JP Morgan: India pre-budget outlook: the devil could be in the details

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India pre-budget outlook: the devil could be in the details

The FY11 fiscal deficit outturn will likely come around 5% of GDP, well below the budgeted 5.5% of GDP on higher revenues and nominal GDP growth But net of asset sales the deficit will be much higher around 6.8% of GDP just a little less than the 6.9% of GDP deficit in FY10 The FY12 budget is likely to target of 4.8 % of GDP, with an implied net borrowing of around Rs 3.8 trillion, larger than in FY11 With potential asset sales far less than in FY11 and likely increases in oil and food subsidies the budget target will be hard to achieve Bond yields will likely remain range bound in 1HFY12, picking up in the latter half especially if private credit growth accelerates FY11 fiscal outturn will flatter to deceive Cosmetically the FY11 budget outturn will look very good helped by the large spectrum sales (1.4% of GDP), better-than-budgeted tax collection (thanks to higher inflation), and significantly higher nominal GDP than expected (once again on account of higher-than-expected inflation). Furthermore, the government has so far only allocated Rs 31 billion for this year’s oil subsidies (the allocation of Rs 140 billion in the August 2010 supplementary budget was to cover the arrears from the last fiscal). We expect the government’s share of the total under recoveries to come around Rs 430 billion based on an average of $85/barrel in crude prices. If the government allocates another Rs 210 billion to the oil companies (as it has indicated it will) and runs arrears of Rs190 billion as it did last year, then the fiscal deficit is likely to print around 5 % of GDP much better than the budgeted 5.5% of GDP. This would allow the government to add about Rs 200 billion to its cash balances, especially as some of the expenditure that was increased through the two supplementary budgets passed late last year is likely to be unspent. The government will parade this apparent 1½ percentage of GDP deficit reduction while preserving GDP growth at 8.5% as skillful macroeconomic management. But appearances can be deceptive. If one excludes the one-off spectrum sales revenue and the disinvestment receipts (as asset sales are excluded from revenue in standard definition of the deficit) then the fiscal deficit will stand around 6.8 % of GDP, just a shade lower than the 6.9 % of GDP in FY10 and the effective fiscal consolidation will be only 0.1% pts of GDP, much less than what was budgeted. And this is what complicated macroeconomic management. It was one thing to provide stimulus in FY09 and FY10 when the economy was staring at the possibility of 6-7% growth, but by not withdrawing the stimulus in FY11 when the economy was growing around 8-9%, the government added to the significant demand pressures. As we have argued before, the current high inflation and inflationary expectations are largely an unsurprising consequence of loose monetary and fiscal policies that has pushed the economy to grow beyond its capacity. FY12 budget will likely target a deficit of 4.8% of GDP In line with the recommendations of the 13th Finance Commission and the need to begin withdrawing stimulus to help control inflation, the government will likely target a deficit of 4.8% of GDP for FY12. On the face of it reducing the deficit from FY11’s 5% of GDP does not look difficult. But this year’s 1.4% of GDP in spectrum sales was a one-off event. In its absence reaching 4.8% of GDP will be a tall order. We expect the government to cover this gap by raising tax and non-tax revenue and understating eventual expenditures: Expanding the base of the service tax to health, education, and possibly new properties. Budgeting a healthy disinvestment revenue given that some IPOs scheduled for this year (IOC, Hindustan Copper and possibly Steel Authority of India Limited) will likely be shifted to FY12 Rolling back the excise duty on automobiles to 12% from 10% Understating the oil subsidy. As before, the government will budget the traditional Rs 31 billion for oil subsidies. Our estimates suggest that at $95/barrel average price for crude the subsidy could be at least Rs 300 billion for FY12 even if diesel is fully deregulated Not including the additional spending required under the Right to Food Security Act on the grounds that it has not been approved by parliament as yet. Partially offsetting these will be a likely significant rise in NREGA (the rural unemployment guarantee scheme) allocation. Towards the end of last year, the government decided to inflation link payments under the scheme retroactively. While the exact formula linking the payments to inflation has not yet been drawn up, we expect the allocation to rise form Rs 400 billion to around Rs 550 billion. The budget could also increase the income tax exemption limit from Rs 160, 000 to Rs 200,000 as a means to provide some tax relief for lower income groups in light of high food inflation over the last year eroding their purchasing power. The revenue impact of this change is unlikely to be large. Importantly, the government could reduce the withholding tax on local currency corporate bonds (especially for infrastructure) to ease investment financing and to deepen the bond market. Separately, there has been some anticipation in the market that the government could announce a large amnesty plan to bring the black economy, especially funds held abroad, into the formal economic system. While the budget could contain lot of sound and fury about the black economy, there is unlikely to be any substantive steps taken towards reducing the size of the underground economy. Higher borrowing, but impact on bond yields likely to be muted until 2HFY12 The 4.8% of GDP deficit target will imply a gross borrowing of Rs 4.3-4.5 trillion depending on the size of the cash balance that the government enters the next fiscal with.. This is about the same as FY11’s borrowing, but with lower redemptions the net borrowing will be higher at around Rs 3.6-3.8 trillion. However, we do not expect the bond market to react too negatively to this announcement. As long as there is only modest pressure from private credit demand and the eventual sizes of oil and food subsidies remain uncertain, bond yields should trade around the current level and could even rally modestly. Rather we expect yields to come under pressure post October 2011 after the first supplementary budget is announced. It is then that the government is likely to clarify the price tag of the Right to Food Security Act and provide the first glimpse of the FY12 oil subsidy bill. The pressure on bond yields will, however, be resisted. The RBI could engage in substantial OMOs as a means to create reserve money, rollback the SLR requirement for banks to 25% once liquidity improves, and the government could raise FII limits for government bonds. The authorities have sufficient tools to limit the rise in bond yields. With bond yields remaining below 8.5% in FY12, while continued tight liquidity and stubbornly-high inflation forcing 4-5 more policy rate hikes, the yield curve is likely to bear flatten further. The key risk is the strength of private credit growth. If credit growth spikes suddenly, bond yields could go temporarily higher before RBI and government actions calm the market.