India: FY12 budget surprises positively but beware of the fine print: JP Morgan

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India: FY12 budget surprises positively but beware of the fine print

FY12 fiscal deficit targeted at 4.6% of GDP, lower than the expected 4.8% Net borrowing announced to be Rs3.4 trillion, almost Rs400 billion lower than expected Equity market heaved a sigh of relief on escaping feared increases in taxes; bond yields rallied on the lower borrowing; and the INR remained stable Net of asset sales, however, achieving this fiscal deficit target in FY12 would entail an effective fiscal consolidation of an unprecedented 1.7% of GDP in one year With no substantive tax increases or expenditure cuts, the fiscal outturn for FY12 could be significantly higher But these risks will begin to materialize only in 2HFY12, in the interim we continue to expect the yield curve to flatten FY11 fiscal deficit expected to print at 5.1 % of GDP (budget target 5.5%) on account of 3G asset sales and higher nominal GDP FY12 budget beats market expectations… The Finance Minister pegged the FY12 fiscal deficit to 4.6% of GDP (Consensus: 4.8 % of GDP) and a corresponding market borrowing of Rs. 3.4 trillion, almost Rs. 400 billion lower than what the market had forecast, causing markets to rally sharply. On the news the equity market rose more than 3 percent in response, yields fell by 7-8 basis points and the rupee appreciated by about 0.2 percent. However, much of these gains were pared back in the rest of the day. The market cheered the fact that the government was able to deliver a lower-than-anticipated fiscal deficit without resorting to more broad-based increases in excise duty, as was feared. On the contrary, the basic exemption for personal income taxes was lifted from Rs. 1, 60,000 to Rs 1, 80,000 (including higher exemptions for senior citizens) and the current surcharge for domestic companies was reduced from 7.5 percent to 5 percent. Further, total expenditure was only budgeted. In addition, gross expenditure was only budgeted to grow a little over 3% over last year compared to a 10 percent increase the previous year. At first pass, therefore, it appeared that the finance minister had avoided raising taxes by as much as he may have and instead resorted to curtailing expenditure growth to reduce the fiscal deficit. …but beware of the fine print A closer reading of the fine print, however, suggests that the outlook may not be nearly as favourable. For one, the FY12 budget estimates are predicated on optimistic assumptions of tax buoyancy. It is estimated that the tax buoyancy in FY11 will be about 1.2 (rate of growth of gross tax collections being 20 percent higher than nominal GDP growth) whereas that of FY12 is being estimated at 1.3. Tax buoyancy typically reduces as one proceeds into the recovery stage and so one would have expected estimated tax buoyancy to reduce and not increase! In addition, predictably, subsidies seem to have been under-budgeted again. While the allocation for oil subsidies has been budgeted at Rs 240 billion (a welcome departure from the Rs 31 billion of the previous year), even this allocation is expected to cover only half the Government’s share of the under-recovery even if crude stays at $90/barrel. More worringly, food subsidies have been budgeted at the same amount as last year despite the fact that higher minimum support prices, potentially higher procurements levels and a Food Security that is imminent could push the subsidy bill up by another Rs 10-20,000 crore this year. Similarly, the allocation for NREGA has been held at Rs 400 billion, even though linking NREGA wages to CPI (as was reiterated by the Finance Minister) could result in significantly higher allocations. In sum, as the fiscal year proceeds and it becomes clear that allocations for subsidies and key programs such as NREGA need to be revised upwards by up to 0.5 % of GDP, the initial euphoria surrounding today’s budget may fade rapidly. The magnitude of achieving a fiscal consolidation of this magnitude is better understood as follows: net of asset sales, achieving the budgeted fiscal deficit would entail a staggering fiscal consolidation of 1.7 % of GDP. In FY11 the budget consolidation on the same measure was 0.2% of GDP, down from 6.9% in FY10 to 6.7% in FY11. Bonds likely to remain stable until the supplementary budgets Bonds are expected to rally in the first half of this year on lower-than-anticipated borrowing. While the bond market was expected net borrowing to print at Rs 3.8 trillion, for FY12, today’s budget announced a borrowing program that was almost Rs 400 billion lower. However, if the risks listed above do materialize in the second half of the year and credit demands pick up, bonds could come under pressure. The pressure point will likely be the first supplementary budget expected in October. FY11 fiscal deficit to print at 5.1 % of GDP, as expected In addition, as was widely expected, revised estimates for the FY11 budget pegged the FY11 deficit at 5.1 % of GDP, significantly lower than the 5.5 % that was budgeted. Much of this, however, is on account of the fact that nominal GDP is expected to grow at 20% -- significantly higher than the 12 percent budgeted – on account of higher than forecasted inflation. This, in conjunction with the fact, that 3G spectrum sales boosted revenues by 1.4 % of GDP meant that the consolidation almost happened inadvertently, and not because expenditures were particularly curtailed. Foreign retail investors now able to invest in mutual funds Authorities also used the budget to announce that retail foreign investors will now be directly allowed to invest in Indian equity mutual funds as long as they meet their KYC requirements. This could potentially significantly increase capital inflows in India in the coming quarters, and help buffer the risks associated on the external accounts with falling FDI. In addition, the withholding tax infrastructure debt funds (SPVs) has been reduced from 20% to 5%. Separately the FII limit for local currency corporate bond has been increased from $5bn to $25 for infrastructure bonds of residual maturity of more than 5 years.