Please Share:: 
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� �
India: A fiscal horror show?
Previewing the 2012/13 budget
First, the good news. Contrary to the belief of many, India is a long way
from experiencing the kind of fiscal horror show that has engulfed many
developed world countries in recent times. While the country’s (central and
state) budget deficit is running at around 8% of GDP, similar to that of many
western countries, India has the huge advantage of double-digit money GDP
growth. With bond yields pegged back by captive buyers, in the form of the
commercial banks, this means general government debt is falling rather than
rising as a share of GDP in India.
But this is not to say that the Finance Ministry can relax and kick back
ahead of the budget. The Reserve Bank of India, for one, will be looking for
some tough measures to be delivered, while a lower budget deficit would help
reduce the current account deficit and the ‘crowding out’ of private investment.
Budget measures. As such, we believe Finance Minister Pranab Mukherjee is
likely to announce an increase in the breadth of the services tax and, possibly, a
rise in the excise and services tax rate itself, as well as an increase in
subsidised fuel prices on 16 March. He may also set out a medium-term fiscal
consolidation plan, involving further details concerning the introduction of the
Direct Tax Code (DCT) and Goods and Services Tax (GST), both of which have
been delayed. The finance minister will, however, do well to convince
stakeholders of the credibility of such a program, in our view.
Fiscal forecasts. Put such measures together with a roughly 8% real GDP
growth forecast as well as an upbeat assessment of divestment and telecom
spectrum receipts and we suspect Mukherjee will forecast a 5% of GDP central
government deficit in 2012/13, down from a revised 5.6% in 2011/12.
RBI likely to cut rates in mid-March and beyond. Although we doubt such a
figure will be achieved (we forecast a 5.8% outturn in 2012/13), we suspect the
budget will deliver just about enough to start the repo rate cutting ball rolling at
the 15 March RBI meeting. It seems inconceivable that the contents of the
budget will not have been presented to the central bank by the time of its
meeting. A further big upward move in the oil price is the main risk to this view.
We continue to look for a total of 175bps of repo rate reductions by early-
2013. With wholesale price inflation falling a little further and staying in the
comfort zone through 2012 and the economy experiencing a further protracted
period of sub-trend real GDP growth, the RBI is likely to take back some of the
500bps in effective tightening it delivered during 2010-11.
We expect the curve to bull steepen and 10y bond yields to fall below 8%
in 3 months and trade to 7.5% by end 2012. The easing cycle and
expectations of some moderation of the significant liquidity deficit should
support bonds. We do not expect much market reaction from the FY13
borrowing total, INR4.1tn net, as markets will likely be focused on RBI’s policy
rate actions and guidance coupled with the outlook for liquidity conditions.
Four questions
That India’s fiscal position leaves a lot to be desired is clear. But four questions still arise:
1. Is the country heading towards a ‘fiscal horror show’ of the sort we have become
increasingly accustomed to in the developed world over recent times?
2. What, if anything, is the government likely to do to address the issue in its 16
March budget?
3. To what extent will the answer to the second question influence what the Reserve
Bank of India does on interest rates this year?
4. How much in the way of bond issuance should we expect in 2012/13 and what
are the likely implications for the market?
In our view, the answers to these issues will go a long way to determining the performance
of India’s financial markets over coming months. We will address each in turn.
1. How bad is bad?
Historical and international comparisons
Exhibit 1 tracks the development of India’s general government fiscal deficit, showing the
contribution from the central and state governments, while Exhibit 2 puts our 2011/12
deficit and debt projections (8.2% and 65% of GDP respectively) into some sort of
international perspective. The (relatively) good news here is that India’s public finances
are in better shape than those of the US, as well as of many of the euro zone nations. But
clearly this is not saying a lot. The fact is that all other Asian countries we cover, barring
Japan, have a lower budget deficit than India, while only Singapore (for purely technical
reasons) has a larger debt/GDP ratio. As is well known, India’s comparatively high deficit
mainly reflects its narrow revenue base. On the basis of IMF data, Indian general
government revenues amounted to 18.5% of GDP last year, whereas they averaged 26%
in all Emerging Markets. The equivalent figures for government spending were 26.5% and
28.5% of GDP respectively.
Is India’s debt sustainable?
In practice, however, this tells us nothing about the sustainability or otherwise of the Indian
government’s debt position. After all, a given level of the budget deficit may be consistent
with a stable or falling debt/GDP ratio in one country and a rising one in another. The
formula to calculate the so-called Debt Stabilising Primary Surplus (DSPS)1 is as follows:
DSPS = (nominal interest rate on government debt - nominal GDP growth) * Debt/GDP ratio
In India’s case, this works out to be roughly -6.5% of GDP in 2011/12 ((8-18)*0.65), which
is comfortably below the IMF’s estimate of the country’s primary deficit of 3.6% of GDP2.
What saves the country is the fact that its nominal GDP growth is much higher than the
interest rate paid on government debt – something that is not true of many countries in the
developed world right now but which has been the case in India for many years. This in
turn helps explain the trend decline in the government’s debt/GDP ratio since the early
2000s
Of course, if India’s debt interest rate costs were to rise sharply and/or nominal GDP
growth to slow, then a much smaller primary deficit (or even a surplus) would be required
to keep the debt ratio stable, let alone bring it down. But big adverse moves in either
series seem unlikely, in the short term at least, for several reasons.
• Having already lowered the Cash Reserve Ratio, the Reserve Bank of India has made it
clear that the next move in the repo rate is down. History suggests this will keep a firm
lid on bond yields even in the context of rising sovereign issuance.
• On a more structural basis, the government has a large captive audience for its bonds in
the form of commercial banks which are obliged to spend 24% of their deposits on
government bonds (the so-called Statutory Liquidity Requirement or SLR). High
personal savings (around 25% of GDP) also help in this regard.
• India’s nominal GDP growth has not been lower than 12% since 2003. The move up in
trend real GDP growth over the last decade combined with the country’s structurally high
inflation rate has ensured that this is the case. At the same time, bond yields are
towards the top end of their trading range of the last decade.
Apart from the interest rate-growth differential, the IMF has also identified a range of other
indicators which, in the past, have provided useful early warning signals about extreme
government funding problems or spikes in sovereign bond spreads. These are shown in
Exhibit 5 below, where we have compared the relevant numbers for India (in 2011, unless
otherwise stated) with those of the other BRIC nations. All the figures are sourced from
the IMF itself.
The results are mixed for India. While it scores relatively poorly in terms of debt and the
cyclically adjustment primary balance, it does ’better’ on pension and health spending as
well as the importance of short-term debt. Overall, India’s fiscal position is probably best
described as bad but not that bad.
The wider benefits of deficit reduction
While India’s debt position is a long way from an unsustainable/explosive path, this is not
to suggest that the government can safely rest on its laurels. Apart from the fact that the
interest rate/growth differential is unlikely to remain so favourable over the long term, if the
fiscal authorities were to bring down the budget deficit on a structural basis, a number of
economic benefits should ensue. First, less in the way of private investment is likely to be
’crowded out’; second, it should help bring down the current account deficit; third, it may
have some dampening effects on domestically generated inflationary pressures; finally, it
would make it easier for the RBI to cut interest rates.
2. What will the government do on 16 March?
A bit of background
Before discussing the likely make-up of the central government’s 2012/13 budget it is
worth providing a little bit more context in the form of Exhibit 6. This shows how,
according to IMF estimates, India’s Cyclically Adjusted Primary Balance (CAFB – the best
indicator of the underlying course of fiscal policy, stripping out the impact of the economic
cycle and debt interest costs on the public finances) has developed over recent years.
Having been zero in 2006, the CAFB ballooned in 2008 and 2009 as the government
introduced new welfare schemes and eased fiscal policy aggressively in reaction to the
global financial crisis. In the following two years, only a small part of this stimulus has
been taken back. Partly as result, the overall central government budget deficit appears
all but certain to overshoot the official target of 4.6% of GDP in 2011/12. Our own forecast
remains at 5.6% of GDP, with the risks tilted modestly to the upside.
With this in mind, and given our earlier remarks concerning the potential benefits of
reducing the deficit, there would appear to be a strong case for tightening the fiscal stance
in the upcoming budget. In practice, however, it is not quite as simple as this. The
weakness of GDP growth and the strength of inflation over the last couple of years mean
there is no shortage of pressure, both within and outside the Congress-led coalition, to
provide some help to poorer members of society.
The budget announcement – our expectations
As such, we expect the budget announcement on 16 March to encompass many of the
following:
Budget assumptions
• Finance Minister Pranab Mukherjee is likely to raise his estimate of the central
government budget deficit in 2011/12 from the current 4.6% of GDP to something in the
range of 5.5-6.0%.
• We expect him to forecast a reduction in the budget deficit to 4.8-5.3% of GDP for the
fiscal year 2012/13. This will probably be based on a real GDP growth assumption in
the order of 8%, with the WPI set at 5.5-6%. Our own growth projection, as well as that
of the consensus, is 7.3%, while we expect the WPI rate to average 5.8% in 2012/13
(the consensus is at 6.6%), ending the fiscal year at 6%.
• The budget will no doubt include upbeat assumptions concerning proceeds from the
government’s divestment program and the sale of telecom spectrum. We are expecting
it to announce a target of about INR500bn in privatisation receipts and INR650bn in
spectrum (1.2% of GDP in total). During the current fiscal year, the government has
raised little more than INR11bn from divestments, which compares with a target of
INR400bn this time last year. Having said that, stronger market conditions suggest that
it should fare a lot better in 2012/13.
Tightening measures, Direct Tax Code and GST
• We expect the finance minister to unveil several tightening measures. In our view, these
will include an increase in the breadth of the service tax as well as a rise in the excise
and service tax rate from 10% to 11% (it was lowered from 12% in response to the
global financial crisis).
• Given the recent spike in the oil price and the implications this will have for the
government’s subsidy bill (we estimate that a 10% oil price increase typically adds 0.2%
of GDP to the fiscal deficit), then a further increase in subsidised fuel prices, including
diesel, kerosene and LPG, is probable. Exhibit 7 shows how the oil price has once
again been rising relative to the regulated diesel price (as measured by the diesel price
index in the India’s wholesale price series) in recent times.
• The finance minister will probably set out some sort of medium-term fiscal consolidation
program, although the risk is that it will lack credibility. Hopefully, it will at least
encompass more details concerning the introduction of the Direct Tax Code (DTC) as
well as the Goods and Service Tax (GST). The latter has already been pushed back a
couple of times, while the DTC is still being scrutinised by the parliamentary standing
committee (it was originally due to be implemented from the start of the 2012/13 fiscal
year). Both schemes are intended to be revenue neutral, but there are legitimate hopes
that by simplifying the tax collection process, significant efficiency gains will be achieved.
Income tax adjustment, the food security bill and structural issues
• In order to help compensate people for the high level of inflation, we expect the tax
exemption limit to be raised by roughly 11% (INR20,000) to INR200,000. To what
extent, if at all, the tax slabs are raised, is a more difficult call. On balance, we are
looking for at least a modest increase.
• It seems unlikely that Mukherjee will allocate much in the way of funding for the Food
Security Bill, which is due to be rolled out by November 2012, having been considered
by a parliamentary standing committee (delays to this timetable are of course possible).
As a reminder, the Bill is designed to provide subsidised food grains to 75% of the rural
population and 50% of the urban population. A minimum of 46% of the rural population
and 28% of the urban population are meant to get 7kg of food grains per person per
month. The total cost of the Bill, when fully implemented, is estimated to be INR1,120bn
(about 1% of 2012/13 GDP) – enough to put a big dent in the public finances. The
finance minister will need to explain how he intends to finance this.
• We would be surprised if any ’market-friendly’ structural economic reforms were to be
announced in the budget. Although notionally the government has only “postponed” the
plan to allow single-brand foreign retailers entry to the domestic market, our guess is
that it will prove a long delay.
Taking all this into account and building in our own, more pessimistic, economic growth
forecasts, we expect the central government budget deficit to come in at 5.8% of GDP in
2012/13 (8.3% for the general government). This is actually a slight reduction from our
previous 6% forecast, reflecting a more optimistic assumption about divestment and
telecom spectrum receipts, but very similar to the probable outcome for 2011/12. We
believe a further period of sub-par economic growth will continue to keep a firm lid on
revenues, while the funding of the Food Security Bill, assuming it begins during the
2012/13 fiscal year, will put upward pressure on the deficit as well.
3. Assessing the RBI’s reaction
If our expectations of what will be unveiled in the budget are roughly right, how is the
Reserve Bank of India likely to react?
In his statement of 24 January, following the central bank’s monetary policy meeting,
Governor Subbarao argued that “there is an urgent need for decisive fiscal consolidation
… This is critical to yielding the space required for lowering rates without the imminent risk
of resurgent inflation. The forthcoming Union Budget must exploit the opportunity to begin
this process in a credible and sustainable way”.
No doubt, there was a sizeable element of ’jaw-boning’ involved here, but, even so, it is
clear that the RBI will be paying attention to the contents of the budget when it decides
whether or not to lower rates on 15 March (it is highly probable that the budget will have
been presented to the central bank by the time of its next meeting). In our judgment, while
the RBI would ideally want to see a more aggressive tightening of the underlying fiscal
stance than is likely to be delivered, the budget will do just about enough to start the rate
cutting ball rolling.
We are looking for a total of 175bps of repo rate reductions between March this year and
January 2013, bringing the rate down to 6.75% from its current 8.5% level. Although this
may sound aggressive (and, as far as we are aware, is more than any other market
commentators are looking for), it is worth noting that the RBI effectively tightened policy by
500bps during 2010-11, while the long-term average for the repo rate is 7.0%.
Key to our projection is what happens to WPI inflation, the importance of which is
illustrated in Exhibit 8. This suggests that since Dr. Subbarao took charge of the central
bank in September 2008, the repo rate has effectively become a lagging function of
wholesale price developments. Prior to his governorship, and contrary to conventional
wisdom, there was no obvious relationship between the two series whatsoever.
In our view, wholesale price inflation will edge lower in the next few months (we are
looking for it to fall to less than 6% by April/May from 6.6% in January), based largely on
the fact that the year-on-year change in the rupee-denominated CRB index has already
dropped from 40% close to zero. As Exhibit 9 shows, this series typically provides a lead
of three to four months to WPI inflation.
In order to gauge what may happen thereafter, we have extended the grey line in the chart
on the basis that oil, food and metal prices remain at their current levels (USD125/barrel in
the case of the first of these). Many argue that WPI inflation will move up from the June
quarter reflecting adverse base effects, but for this to happen we believe the rupee would
need to depreciate precipitately and/or commodity prices rise sharply. Neither is part of
our central scenario.
Apart from WPI inflation, economic growth is presumably of some relevance to the RBI as
well. While the March quarter of 2012 is likely to represent the bottom of the GDP growth
cycle, we doubt year-on-year growth will exceed 7% until the December quarter of the
year and 8% until the September quarter of 2013. The Reserve Bank used to peg the
trend rate of economic growth at 8-8.5%, although it may have cut this recently. In our
view, the sustainable growth rate has been and remains at around 7.5%.
Bond issuance and market implications
We expect the government to announce a net market borrowing number in the vicinity of
INR4.1tn (gross INR5tn) for FY13. This would be marginally lower than the INR4.2tn (net)
for FY12, which was much higher than the FY12 budgeted numbers given the INR928.7bn
slippage. We do not expect much market reaction from the borrowing details as markets
will likely be focused on RBI’s policy rate actions and guidance (15 March) coupled with
the outlook for liquidity conditions.
The start of the easing cycle and expectations of some moderation of the significant
liquidity deficit should support bonds. We expect the bond curve to bull steepen to reflect
lower front end rates. The benchmark 10y bond is trading at very tight spreads to the front
end and also commands a sizeable liquidity premium. Foreign investor and RBI purchases
have been a big support for the market in recent months and these positives will likely fade
with the start of the new fiscal year. The large bond redemptions in April and May will
provide some support in the near term, but sustained supply will likely keep the overall
move in long bonds muted despite the expected RBI rate cuts. We expect the 10y bond
yield to fall below 8% in three months and trade towards 7.5% by end 2012 if global
commodity prices are well behaved and inflation trends remain benign.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� �
India: A fiscal horror show?
Previewing the 2012/13 budget
First, the good news. Contrary to the belief of many, India is a long way
from experiencing the kind of fiscal horror show that has engulfed many
developed world countries in recent times. While the country’s (central and
state) budget deficit is running at around 8% of GDP, similar to that of many
western countries, India has the huge advantage of double-digit money GDP
growth. With bond yields pegged back by captive buyers, in the form of the
commercial banks, this means general government debt is falling rather than
rising as a share of GDP in India.
But this is not to say that the Finance Ministry can relax and kick back
ahead of the budget. The Reserve Bank of India, for one, will be looking for
some tough measures to be delivered, while a lower budget deficit would help
reduce the current account deficit and the ‘crowding out’ of private investment.
Budget measures. As such, we believe Finance Minister Pranab Mukherjee is
likely to announce an increase in the breadth of the services tax and, possibly, a
rise in the excise and services tax rate itself, as well as an increase in
subsidised fuel prices on 16 March. He may also set out a medium-term fiscal
consolidation plan, involving further details concerning the introduction of the
Direct Tax Code (DCT) and Goods and Services Tax (GST), both of which have
been delayed. The finance minister will, however, do well to convince
stakeholders of the credibility of such a program, in our view.
Fiscal forecasts. Put such measures together with a roughly 8% real GDP
growth forecast as well as an upbeat assessment of divestment and telecom
spectrum receipts and we suspect Mukherjee will forecast a 5% of GDP central
government deficit in 2012/13, down from a revised 5.6% in 2011/12.
RBI likely to cut rates in mid-March and beyond. Although we doubt such a
figure will be achieved (we forecast a 5.8% outturn in 2012/13), we suspect the
budget will deliver just about enough to start the repo rate cutting ball rolling at
the 15 March RBI meeting. It seems inconceivable that the contents of the
budget will not have been presented to the central bank by the time of its
meeting. A further big upward move in the oil price is the main risk to this view.
We continue to look for a total of 175bps of repo rate reductions by early-
2013. With wholesale price inflation falling a little further and staying in the
comfort zone through 2012 and the economy experiencing a further protracted
period of sub-trend real GDP growth, the RBI is likely to take back some of the
500bps in effective tightening it delivered during 2010-11.
We expect the curve to bull steepen and 10y bond yields to fall below 8%
in 3 months and trade to 7.5% by end 2012. The easing cycle and
expectations of some moderation of the significant liquidity deficit should
support bonds. We do not expect much market reaction from the FY13
borrowing total, INR4.1tn net, as markets will likely be focused on RBI’s policy
rate actions and guidance coupled with the outlook for liquidity conditions.
Four questions
That India’s fiscal position leaves a lot to be desired is clear. But four questions still arise:
1. Is the country heading towards a ‘fiscal horror show’ of the sort we have become
increasingly accustomed to in the developed world over recent times?
2. What, if anything, is the government likely to do to address the issue in its 16
March budget?
3. To what extent will the answer to the second question influence what the Reserve
Bank of India does on interest rates this year?
4. How much in the way of bond issuance should we expect in 2012/13 and what
are the likely implications for the market?
In our view, the answers to these issues will go a long way to determining the performance
of India’s financial markets over coming months. We will address each in turn.
1. How bad is bad?
Historical and international comparisons
Exhibit 1 tracks the development of India’s general government fiscal deficit, showing the
contribution from the central and state governments, while Exhibit 2 puts our 2011/12
deficit and debt projections (8.2% and 65% of GDP respectively) into some sort of
international perspective. The (relatively) good news here is that India’s public finances
are in better shape than those of the US, as well as of many of the euro zone nations. But
clearly this is not saying a lot. The fact is that all other Asian countries we cover, barring
Japan, have a lower budget deficit than India, while only Singapore (for purely technical
reasons) has a larger debt/GDP ratio. As is well known, India’s comparatively high deficit
mainly reflects its narrow revenue base. On the basis of IMF data, Indian general
government revenues amounted to 18.5% of GDP last year, whereas they averaged 26%
in all Emerging Markets. The equivalent figures for government spending were 26.5% and
28.5% of GDP respectively.
Is India’s debt sustainable?
In practice, however, this tells us nothing about the sustainability or otherwise of the Indian
government’s debt position. After all, a given level of the budget deficit may be consistent
with a stable or falling debt/GDP ratio in one country and a rising one in another. The
formula to calculate the so-called Debt Stabilising Primary Surplus (DSPS)1 is as follows:
DSPS = (nominal interest rate on government debt - nominal GDP growth) * Debt/GDP ratio
In India’s case, this works out to be roughly -6.5% of GDP in 2011/12 ((8-18)*0.65), which
is comfortably below the IMF’s estimate of the country’s primary deficit of 3.6% of GDP2.
What saves the country is the fact that its nominal GDP growth is much higher than the
interest rate paid on government debt – something that is not true of many countries in the
developed world right now but which has been the case in India for many years. This in
turn helps explain the trend decline in the government’s debt/GDP ratio since the early
2000s
Of course, if India’s debt interest rate costs were to rise sharply and/or nominal GDP
growth to slow, then a much smaller primary deficit (or even a surplus) would be required
to keep the debt ratio stable, let alone bring it down. But big adverse moves in either
series seem unlikely, in the short term at least, for several reasons.
• Having already lowered the Cash Reserve Ratio, the Reserve Bank of India has made it
clear that the next move in the repo rate is down. History suggests this will keep a firm
lid on bond yields even in the context of rising sovereign issuance.
• On a more structural basis, the government has a large captive audience for its bonds in
the form of commercial banks which are obliged to spend 24% of their deposits on
government bonds (the so-called Statutory Liquidity Requirement or SLR). High
personal savings (around 25% of GDP) also help in this regard.
• India’s nominal GDP growth has not been lower than 12% since 2003. The move up in
trend real GDP growth over the last decade combined with the country’s structurally high
inflation rate has ensured that this is the case. At the same time, bond yields are
towards the top end of their trading range of the last decade.
Apart from the interest rate-growth differential, the IMF has also identified a range of other
indicators which, in the past, have provided useful early warning signals about extreme
government funding problems or spikes in sovereign bond spreads. These are shown in
Exhibit 5 below, where we have compared the relevant numbers for India (in 2011, unless
otherwise stated) with those of the other BRIC nations. All the figures are sourced from
the IMF itself.
The results are mixed for India. While it scores relatively poorly in terms of debt and the
cyclically adjustment primary balance, it does ’better’ on pension and health spending as
well as the importance of short-term debt. Overall, India’s fiscal position is probably best
described as bad but not that bad.
The wider benefits of deficit reduction
While India’s debt position is a long way from an unsustainable/explosive path, this is not
to suggest that the government can safely rest on its laurels. Apart from the fact that the
interest rate/growth differential is unlikely to remain so favourable over the long term, if the
fiscal authorities were to bring down the budget deficit on a structural basis, a number of
economic benefits should ensue. First, less in the way of private investment is likely to be
’crowded out’; second, it should help bring down the current account deficit; third, it may
have some dampening effects on domestically generated inflationary pressures; finally, it
would make it easier for the RBI to cut interest rates.
2. What will the government do on 16 March?
A bit of background
Before discussing the likely make-up of the central government’s 2012/13 budget it is
worth providing a little bit more context in the form of Exhibit 6. This shows how,
according to IMF estimates, India’s Cyclically Adjusted Primary Balance (CAFB – the best
indicator of the underlying course of fiscal policy, stripping out the impact of the economic
cycle and debt interest costs on the public finances) has developed over recent years.
Having been zero in 2006, the CAFB ballooned in 2008 and 2009 as the government
introduced new welfare schemes and eased fiscal policy aggressively in reaction to the
global financial crisis. In the following two years, only a small part of this stimulus has
been taken back. Partly as result, the overall central government budget deficit appears
all but certain to overshoot the official target of 4.6% of GDP in 2011/12. Our own forecast
remains at 5.6% of GDP, with the risks tilted modestly to the upside.
With this in mind, and given our earlier remarks concerning the potential benefits of
reducing the deficit, there would appear to be a strong case for tightening the fiscal stance
in the upcoming budget. In practice, however, it is not quite as simple as this. The
weakness of GDP growth and the strength of inflation over the last couple of years mean
there is no shortage of pressure, both within and outside the Congress-led coalition, to
provide some help to poorer members of society.
The budget announcement – our expectations
As such, we expect the budget announcement on 16 March to encompass many of the
following:
Budget assumptions
• Finance Minister Pranab Mukherjee is likely to raise his estimate of the central
government budget deficit in 2011/12 from the current 4.6% of GDP to something in the
range of 5.5-6.0%.
• We expect him to forecast a reduction in the budget deficit to 4.8-5.3% of GDP for the
fiscal year 2012/13. This will probably be based on a real GDP growth assumption in
the order of 8%, with the WPI set at 5.5-6%. Our own growth projection, as well as that
of the consensus, is 7.3%, while we expect the WPI rate to average 5.8% in 2012/13
(the consensus is at 6.6%), ending the fiscal year at 6%.
• The budget will no doubt include upbeat assumptions concerning proceeds from the
government’s divestment program and the sale of telecom spectrum. We are expecting
it to announce a target of about INR500bn in privatisation receipts and INR650bn in
spectrum (1.2% of GDP in total). During the current fiscal year, the government has
raised little more than INR11bn from divestments, which compares with a target of
INR400bn this time last year. Having said that, stronger market conditions suggest that
it should fare a lot better in 2012/13.
Tightening measures, Direct Tax Code and GST
• We expect the finance minister to unveil several tightening measures. In our view, these
will include an increase in the breadth of the service tax as well as a rise in the excise
and service tax rate from 10% to 11% (it was lowered from 12% in response to the
global financial crisis).
• Given the recent spike in the oil price and the implications this will have for the
government’s subsidy bill (we estimate that a 10% oil price increase typically adds 0.2%
of GDP to the fiscal deficit), then a further increase in subsidised fuel prices, including
diesel, kerosene and LPG, is probable. Exhibit 7 shows how the oil price has once
again been rising relative to the regulated diesel price (as measured by the diesel price
index in the India’s wholesale price series) in recent times.
• The finance minister will probably set out some sort of medium-term fiscal consolidation
program, although the risk is that it will lack credibility. Hopefully, it will at least
encompass more details concerning the introduction of the Direct Tax Code (DTC) as
well as the Goods and Service Tax (GST). The latter has already been pushed back a
couple of times, while the DTC is still being scrutinised by the parliamentary standing
committee (it was originally due to be implemented from the start of the 2012/13 fiscal
year). Both schemes are intended to be revenue neutral, but there are legitimate hopes
that by simplifying the tax collection process, significant efficiency gains will be achieved.
Income tax adjustment, the food security bill and structural issues
• In order to help compensate people for the high level of inflation, we expect the tax
exemption limit to be raised by roughly 11% (INR20,000) to INR200,000. To what
extent, if at all, the tax slabs are raised, is a more difficult call. On balance, we are
looking for at least a modest increase.
• It seems unlikely that Mukherjee will allocate much in the way of funding for the Food
Security Bill, which is due to be rolled out by November 2012, having been considered
by a parliamentary standing committee (delays to this timetable are of course possible).
As a reminder, the Bill is designed to provide subsidised food grains to 75% of the rural
population and 50% of the urban population. A minimum of 46% of the rural population
and 28% of the urban population are meant to get 7kg of food grains per person per
month. The total cost of the Bill, when fully implemented, is estimated to be INR1,120bn
(about 1% of 2012/13 GDP) – enough to put a big dent in the public finances. The
finance minister will need to explain how he intends to finance this.
• We would be surprised if any ’market-friendly’ structural economic reforms were to be
announced in the budget. Although notionally the government has only “postponed” the
plan to allow single-brand foreign retailers entry to the domestic market, our guess is
that it will prove a long delay.
Taking all this into account and building in our own, more pessimistic, economic growth
forecasts, we expect the central government budget deficit to come in at 5.8% of GDP in
2012/13 (8.3% for the general government). This is actually a slight reduction from our
previous 6% forecast, reflecting a more optimistic assumption about divestment and
telecom spectrum receipts, but very similar to the probable outcome for 2011/12. We
believe a further period of sub-par economic growth will continue to keep a firm lid on
revenues, while the funding of the Food Security Bill, assuming it begins during the
2012/13 fiscal year, will put upward pressure on the deficit as well.
3. Assessing the RBI’s reaction
If our expectations of what will be unveiled in the budget are roughly right, how is the
Reserve Bank of India likely to react?
In his statement of 24 January, following the central bank’s monetary policy meeting,
Governor Subbarao argued that “there is an urgent need for decisive fiscal consolidation
… This is critical to yielding the space required for lowering rates without the imminent risk
of resurgent inflation. The forthcoming Union Budget must exploit the opportunity to begin
this process in a credible and sustainable way”.
No doubt, there was a sizeable element of ’jaw-boning’ involved here, but, even so, it is
clear that the RBI will be paying attention to the contents of the budget when it decides
whether or not to lower rates on 15 March (it is highly probable that the budget will have
been presented to the central bank by the time of its next meeting). In our judgment, while
the RBI would ideally want to see a more aggressive tightening of the underlying fiscal
stance than is likely to be delivered, the budget will do just about enough to start the rate
cutting ball rolling.
We are looking for a total of 175bps of repo rate reductions between March this year and
January 2013, bringing the rate down to 6.75% from its current 8.5% level. Although this
may sound aggressive (and, as far as we are aware, is more than any other market
commentators are looking for), it is worth noting that the RBI effectively tightened policy by
500bps during 2010-11, while the long-term average for the repo rate is 7.0%.
Key to our projection is what happens to WPI inflation, the importance of which is
illustrated in Exhibit 8. This suggests that since Dr. Subbarao took charge of the central
bank in September 2008, the repo rate has effectively become a lagging function of
wholesale price developments. Prior to his governorship, and contrary to conventional
wisdom, there was no obvious relationship between the two series whatsoever.
In our view, wholesale price inflation will edge lower in the next few months (we are
looking for it to fall to less than 6% by April/May from 6.6% in January), based largely on
the fact that the year-on-year change in the rupee-denominated CRB index has already
dropped from 40% close to zero. As Exhibit 9 shows, this series typically provides a lead
of three to four months to WPI inflation.
In order to gauge what may happen thereafter, we have extended the grey line in the chart
on the basis that oil, food and metal prices remain at their current levels (USD125/barrel in
the case of the first of these). Many argue that WPI inflation will move up from the June
quarter reflecting adverse base effects, but for this to happen we believe the rupee would
need to depreciate precipitately and/or commodity prices rise sharply. Neither is part of
our central scenario.
Apart from WPI inflation, economic growth is presumably of some relevance to the RBI as
well. While the March quarter of 2012 is likely to represent the bottom of the GDP growth
cycle, we doubt year-on-year growth will exceed 7% until the December quarter of the
year and 8% until the September quarter of 2013. The Reserve Bank used to peg the
trend rate of economic growth at 8-8.5%, although it may have cut this recently. In our
view, the sustainable growth rate has been and remains at around 7.5%.
Bond issuance and market implications
We expect the government to announce a net market borrowing number in the vicinity of
INR4.1tn (gross INR5tn) for FY13. This would be marginally lower than the INR4.2tn (net)
for FY12, which was much higher than the FY12 budgeted numbers given the INR928.7bn
slippage. We do not expect much market reaction from the borrowing details as markets
will likely be focused on RBI’s policy rate actions and guidance (15 March) coupled with
the outlook for liquidity conditions.
The start of the easing cycle and expectations of some moderation of the significant
liquidity deficit should support bonds. We expect the bond curve to bull steepen to reflect
lower front end rates. The benchmark 10y bond is trading at very tight spreads to the front
end and also commands a sizeable liquidity premium. Foreign investor and RBI purchases
have been a big support for the market in recent months and these positives will likely fade
with the start of the new fiscal year. The large bond redemptions in April and May will
provide some support in the near term, but sustained supply will likely keep the overall
move in long bonds muted despite the expected RBI rate cuts. We expect the 10y bond
yield to fall below 8% in three months and trade towards 7.5% by end 2012 if global
commodity prices are well behaved and inflation trends remain benign.
No comments:
Post a Comment