with a clear path for fiscal consolidation. The interim budget in February promised that the deficit would shrink to below 4.5% of gross domestic product by March 2026.

While the markets may quibble over the details, there’s agreement on the direction of India’s deficit: downwards. Modi needs to preserve that trust, even when faced with new demands from pesky regional parties.

Such pressures are, after all, only part of the strains that India’s budget will have to address. Most politicians interpreted the unexpected election results as a sign that India’s job shortage was beginning to bite. The government will be tempted to respond by being more generous — for example, by expanding the number of make-work public sector jobs available to India’s vast army of unemployed youth.

To excuse fuzzier fiscal math, Modi’s officials might look to another source of support. On June 28, India formally became part of JPMorgan Chase & Co’s index of emerging-market government bonds. Starting from Jan. 31, 2025, the appropriate Indian government paper will also be added to the Bloomberg Emerging Market Local Currency Government Index. (Bloomberg LP, the parent company of Bloomberg News, offers index products for various asset classes through Bloomberg Index Services Ltd.)

Some estimate that the June addition alone could lead to an inflow of about $2 billion (Rs 16,711 crore) a month more into rupee-denominated government securities. That would likely push down borrowing costs for New Delhi.

Finance Ministry bureaucrats might also feel a little less worried about the effect of their mammoth borrowing plans on the rest of the domestic bond market. The central bank will be relieved that its troublesome charges in the banking sector will be able to access additional liquidity.

The government has long seen inclusion in emerging-market bond indices — and the capital inflows and lower borrowing costs that come with it — as hard-earned reward for what it believes has been an outstanding macroeconomic performance. The risk is downplayed: India’s economy is too large, officials think, and these purchases too small to cause a major crisis if they were to reverse.

That’s no justification for billion-dollar handouts to your political supporters, however. While increased access to foreign financing makes the job of budgeting easier, the exposure imposes additional responsibilities.

You must be more transparent and fiscally responsible, not less, or you risk the shocks that come with reversing capital flows. Economists at the Finance Ministry’s in-house think tank have already warned that India must prepare for “greater scrutiny on the government’s fiscal metrics and its broader macro-fiscal policy framework.”

One or two spendthrift budgets may not cause a crisis. Still, a sudden outflow of cash would make a bad decision look worse. As former UK Prime Minister Liz Truss’s disastrous 2022 budget showed, you don’t want to be caught between spiraling rates, plummeting confidence, and a yawning deficit.

The price India’s government will pay for lower borrowing costs is being accountable to a new and sensitive set of critics: the bond markets. Even if everything looks to be falling into place for Modi, he can’t relax his fiscal vigilance yet.