Playing it safe
Budgets are not that hard to make. Most heads of expenditure and revenues are predictable to a degree, so one just needs to overlay intent. For example, anyone who has seen a split of my family’s expenditure and is aware of my income sources, can fairly accurately project my budget for the coming year. To be sure there are discretionary items: the number of times we eat out or the locations of our holidays. But a simple discussion with family members should help provide visibility on these as well. This exercise for the Indian economy may seem daunting, but its size and the complexity of the administrative set-up actually make the job of budget-making much simpler: most large line items carry inertia.
The trick is in getting the intent right. The FM’s interactions with investors and the media in the run-up to the budget had suggested some creativity, some out-of-the-box thinking to pull the economy out of the fiscal trap. After all, the problem is non-trivial. There is a need to consolidate fiscally just when the economy is slowing down and needs the government to accelerate spending. High deficits result in crowding out of private investments and keep inflation high, thus resulting in a tight monetary policy.
The buzz in budget expectations was on “fiscal consolidation: near-term pain for medium-term gain”. With a slowing economy limiting options to raise revenues, many had expected the government to achieve this by cutting expenditure quite dramatically. Even to non-believers of Keynesian economics, it was obvious that a government-spending squeeze would exacerbate the slowdown. Fiscal consolidation, after all, is never a three-month process. It usually goes through a vicious cycle of slowing growth and multiple expenditure cuts before the economy bottoms out. One year before general elections this would have been political hara-kiri.
Not surprisingly, the government instead chose to accelerate spending. The FY14 budget assumes a 16% increase in total expenditure after just 10% growth in FY13. Once adjusted for under-provisioned subsidies for oil and food, the increase is actually 20%. That number is among the highest in the last few decades, and the highest since FY09, the year before the last election. Some of this increase in our view is expenditure pushed out from FY13 to manage cash flows, especially in defence, rural development and the finance ministry’s own expenditures. But a meaningful chunk is a real incremental spending, equal to 1-1.5% of GDP. To be fair, as can be assessed from immediate reactions from other political parties (both the SP and the BJP made statements writing off early polls as the budget did not contain any sops), this wasn’t your typical pre-poll budget. There weren’t any loan waivers, no new schemes to please the voter, no increase in subsidies or reductions in tax rates. But given the circumstance, this perhaps was as much as the finance minister could do.
The increase in taxes for the surprisingly few ultra-rich taxpayers is unlikely to dent consumption. It will only take away from their savings (if only 42,800 Indians declare taxable income of ₹1 crore or more, one only needs to look at the number of luxury real-estate transactions and high-end cars to understand how understated the number is!). Similarly, the higher duties on imported automobiles could incentivise indigenisation rather than curb consumption.
The expenditure hike should support growth. The trouble though is that it is being perceived as the “wrong type of growth”: consumption boosted by government measures that drives up the current account deficit that further increases our reliance on capital flows, and keeps a sword hanging over the rupee. This can also constrain the RBI from embarking on a prolonged rate cutting spree — something that could have at the margin helped the investment cycle improve. The incentives given for capex of ₹100 crore or higher should provide some support, but it won’t dramatically change the investment environment. Unfortunately, other much awaited steps such as the GST and coal-price pooling remain work-in-progress.
Any analysis of budgets and their impact on the economy would be incomplete without including state budgets: all states, put together, spend 25% more than the Centre, and their spending is far more entitlement driven and welfare-focused. The state budgets released thus far also show preparedness for the upcoming general elections.
Who benefits? The largest quantum of increase after interest payments and defence in the budget is for rural development. The slowdown in road-building under the rural roads programme is now behind us: a sharp pick-up is expected in the coming year, lasting through the 12th Five Year Plan. There has been a generous increase in allocation for NREGA, and expenditure under the rural housing scheme (Indira Awaas Yojana) is likely to pick up as well. The sharply higher targets for agricultural credit (up 22% to ₹7 trillion) and expansion of the interest rate subvention scheme are also likely to spur rural consumption and, potentially, productivity too. For it to become sustainable though, and not remain dependent on the largesse of states and the Centre, bottom-up productivity gains must come through in rural India.
The one that got away
Over a period of time, as direct and indirect taxes have been made uniform and decisions on subsidies are taken outside of the budget, the annual exercise has become very predictable. More so this time around since the FM was on a global roadshow earlier this year communicating his fiscal targets.
Not more than six months ago, most investors and analysts were expecting the FY13 fiscal deficit to be close to 6%. To the minister’s credit, in the FY14 budget, the number is much lower at 5.2% with a projection to reduce it to 4.8% in FY15. While this sounds good on paper, risk of slippages cannot be ruled out.
Assumption of 19% tax revenue appears optimistic, so do some of the non-tax revenue assumptions. The selloff target of₹54,000 crore and revenue estimates from auctioning the telecom licence, spectrum for mobile telephony, including FM radio auctions of₹40,000 crore are also quite optimistic. Subsidies are underfunded as usual, though not as much as the last time. A 10% drop in subsidy assumption appears tough to reconcile with, especially given that it’s a pre-election year. However, the plan expenditure growth estimate of 29% offers some cushion. The government can tighten the belt here, if need be. On the whole, there is a risk of 20-30 bps of slippage. The FM has also done well to restrain from populism. The share of so-called populist measures (rural development, agriculture and social services) as a proportion of the plan expenditure is set to drop three percentage points to 60% in FY14. Prior to the 2009 elections, this ratio had shot up from 58% in FY07 to 68% in FY09.
There have been some measures to boost the investment cycle but not a whole lot. The 15% additional depreciation allowance should incentivise project developers to commission projects by March 2015 to avail of the benefit. Another issue with the investment cycle has been poor financial savings. Over the past two-three years, household savings have gone into gold. This is unproductive as the money essentially goes out of the economy into the hands of gold miners and traders located outside the country. It also complicates the issue of current account deficit and puts the rupee under pressure. To shift household savings into financial savings, inflation linked bonds have been proposed. But what will really kickstart the investment cycle is more assertive action from the Cabinet Committee on Investment to sort out regulatory issues.
Finally, the uncertainty created by the additional clause on Taxation Residency Certificate (TRC) for foreign investors was the single-biggest negative. The clause says TRC will be necessary but not a sufficient condition for investors seeking benefit of Double Taxation Avoidance Agreement (DTAA). This clause has created uncertainties in the market similar to the General Anti-Avoidance Rules (GAAR) issue and possibly caused the market sell down. This clause runs completely counter to the assurances given by the FM to global investors about a stable taxation regime.
The minister clarified later that this additional clause should not be interpreted as a reincarnation of GAAR and there is a possibility that it will be rectified. Hence, a clear and unambiguous clarification at the earliest will be essential to calm investors. At a time when the current account deficit is at an all-time high of $80 billion and the country is heavily dependent on capital flows to stabilise the currency, we can’t afford to rattle foreign investor sentiments.
Overall, the minister has done well by ensuring a tight fiscal policy and refraining from overt populism. But the TRC-related uncertainties were clearly unwarranted.
Taking the easy way out
Other than a sensible deficit target of 4.8%, there is very little to cheer about the budget. Not only did the FM squander an opportunity to address structural issues such as the high current account deficit and persistently high inflation, even more worryingly, he has opened a can of worms in Section 90A of the Finance Bill.
The good: The only silver lining was the decisive fiscal consolidation in FY13: down from a potential 5.9% to 5.2% through expenditure cuts in the second half of the fiscal. While there will be moderate fiscal slippage in FY14 (owing to pre-election pressures) of around 40 bps, assumptions regarding petroleum subsidies, tax revenue and divestment receipts are more prudent than was the case under the earlier finance minister.
The bad: While the minister left the headline service and excise duty rates unchanged, the key disappointment was the failure to consolidate excise rates — a step that would critically make the deadline of Goods and Service Tax (GST) implementation on April 1, 2014 possible. A plethora of irrational exemptions and concessions are available on excise rates and their consolidation is a pre-requisite to moving to a unified GST. Instead, all that the minister did was to provide₹9,000 crore for CST compensation for states — the bare minimum towards GST implementation.
Furthermore, the FM failed to address the current account deficit issue. Innovative measures like the announcement of an amnesty scheme for disclosure of foreign income (similar to a scheme in 1997) could have provided instant relief. Instead, he bewilderingly chose to ease baggage rules regarding bringing jewellery into India!
The ugly: The most retrograde part is the one step forward on GAAR but two steps back on conditions for availing DTAA benefits. The fine print of the Finance Bill specifies that while GAAR has been postponed by two years, the Tax Residency Certificate is necessary but not sufficient to avail of the DTAA benefits. This is applicable from April 1, 2013.
Also, the fact that the minister chose to tax corporates to support plan expenditure growth at a time when private corporate capex growth is compromised is another ugly part of the budget. While the FM promised the compression of the number of Centrally Sponsored Schemes and Additional Central Assistance schemes from 173 in the 11th Plan to 70, the 30% YoY increase in discretionary spending only highlights the populist tendencies of the government. That this increase in discretionary spend was accompanied by an increase in the corporate surcharge from 5% to 10% on domestic companies again sends an adverse signal to India Inc.
What now? While the finance minister announced a range of incremental sops for specific sectors (for instance, corporates which invest more than $25 million on plant and machinery in FY14 will get a tax break equal to 15% of the amount invested), what does the budget in its totality mean for the Indian economy?
The meaningful quantum of policy momentum generated since September 2012 as well as the fiscal consolidation delivered in FY13 is likely to substantially mitigate the chances of a sovereign credit rating downgrade over the next 12 months. However, although economic growth is likely to recover in FY14, the fact that the FM did not use the opportunity at hand to administer structural reform raises concerns regarding the sustainability of a growth recovery in India and leaves India exposed to serious currency risk over the next 12 months.
Why the budget didn’t matter
The macro economic backdrop to the budget was well known — mounting fiscal and current account deficits, high inflation and interest rates, falling domestic savings, lull in new projects, a raft of stalled infrastructure and other projects, limping corporate profitability and an unhelpful global economy. The verdict of the equity market on the budget day was rather quick and brutal. It did not have enough to offer for either reviving the investment cycle or promoting savings and investment — the two legs on which market expectations stood. The provision for investment allowance of 15% for new investments in plant and machinery in excess of ₹100 crore hardly addressed the gravity of the problem. Given the large number of stalled investments on account of some governmental approval or the other, the new provision is unlikely to enthuse entrepreneurs to commit to new capacity creation that can lead to robust growth and employment generation.
The burgeoning current account deficit, which is reflected in the large savings-investment gap, required action in terms of export promotion, import moderation and incentives for long term savings. The fact that the budget did not have any credible measures to address these issues clearly spooked the markets. Instead, the securities transaction tax on equity futures — the very antithesis of long term investment — has been pared. That said, the modicum of fiscal discipline demonstrated in the budget, as also the restraint shown in further multiplying the largely misdirected and leaky social spending programmes in a pre-election budget are certainly the commendable parts of the budget.
If truth be told, the pall of gloom in the economy is largely because of the muddle in the three important sectors that are crying for urgent attention — power, roads and mining. This has been the epicentre of the politician–bureaucrat patronage edifice which has willingly lent itself to manipulation by crafty businessmen for unjust enrichment. Given the network externality effect of these sectors, the compounded impact on the level of economic activity in the country is immense and this has partly led to the slowdown and the general sentiment of gloom. These issues can hardly be addressed by the federal budget but it is certainly the responsibility of the elected government to find quick and credible solutions to this impasse.
Now with the budget out of the way, how do portfolio investors look at the India investment opportunity? For foreign investors, investing in India is certainly not a lost cause. It is the domestic institutional investors who seem to be lacking confidence in the Indian market as evidenced by their continuous net selling since January 2012 of around $4.5 billion. On the contrary, foreign portfolio investors have been robust buyers of Indian equities with some $33 billion during the same period. The 22% rise in dollars terms in the Sensex in 2012 was largely driven by these robust inflows that helped rerate the market with hardly any support from earnings growth. Any forecast of the Indian market has to factor in the likelihood of continued FII inflows and any possible momentum in earnings growth given that the market can no longer be considered cheap at 14 times FY14 earnings. The outlook on earnings growth now is decidedly dim with brokerages continuing to downgrade earnings on the back of continued headwinds on corporate topline growth and margins.
The robust FII inflows over the last 14 months have been a result of continued monetary easing in the US and Europe and more recently in Japan. Though markets reacted rather violently to talks of a potential end to the monetary easing sometime ago, these apprehensions have been now put to rest by the Fed. There has been some nervousness, of late, in the European markets after the Italian elections produced a hung parliament with Italian bond yields spiking up sharply. Though the situation is somewhat tricky, Italy is no stranger to hung parliaments and coalition governments and some solution would hopefully be found, and normalcy would return to the European bourses. With the surfeit of liquidity sloshing international markets, India should justifiably hope to attract a fair share of the emerging market inflows, though a better crafted Indian budget would have made the case more attractive.
However, decades of benign neglect in building effective and robust domestic institutions to channelise long term household savings has made Indian economic growth hostage to the vagaries of foreign investor sentiment. Domestic institutional flows, being less than a fifth of the FII flows have little impact on the market. To illustrate, in 2011 domestic institutions pumped in some $1.5 billion into equities, but the $0.4 billion of FII outflows caused a 37% fall in the Sensex in dollar terms. It is no wonder, therefore, that even domestic investors tend to interpret every new development from an FII prism. Given the global economy is far from recovering from the 2008 meltdown and the subsequent sovereign debt crises, Indian markets can nose dive any time a new crisis occurs in the developed world.
The proposed amendment relating to tax residency certificates has to be seen in this light. It is surprising that even two decades after FIIs were allowed to access the markets, policy makers are unable to provide a modicum of tax certainty to these investors on their Indian earnings. In fact, there is a good case to levy a low single-digit tax on FII earnings in India to obviate the need to route investments through jurisdictions with which India has DTAT.
To sum up, the budget is clearly a case of a missed opportunity but with some efforts at raising the bar of standards in public governance. The several advantages that India has in terms of domestic economy led growth, market diversity, rule of law and investment absorption capacity have the potential to attract continued foreign portfolio investments especially in the context of aggressive monetary easing in the developed world. Investors, however, need to be aware of the high vulnerability of Indian equities to changing FII sentiment.
The views expressed here are Personal