Low on ambition; high on realism

Posted On Monday, Mar 19, 2012


Arvind Chari, Fund Manager - Debt

The government has presumably embarked on the much required fiscal consolidation by budgeting the fiscal deficit at 5.1% of GDP. The number is high in absolute terms and needs to move towards the 4% mark; but on a relative basis it is lower than the 5.9% to GDP number for fiscal year 2012. A low fiscal deficit is extremely crucial to boost domestic savings; provide funds for private investments and soften inflation pressures.

Restoring Credibility?

In FY 12, the government budgeted for an unachievable fiscal deficit of 4.6% of GDP but ended the year at 5.9% thereby completely eroding its credibility towards economic management. It was a case of several misses and over expectations – starting from an assumption of 9% growth in the backdrop of global recession; no rationalization of taxes; fall in tax growth on domestic slowdown; non-alignment of oil and fertilizer price despite increasing global prices leading to higher subsidies and an embarrassing mis-handling of the disinvestment process.

This year’s statement of accounts seems much more realistic and achievable under normal market conditions. The GDP growth has been pegged at 7.6% of GDP; tax rates (excise and service) have been increased from 10% to 12% ; the government has higher chances of achieving asset sales (telecom spectrum and shares). Crucially, all services have been brought under the tax net (barring 17 under the negative list) which will lead to an increase in India’s tax to GDP ratio. It would also move towards correcting the distortion of Services accounting for 55% of GDP but tax from services contributing only upto 1% of GDP. Also, it appears that the finance minister has been wiser from last year expectations and has taken into account the weak government mandate in pushing through steep price hikes required to reduce subsidies. Thus, subsidy provision remains high at 1.9% of GDP on limited room to increase prices of Oil and fertilizer. An increase of around 10% can be estimated in domestic prices to achieve the stated subsidy. This appears as a more realistic assumption and actually provides scope for positive surprises on the subsidy front on a fall in commodity prices or on a likelihood of higher price increases if overall inflation moderates more than expected. So unlike last time, the markets or policy makers, need not second guess the stated number.

Realistic; but low on ambition and structural reforms

The budget estimate still crucially lack any efforts towards curtailing expenditure. The decrease in fiscal deficit is coming purely from the revenue side through tax hikes and asset sales. The expenditure is actually slated to continue to grow at around nominal GDP. This, over time, is not sustainable and the government would need serious expenditure reforms to move towards a more credible path of fiscal consolidation by targeting a fiscal deficit of around 4% of GDP in the next 2 years.

Another disappointing feature of the budget was a lack of shift in the expenditure towards investment building than consumption. India needs a push towards increasing its investment / GDP and the government being a big component of the economy; a perceptible shift in government expenditure towards investment building from consumption spending would have re-kindled the capex cycle. Also, the continued stress on boosting consumption and keeping the expenditure would keep inflation pressures high. High fiscal deficit and its resultant high inflation has dampened spirits and has resulted in no increase in private corporate capex to GDP. For India to sustain GDP growth above 7%; a sharp increase in domestic savings and private capital formation is required which can be facilitated by lower fiscal deficit.

Although, it seems that the budget has become more of a non-event and is largely a statement of accounts and that larger policy decisions can be taken outside the budget, but given the current state of the economy and the falling government credibility, it seems that the UPA government has missed an opportunity to showcase its intention towards sustaining and improving the growth momentum by announcing some key investment and capital spending programmes for the next 5 years and the path towards achieving the same. The lack of it is also a prime reason of why there is a general sense of disappointment post the budget announcement.

Another miss was the lack of announcement or time lines for the introduction of the GST (Goods and Services Tax ) and the new Direct taxes code. These are amonsgt the structural reforms that needs to be undertaken with earnest as against the market clamor of FDI in retail or aviation.

Bond market expectations and Monetary policy

The bond markets were clearly disappointed as although the fiscal deficit was around market expectations, the gross borrowing number was higher than anticipated. Given that the markets have got used to RBI OMOs in the last 4 months, the weekly gross issuance without RBI support would seem heavy and could lead to bond yields trending higher from current levels. It appears that as with the fiscal deficit assumption, the finance minister has played it safe and budgeted for a higher market borrowing upfront unlike last year where they kept surprising the markets with higher borrowing in the second half of the fiscal. So, now the overall numbers are out without much ambiguity and the markets need to prices it based on overall demand / supply and macro environment.

But the 5.1% fiscal deficit and the likelihood of this being achieved over the course of the year, should comfort the RBI. This appears to be an earnest effort by the government towards fiscal consolidation and the RBI should consider it as a big trigger towards beginning its rate cutting cycle. The commitment of capping subsidies at 2% of GDP is also an important element for the RBI to consider. It would be preferable if the RBI would cut its interest rates in April by reducing the repo rate by atleast 25 bps. Further rate cuts would depend on global oil prices and the impact on core inflation from the increase in domestic diesel, petrol, fertilizer and electricity prices.

Overall, this budget puts us back on a credible track of fiscal consolidation and if followed by expenditure reforms in the coming years by rationalizing subsidies and boosting investments, it would give a big boost towards achieving a higher non-inflationary growth trajectory.

The views expressed here constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. This information is meant for general reading purpose only and is not meant to serve as a professional guide for the readers. This document has been prepared on the basis of publicly available information, internally developed data and other sources believed to be reliable. The Sponsor, The Investment Manager, The Trustee or any of their respective directors, employees, affiliates or representatives do not assume any responsibility for, or warrant the accuracy, completeness, adequacy and reliability of such information. Whilst no action has been solicited based upon the information provided herein, due care has been taken to ensure that the facts are accurate and opinions given fair and reasonable. This information is not intended to be an offer or solicitation for the purchase or sale of any financial product or instrument. Recipients of this information should rely on information/data arising out of their own investigations. Readers are advised to seek independent professional advice and arrive at an informed investment decision before making any investments. None of The Sponsor, The Investment Manager, The Trustee, their respective directors, employees, affiliates or representatives shall be liable for any direct,indirect, special, incidental, consequential, punitive or exemplary damages, including lost profits arising in any way from the information contained in this material. Please visit – www.quantumamc.com/disclaimer to read scheme specific risk factors.

Above article is authored by Quantum.

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