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India – Time for a bold budget
FY13 budget should attempt fiscal consolidation; the deficit should shrink to 5.3% of GDP from 5.8%
Expenditure compression will be difficult to achieve; the proportion of capital spend should rise
Indirect tax rates might be increased and the emphasis will be on non-tax revenue to reduce the deficit
RBI OMOs will be required to relieve supply pressure as gross market borrowing is likely to be INR 5.4trn
Summary
The Finance Minister (FM) will present the FY13 (starts 1 April 2012) central
government budget on 16 March. We expect the FY12 fiscal deficit to be 5.8% of
GDP (1.2% of GDP higher than the budget) but moderate fiscal consolidation should
bring this down to 5.3% of GDP in FY13. Revenue growth is likely to be limited by
lower nominal GDP growth in FY13 but indirect tax rates could be nudged up to
provide revenue support. The new direct tax code (DTC) and uniform goods and
services tax (GST) are likely to be deferred until FY14 and only a few small steps are
likely to be announced to smooth the transition. Dependence on divestment proceeds
and other forms of non-tax revenue are likely to continue in the FY13 budget.
The government urgently needs to reduce unproductive expenditure on subsidies to
demonstrate its commitment to fiscal consolidation. Deregulation of all administered
prices on fuel and fertiliser products is unlikely to happen immediately but some price
increases are possible to reduce the subsidy burden and signal policy direction.
Although in the near term these price corrections could be inflationary, the Reserve
Bank of India (RBI) is likely to focus more on the medium-term impact of fiscal
consolidation to tame structural inflation pressures. Monetary policy can only be
eased substantially in FY13 if the budget outlines a credible fiscal consolidation plan.
Even if fuel subsidies are brought down, new pressures could emerge from food
subsidies, allocations for bank recapitalisation and debt restructuring for power
distribution utilities. Overall, the expenditure-to-GDP ratio in FY13 might not improve
substantially from FY12. We would view the budget positively were the FM to
improve the quality of fiscal spending by increasing the share of capital expenditure
(13% of total expenditure in FY12) on infrastructure projects.
The outcome of state elections on 6 March will determine the final shape of the
budget. A positive result for the ruling United Progressive Alliance (UPA) could
prompt the FM to take bold steps towards fiscal consolidation. The announcement of
a fiscal deficit below 5% of GDP is possible, but markets would closely scrutinise all
the assumptions behind such an optimistic projection. In our baseline scenario we
expect gross market borrowing to be around INR 5.4trn, which is marginally higher
than current market estimates. In such a case, we believe support from the RBI via
open market operations (OMOs) will again be required in FY13 to avoid supply
pressure in the rates markets.
FY13 budget backdrop
The backdrop to the FY13 budget announcement due on 16 March is interesting from
the following perspectives:
Growth, particularly investment activity, has decelerated substantially and
demands policy attention. While inflation has edged down, it has yet to
settle within the RBI’s comfort zone. The complexity of the macro backdrop
is exacerbated by an uncertain global environment.
The last three budgets have all been criticised as being populist, with scant
regard for fiscal discipline. Therefore, returning to a sustainable fiscal path
will be a policy priority.
This is all the more important because the RBI has indicated that its ability
to ease monetary policy depends on the extent of fiscal consolidation.
The FY12 fiscal deficit could exceed the initial target of 4.6% of GDP by
close to 1.2% of GDP. If so, markets would scrutinise all the assumptions
behind the FY13 budget even more closely.
The FY14 budget (to be presented February 2013) will be the last before the
2014 national elections and is likely to be a populist one. Logically, the FY13
budget is therefore the one to push through some hard decisions.
As the FY13 budget will be presented almost immediately after the five state
election results are announced; the outcome could force the FM to shift the
focus of the budget to suit political needs.
FY13 will be the first year of the 12th Five-Year Plan (FYP). A reorientation
of expenditure to meet its objectives will be a critical challenge for this
budget, given that close to 40% of the resource requirements for the FYP
are allocated from the budget.
Strategies and issues
The path of fiscal consolidation: All eyes will be on the FY13 fiscal deficit estimate
as the FM presents his budget, but it will be equally important to present a credible
roadmap. The Thirteenth Finance Commission suggested a fiscal consolidation
roadmap in December 2009 to bring down the fiscal deficit to 3% of GDP by FY14.
According to that roadmap, the FY13 fiscal deficit should have been 4.2% of GDP.
Adhering to that target will be impossible in FY13. However, committing credibly to
return to this path of consolidation within a stipulated time frame will be critical to
convince investors of the seriousness of government efforts. Policy makers need to
acknowledge that fiscal deficit reduction should be a policy priority, much like
stimulating growth, controlling inflation or redistributing wealth.
Expenditure measures to determine the quality of fiscal consolidation: Often,
how government earns its revenue and where it spends it matters more than the
extent of the fiscal deficit. Expenditure containment has always been the biggest
challenge in India. For a brief period during FY06-07 the expenditure-to-GDP ratio
was reduced to below 14% but it increased sharply to close to 16% in an effort to
stimulate the economy after the 2009 financial crisis. The majority of fiscal
expenditure is sticky, with very little scope for reduction. In FY12, almost half of the
total spend was on interest rates, subsidies and defence. If we add around 20% of
total expenditure on salaries of public-sector employees, then only 30% of the total
spend is discretionary.
So, efforts to reduce expenditure can come from two broad directions. First, the
deployment of resources to promote ‘inclusive’ growth. In the 11th FYP the government
has spent close to INR 7trn (14% of total government spend during this period) on
the top 13 flagship programmes of rural development and poverty alleviation to
promote inclusive growth. Political considerations dictate that substantial resources
need to be allocated for this purpose even in FY13; however, there is ample scope
for better utilisation. Overlaps between different government-sponsored schemes
need to be corrected by reducing the number of such schemes. In this context, the
FM should consider the recommendations of a recent committee report which
suggested reducing the number of centrally sponsored schemes to 59 from 147.
Second, the FM himself admitted recently that he is “losing sleep” over subsidies.
While complete deregulation of diesel, cooking gas and fertiliser prices will be difficult
to achieve immediately, the FM should seriously consider increasing prices to reduce
the extent of the subsidy. Any step in this direction would reduce distortion and should
be viewed as a positive reform. This will also be necessary because food subsidies
are likely to rise substantially once the National Food Security Act is passed by
parliament (expected by mid-2012) and the FM might also have to provide for bank
recapitalisation in the FY13 budget. On the positive side, it is possible that he will unveil
some plans for the direct transfer of cash subsidies, taking advantage of the unique
identification numbers that are being assigned to the entire population. This will help to
better target subsidies and could potentially reduce leakages in subsidy distribution.
Another aspect of the uneven nature of spending is that capital expenditure is only 13%
of total spending now; it was close to 23% in 2004-05, during the first two years of the
ruling UPA’s term. When insufficient infrastructure spending acts as a drag on
potential growth, there is an urgent need to increase it. Correcting this imbalance will
be one of the most critical aspects of the FY13 budget.
Staggered overhaul of the tax regime: Rising revenue generation on the back of
high growth led to the fiscal deficit dropping to 2.5% by FY08 from 6% in FY02.
During this period the tax-to-GDP ratio increased to 12% from 8%, a significant
achievement. The tax-to-GDP ratio is again close to 10% in FY12 and the emphasis
in the FY13 budget should be on increasing it. Indirect tax reductions implemented in
2008 to minimise the impact of the global financial crisis have not yet been reversed.
Revenue foregone because of different types of tax incentives was 6.6% of GDP in
FY11 (slightly better than 8.15% of GDP in FY09) but revenue collection could be
further improved by removing some of these incentives.
Two major structural reforms to overhaul the direct and indirect tax system – a new
direct tax code (DTC) and a uniform goods and service tax (GST) – are on the
agenda but are unlikely to be implemented in the FY13 budget. However, the FM
might want to introduce some changes in the tax structure so that the move to the
new system is staggered and non-disruptive. Some of the measures expected in the
FY13 budget could include a reclassification of the income tax brackets, increasing
the excise and customs duties and bringing more services within the tax net. Some
elements of the GST are still being debated with the states and hence some clarity
on the expected timeline of the introduction of GST could be included in the budget.
Also, addressing the issue of ‘black money’ could arise in the budget and a tax
amnesty scheme is one of the policy tools available. The last such scheme, in 1997,
resulted in INR 105bn of revenue, with more than 450,000 people disclosing nontaxed
income under the scheme. However, recent media reports suggest that such
measures may not be included in the budget.
Sustainable fiscal consolidation should not be based on non-tax revenue: With
the economy likely to grow below trend in FY13, the FM cannot rely on unexpected
windfalls in terms of tax revenue collection. However, non-tax revenue could be an
important way of achieving a lower fiscal deficit number. The government has been
contemplating different mechanisms to convert assets into cash flow. In its simplest
form, the government divests shares in public-sector companies to fund social-sector
programmes. In FY12, the government has fallen short of its divestment target
because of depressed equity markets. So, in FY13, the strategy could be to auction
off these stakes to institutional investors rather than taking the IPO route. This has
been made possible by recent regulatory changes. The first such transaction could
take place in FY12, which would prepare the government for more such auctions in
FY13. Also, there have been some innovative suggestions about how to utilise some
of the government’s private-sector stock holdings held in an entity called SUUTI.
These assets could possibly be transferred to a special purpose vehicle which could
then leverage them by borrowing from banks. The borrowed amount could then be
used to participate in the public-sector divestment programme. Not all the
stakeholders have yet agreed on the modalities of this scheme but the budget could
indicate whether the finance ministry is considering this as an option or not.
Most of India’s natural assets are government-owned. Revenue from selling the right
to exploit them could be a potential source of income. In FY11, the government
received more than INR 1trn from auctioning 3G spectrum. FY12 did not see any
such bonanza but in FY13 the government is likely to budget substantial revenue
from auctioning of 2G licences; 122 that were issued in 2008 were cancelled by a
recent court order. Auctioning of new coal blocks could be another way of generating
revenue. While such measures might improve the FY13 fiscal deficit, we are wary of
the sustainability of such a process.
Going beyond the fiscal deficit, planting the seeds of supply-side reforms:
Although focus on the fiscal deficit estimate is inevitable, the FY13 budget will give
the FM an opportunity to announce significant supply-side reform. These could be
aimed at addressing some of the infrastructure bottlenecks, particularly in the power
sector. Also, any clarity on land acquisition issues would be a positive.
Fiscal and monetary policy interface
January’s monetary policy statement emphasised that substantial monetary policy
easing has to be preceded by fiscal consolidation – both the extent of the fiscal deficit
and quality of fiscal spending matter. In the recent past, much fiscal spending has been
in the form of cash transfers without matching asset creation. Also, the right to
employment, education, food, etc., has taken the form of entitlements which do not
incentivise productivity growth in the rural economy and risk creating an environment of
continued dependence on such schemes. Consumption demand draws support from this
fiscal stance and the impact of interest rate policy on inflation may be largely neutralised.
Another factor is that some of the possible measures to reduce the fiscal deficit could
be inflationary in the short run – such as increasing the administered prices of diesel,
cooking gas, fertiliser, power, etc., to reduce subsidies. The RBI is likely to support
such a fiscal correction because in the medium term those price changes should
reduce demand and bring down inflation. However, in the short run, it is important to
ensure that inflationary expectations remain anchored, even while price corrections
occur. The March monetary policy statement will be released just a day before the
budget. This could make the choice of monetary policy action even more difficult.
FY12 – A year of considerable slippage
The FM is likely to confirm substantial slippage from the budgeted FY12 fiscal deficit
target. Against a budgeted fiscal deficit of 4.6% of GDP, we think the government is
likely to end FY12 with a fiscal deficit of 5.8% of GDP, not very different from the 6%
fiscal deficit witnessed in FY09. Several factors, both on the revenue and expenditure
fronts, have contributed to this slippage. We discuss these in detail below.
Net tax collection has been hit: Despite a reduction in excise duty and customs
duty on petroleum products at the beginning of FY12, indirect tax collection (excise,
customs and services and other taxes account for 42-43% of total tax generation)
has held firm. Growth of 15.1% y/y FYTD (April-January FY12) is not far from the 17%
y/y growth targeted for FY12 as a whole. Indeed, with almost 80% of the targeted
collection already with tax officials, much in line with the historical performance, the
government is set to achieve its revised target of INR 3.92trn from indirect taxes.
Gross direct tax collection remains relatively unscathed. Personal income tax
collection growth has been robust, at 20% FYTD, much in line with targeted growth.
Corporate tax collection (which accounts for c.38% of total tax collection) has grown
by 12%, much lower than the budgeted growth of 20%. However, this is likely to
improve in the next two months. Close to 30% of corporate taxes are collected in the
last quarter of the fiscal year. Thus, even as direct tax growth has slowed to 14.6%
y/y FYTD, far lower than projected growth of 20% y/y for FY12, we believe significant
slippage here is unlikely as we end FY12.
The biggest worry for tax collection arises from the huge tax refunds this year. For
the first 10 months of FY12, tax refunds stood at INR 790bn, almost two-and-a-half
times more than the previous year. Given such huge refunds, 9% growth in net tax
collection versus the 20% targeted does not surprise us. According to official
estimates, refunds for FY12 as a whole will be INR 200-250bn higher than in FY11,
making it difficult to meet the tax collection target. Hence slippage of INR 203bn (0.23%
of GDP) in net tax collection looks highly likely in FY12.
Non-tax revenue will not provide respite as it did in FY11: Unlike FY11 when
spectrum auctions generated extraordinary revenue of INR 1.05trn (1.3% of GDP),
which helped fiscal deficit consolidation, little support is expected in FY12. In fact,
given the lack of clarity on regularity policies regarding spectrum auctions, the
government is set to miss the targeted INR 140bn of revenues which it expected to
raise via this route. Such a loss should be partially offset by additional dividend
receipts from state-owned enterprises. However, the expected increase in dividend
payments is not a consequence of better company performances. It is more a result
of government persuasion to push such enterprises to raise the dividend payout to
the government as revenue proceeds were expected to be below target. While INR
65bn of higher dividends have already been confirmed by some companies, we
believe another INR 40bn of dividend receipts is likely. Nevertheless, marginal
slippage of INR 52bn (0.06% of GDP) on non-tax revenues cannot be ruled out.
Disappointment on divestment prompts a change in strategy: With little progress
on the divestment front – the government has collected INR 11bn versus a targeted
INR 400bn – considerable slippage looks likely. The government now proposes to
use the auction route rather than the IPO route to divest its stake in a state-owned oil
company. If successful, this could partially bridge the gap, but we expect slippage of
at least 0.30% of GDP on the budgeted divestment proceeds. Overall, we expect a
total revenue-collection shortfall of 0.6% of GDP.
Burgeoning subsidies to bloat expenditure: The FY12 budget targeted a 12.5%
decline in subsidies; instead they look likely to rise significantly. Given the weaker
Indian rupee (INR) and increasing oil prices, oil companies’ total losses are likely to
be c.INR 1.4trn. If the government bears 40% of these losses, subsidies are likely to
exceed the budget estimate by INR 600bn (0.5% of GDP). Indeed, the government
announced INR 450bn of subsidy payments to oil companies in the first nine months
of FY12. Similarly, fertiliser subsidies could be INR 100-120bn higher than the INR
500bn target in FY12. They already breached the targeted amount by INR 50bn in
the first nine months of FY12. Hence, subsidy expenditure is at risk of exceeding the
target by as much as 0.8% of GDP.
However, the finance ministry has instructed other ministries not to spend more than
33% of their budgeted spend in Q4-FY12, to avoid bunching up of expenditure in the
last quarter of the fiscal year. Given that several ministries were slow to spend in
the first nine months, expenditure for the full fiscal year could be INR 300bn lower.
Even factoring this in, expenditure is likely to be higher by 0.6% of GDP in FY12.
The fiscal deficit in FY12 is likely to be at 5.8% of GDP, much wider than the initial
target of 4.6%.
FY13 – Back to fiscal consolidation
With such substantial slippage in the FY12 fiscal deficit target, it will be imperative
that the FY13 budget puts India back on the path of fiscal consolidation. This needs
to be achieved both by boosting revenues and curtailing expenditure.
Measures needed to support tax collection: A slower nominal GDP growth (we
expect it to be 14% y/y versus 15.7% in FY12) could weigh on revenue generation.
Therefore the government will be conscious that fiscal austerity should not
substantially dampen growth. While we do not expect a reduction in tax rates owing
to fiscal constraints, an increase in the individual income tax exemption limit could be
considered in order to offset inflationary pressures. This could provide some respite
to private consumption. Growth in private consumption (which accounts for 60% of
overall GDP) slowed to 6.5% y/y in FY12 from 8.1% y/y in FY11. Current talks
indicate that the government is considering increasing individual tax exemption limits
in the range of USD 415-2,500 per person. Assuming the number of tax assesses at
34.8mn, as was the case in FY11, this could provide a direct stimulus of 0.1-0.5% of
GDP and have a multiplier impact on the overall economic activity as personal
disposable income increases. While a corresponding loss in revenue will be
inevitable, this should be offset to some extent as other tax collection improves on a
higher level of economic activity.
The government could also garner some resources by withdrawing some of the tax
stimulus provided post the financial crisis. A 1ppt increase in excise tax to 11% is one
such widely mooted measure. This alone could boost revenue collection by c.0.2% of
GDP. Given the impending implementation of GST, such a measure would have to
be coupled with a similar increase in services taxes, currently at 10%. However, as
the services tax collection as a percentage of GDP (0.9%) is half that of excise tax
collection, the corresponding impact of a 1% increase in services taxes would be an
additional contribution equivalent to c.0.1% of GDP to the tax coffers. Under GST there
will be only a small list of services which will not be taxed, but ahead of this the FM might
want to bring more services under the tax umbrella in FY13 and increase service tax
collection. An increase in customs duty is also under consideration. However, this could
have a significant impact on price pressure and might not be favoured by policy makers.
Non-tax revenues and divestment proceeds could be better: Overall revenue
collection is also likely to receive some support from higher non-tax revenue collection.
Specifically, spectrum auctions in FY13 are likely to provide the government with
relatively higher proceeds than FY12. According to our equity analysts, spectrum
auctions in FY13 are likely to generate INR 160-320bn (0.2-0.4% of GDP) of revenue.
Similarly, capital receipts could be higher, as revenue realisation from divestment
proceeds could be boosted by improved global economic conditions, especially in
H2-FY13. It is highly likely that the government will once again target divestment of
INR 300-400bn (0.3-0.4% of GDP) when it presents FY13 budget on 16 March.
A reduction in recurrent expenditure is necessary: While the government might
have limited room to manoeuvre on most of the rigid and recurrent expenditure
(interest payments, defence, subsidies and salaries), it could still take certain
measures – especially related to petroleum products – to cap the overall subsidy
burden. Our equity team estimates that every USD 10/bbl increase in crude oil prices
increases the petroleum products subsidy burden by 0.3% of GDP. Since the Indian
crude basket is expected to stay at elevated levels – we expect it to be USD 118/bbl,
8% higher than FY12 – oil company losses could be higher than the INR1.4-1.5trn
recorded in FY12. If the government does not pass on any of the burden to
consumers, the petroleum subsidy could once again be high, at 0.7% of GDP in
FY13. However, if the government decides to increase diesel prices by INR 2/litre,
kerosene by INR 1/litre and cooking gas prices by INR 50/cylinder, the fuel subsidy
burden could be lower by 0.14% of GDP. Similarly, some respite is likely as the
government plans to increase the price of urea and link it to the price of gas in an
attempt to reduce its burgeoning fertiliser subsidy bill. For a start, it is considering
increasing urea prices by a flat 10%. If the new fertiliser subsidy scheme is
implemented the government could save c.0.11% of GDP.
Such savings on subsidies (up to 0.25% of GDP) are necessary to free up resources
for additional subsidies which are likely to be introduced in FY13. For instance, while
full implementation of the Food Security Act is unlikely in FY13, recent talks suggest
that the government will allocate a token amount of INR 50bn (c.0.06% of GDP) to
start this plan. More importantly, resources will be needed to provide funds for the
national electricity fund (NEF) which, in turn, will subsidise the interest rate on loans
taken by State Electricity Boards (SEBs) for cutting distribution losses. The SEBs
have accumulated bank debt of INR 1.8trn because of huge losses incurred from
selling electricity below cost and various other inefficiencies associated with
electricity distribution. Given the size of this debt, SEBs are finding it difficult to raise
working capital at reasonable rates. Thus we expect the government to provide them
with financial support via an interest-rate subsidy of INR 250bn in the next two years.
This subsidy will be performance-linked and aimed at an efficient distribution system.
If implemented, it could increase the subsidy burden by c.0.13% of GDP.
Gross budgetary support might grow at a slower pace: Although the planning
commission is seeking an 18% increase in gross budgetary support (GBS) – financial
assistance provided by central government to planned schemes, such as the
employment guarantee scheme and Bharat Nirman project – fiscal constraint might
restrict this to just 11% as reported by newspapers. In FY12, the GBS increase was
targeted at 16% y/y. However, as this is the first year of 12th FYP, the government
might be under pressure to allocate a sufficient amount to infrastructure development.
Our baseline projection for the budget: Details of the budget can be finalised up to
a few days before the budget. State election results due on 6 March may influence
the tone of the budget statement. However, at this stage we expect the FM to
announce a FY13 budget deficit target of 5.3% of GDP, marginally lower than our
initial estimate of 5.5% of GDP. Our expectation is based on the assumption that the
government is able to raise the gross tax collection-to-GDP ratio to 10.8% of GDP
versus 10.4% in FY12 via a combination of indirect tax increases and improved
economic activity. Also, higher proceeds from spectrum auctions and divestment
plans should support overall revenue collection. On other hand, we assume
expenditure will remain at 14.8% of GDP (14.75% in FY12). This is because any
reduction in the subsidy burden is likely to be absorbed by fresh subsides and
infrastructure expenditure requirements.
Risk scenarios: We also look at two alternative scenarios in which the FM could
forecast a fiscal deficit target either higher or lower than our core case. For instance,
if excise and services taxes are increased by 2% instead of 1% each this would
reduce the fiscal deficit by additional 0.3% of GDP from our core case of 5.3% of
GDP. Also, if the government increases administered product prices by more than
we have assumed above or provisions for a lower subsidy burden at the beginning
of the year, projecting an expenditure-to-GDP ratio of 14.5% instead of 14.8% as
in our core case would not be difficult. Hence, a fiscal deficit of 4.8% of GDP could
easily be managed.
Similarly, if the government opts for a more populist budget, a fiscal deficit projection
of 5.5% of GDP would be inevitable. For instance, if it allocates a higher amount to
the Food Security Act or fails to implement the new urea policy in the budget, we
could easily see additional strain on the fiscal deficit equivalent to 0.2% of GDP.
Government borrowing to be the same as last year but
markets expect a lower amount
In FY13, our estimates of fiscal financing indicate that government borrowing will be
at the same level as last year. We believe the government is unlikely to end FY12
with a cash surplus significantly higher than INR 300bn, which is required to redeem
c.INR 260bn worth of GoISecs maturing on 6 April 2012. In the absence of a cash
surplus cushion, the government is likely to follow its historical pattern of financing
c.85-90% of the fiscal deficit via market borrowing (see Table 2). This – in our most
probable scenario – implies net market borrowing of c. INR 4.3-4.5trn (INR 5.2-5.4trn
gross) via GoISecs and c.INR 200bn via T-bills (note that the amount of outstanding
T-bills increased by c.INR 1.16trn during FY12). Our FY13 market borrowing
estimate is close to the actual level the government borrowed from the market in
FY12 (INR 4.36trn). Even with a market borrowing estimate similar to last year’s
we believe RBI support will be important to balance the demand-supply equation in
FY13, albeit less than in FY12. With c.95% of FY13 redemptions due in H1-FY13,
the market borrowing calendar is likely to be front-loaded in H1-FY13. As such, we
expect reinvestment demand to limit the impact of a front-loaded issuance calendar
on GoISec yields.
The rates market expects FY13 net market borrowing in the range of c.INR 3.8-4.2trn
(INR 4.7-5.1trn gross), close to our optimistic scenario. We believe an announcement
closer to the lower end of this range would boost sentiment in the immediate term
and soften yields; we would expect the benchmark 10Y GoISec to soften by c.10bps.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
India – Time for a bold budget
FY13 budget should attempt fiscal consolidation; the deficit should shrink to 5.3% of GDP from 5.8%
Expenditure compression will be difficult to achieve; the proportion of capital spend should rise
Indirect tax rates might be increased and the emphasis will be on non-tax revenue to reduce the deficit
RBI OMOs will be required to relieve supply pressure as gross market borrowing is likely to be INR 5.4trn
Summary
The Finance Minister (FM) will present the FY13 (starts 1 April 2012) central
government budget on 16 March. We expect the FY12 fiscal deficit to be 5.8% of
GDP (1.2% of GDP higher than the budget) but moderate fiscal consolidation should
bring this down to 5.3% of GDP in FY13. Revenue growth is likely to be limited by
lower nominal GDP growth in FY13 but indirect tax rates could be nudged up to
provide revenue support. The new direct tax code (DTC) and uniform goods and
services tax (GST) are likely to be deferred until FY14 and only a few small steps are
likely to be announced to smooth the transition. Dependence on divestment proceeds
and other forms of non-tax revenue are likely to continue in the FY13 budget.
The government urgently needs to reduce unproductive expenditure on subsidies to
demonstrate its commitment to fiscal consolidation. Deregulation of all administered
prices on fuel and fertiliser products is unlikely to happen immediately but some price
increases are possible to reduce the subsidy burden and signal policy direction.
Although in the near term these price corrections could be inflationary, the Reserve
Bank of India (RBI) is likely to focus more on the medium-term impact of fiscal
consolidation to tame structural inflation pressures. Monetary policy can only be
eased substantially in FY13 if the budget outlines a credible fiscal consolidation plan.
Even if fuel subsidies are brought down, new pressures could emerge from food
subsidies, allocations for bank recapitalisation and debt restructuring for power
distribution utilities. Overall, the expenditure-to-GDP ratio in FY13 might not improve
substantially from FY12. We would view the budget positively were the FM to
improve the quality of fiscal spending by increasing the share of capital expenditure
(13% of total expenditure in FY12) on infrastructure projects.
The outcome of state elections on 6 March will determine the final shape of the
budget. A positive result for the ruling United Progressive Alliance (UPA) could
prompt the FM to take bold steps towards fiscal consolidation. The announcement of
a fiscal deficit below 5% of GDP is possible, but markets would closely scrutinise all
the assumptions behind such an optimistic projection. In our baseline scenario we
expect gross market borrowing to be around INR 5.4trn, which is marginally higher
than current market estimates. In such a case, we believe support from the RBI via
open market operations (OMOs) will again be required in FY13 to avoid supply
pressure in the rates markets.
FY13 budget backdrop
The backdrop to the FY13 budget announcement due on 16 March is interesting from
the following perspectives:
Growth, particularly investment activity, has decelerated substantially and
demands policy attention. While inflation has edged down, it has yet to
settle within the RBI’s comfort zone. The complexity of the macro backdrop
is exacerbated by an uncertain global environment.
The last three budgets have all been criticised as being populist, with scant
regard for fiscal discipline. Therefore, returning to a sustainable fiscal path
will be a policy priority.
This is all the more important because the RBI has indicated that its ability
to ease monetary policy depends on the extent of fiscal consolidation.
The FY12 fiscal deficit could exceed the initial target of 4.6% of GDP by
close to 1.2% of GDP. If so, markets would scrutinise all the assumptions
behind the FY13 budget even more closely.
The FY14 budget (to be presented February 2013) will be the last before the
2014 national elections and is likely to be a populist one. Logically, the FY13
budget is therefore the one to push through some hard decisions.
As the FY13 budget will be presented almost immediately after the five state
election results are announced; the outcome could force the FM to shift the
focus of the budget to suit political needs.
FY13 will be the first year of the 12th Five-Year Plan (FYP). A reorientation
of expenditure to meet its objectives will be a critical challenge for this
budget, given that close to 40% of the resource requirements for the FYP
are allocated from the budget.
Strategies and issues
The path of fiscal consolidation: All eyes will be on the FY13 fiscal deficit estimate
as the FM presents his budget, but it will be equally important to present a credible
roadmap. The Thirteenth Finance Commission suggested a fiscal consolidation
roadmap in December 2009 to bring down the fiscal deficit to 3% of GDP by FY14.
According to that roadmap, the FY13 fiscal deficit should have been 4.2% of GDP.
Adhering to that target will be impossible in FY13. However, committing credibly to
return to this path of consolidation within a stipulated time frame will be critical to
convince investors of the seriousness of government efforts. Policy makers need to
acknowledge that fiscal deficit reduction should be a policy priority, much like
stimulating growth, controlling inflation or redistributing wealth.
Expenditure measures to determine the quality of fiscal consolidation: Often,
how government earns its revenue and where it spends it matters more than the
extent of the fiscal deficit. Expenditure containment has always been the biggest
challenge in India. For a brief period during FY06-07 the expenditure-to-GDP ratio
was reduced to below 14% but it increased sharply to close to 16% in an effort to
stimulate the economy after the 2009 financial crisis. The majority of fiscal
expenditure is sticky, with very little scope for reduction. In FY12, almost half of the
total spend was on interest rates, subsidies and defence. If we add around 20% of
total expenditure on salaries of public-sector employees, then only 30% of the total
spend is discretionary.
So, efforts to reduce expenditure can come from two broad directions. First, the
deployment of resources to promote ‘inclusive’ growth. In the 11th FYP the government
has spent close to INR 7trn (14% of total government spend during this period) on
the top 13 flagship programmes of rural development and poverty alleviation to
promote inclusive growth. Political considerations dictate that substantial resources
need to be allocated for this purpose even in FY13; however, there is ample scope
for better utilisation. Overlaps between different government-sponsored schemes
need to be corrected by reducing the number of such schemes. In this context, the
FM should consider the recommendations of a recent committee report which
suggested reducing the number of centrally sponsored schemes to 59 from 147.
Second, the FM himself admitted recently that he is “losing sleep” over subsidies.
While complete deregulation of diesel, cooking gas and fertiliser prices will be difficult
to achieve immediately, the FM should seriously consider increasing prices to reduce
the extent of the subsidy. Any step in this direction would reduce distortion and should
be viewed as a positive reform. This will also be necessary because food subsidies
are likely to rise substantially once the National Food Security Act is passed by
parliament (expected by mid-2012) and the FM might also have to provide for bank
recapitalisation in the FY13 budget. On the positive side, it is possible that he will unveil
some plans for the direct transfer of cash subsidies, taking advantage of the unique
identification numbers that are being assigned to the entire population. This will help to
better target subsidies and could potentially reduce leakages in subsidy distribution.
Another aspect of the uneven nature of spending is that capital expenditure is only 13%
of total spending now; it was close to 23% in 2004-05, during the first two years of the
ruling UPA’s term. When insufficient infrastructure spending acts as a drag on
potential growth, there is an urgent need to increase it. Correcting this imbalance will
be one of the most critical aspects of the FY13 budget.
Staggered overhaul of the tax regime: Rising revenue generation on the back of
high growth led to the fiscal deficit dropping to 2.5% by FY08 from 6% in FY02.
During this period the tax-to-GDP ratio increased to 12% from 8%, a significant
achievement. The tax-to-GDP ratio is again close to 10% in FY12 and the emphasis
in the FY13 budget should be on increasing it. Indirect tax reductions implemented in
2008 to minimise the impact of the global financial crisis have not yet been reversed.
Revenue foregone because of different types of tax incentives was 6.6% of GDP in
FY11 (slightly better than 8.15% of GDP in FY09) but revenue collection could be
further improved by removing some of these incentives.
Two major structural reforms to overhaul the direct and indirect tax system – a new
direct tax code (DTC) and a uniform goods and service tax (GST) – are on the
agenda but are unlikely to be implemented in the FY13 budget. However, the FM
might want to introduce some changes in the tax structure so that the move to the
new system is staggered and non-disruptive. Some of the measures expected in the
FY13 budget could include a reclassification of the income tax brackets, increasing
the excise and customs duties and bringing more services within the tax net. Some
elements of the GST are still being debated with the states and hence some clarity
on the expected timeline of the introduction of GST could be included in the budget.
Also, addressing the issue of ‘black money’ could arise in the budget and a tax
amnesty scheme is one of the policy tools available. The last such scheme, in 1997,
resulted in INR 105bn of revenue, with more than 450,000 people disclosing nontaxed
income under the scheme. However, recent media reports suggest that such
measures may not be included in the budget.
Sustainable fiscal consolidation should not be based on non-tax revenue: With
the economy likely to grow below trend in FY13, the FM cannot rely on unexpected
windfalls in terms of tax revenue collection. However, non-tax revenue could be an
important way of achieving a lower fiscal deficit number. The government has been
contemplating different mechanisms to convert assets into cash flow. In its simplest
form, the government divests shares in public-sector companies to fund social-sector
programmes. In FY12, the government has fallen short of its divestment target
because of depressed equity markets. So, in FY13, the strategy could be to auction
off these stakes to institutional investors rather than taking the IPO route. This has
been made possible by recent regulatory changes. The first such transaction could
take place in FY12, which would prepare the government for more such auctions in
FY13. Also, there have been some innovative suggestions about how to utilise some
of the government’s private-sector stock holdings held in an entity called SUUTI.
These assets could possibly be transferred to a special purpose vehicle which could
then leverage them by borrowing from banks. The borrowed amount could then be
used to participate in the public-sector divestment programme. Not all the
stakeholders have yet agreed on the modalities of this scheme but the budget could
indicate whether the finance ministry is considering this as an option or not.
Most of India’s natural assets are government-owned. Revenue from selling the right
to exploit them could be a potential source of income. In FY11, the government
received more than INR 1trn from auctioning 3G spectrum. FY12 did not see any
such bonanza but in FY13 the government is likely to budget substantial revenue
from auctioning of 2G licences; 122 that were issued in 2008 were cancelled by a
recent court order. Auctioning of new coal blocks could be another way of generating
revenue. While such measures might improve the FY13 fiscal deficit, we are wary of
the sustainability of such a process.
Going beyond the fiscal deficit, planting the seeds of supply-side reforms:
Although focus on the fiscal deficit estimate is inevitable, the FY13 budget will give
the FM an opportunity to announce significant supply-side reform. These could be
aimed at addressing some of the infrastructure bottlenecks, particularly in the power
sector. Also, any clarity on land acquisition issues would be a positive.
Fiscal and monetary policy interface
January’s monetary policy statement emphasised that substantial monetary policy
easing has to be preceded by fiscal consolidation – both the extent of the fiscal deficit
and quality of fiscal spending matter. In the recent past, much fiscal spending has been
in the form of cash transfers without matching asset creation. Also, the right to
employment, education, food, etc., has taken the form of entitlements which do not
incentivise productivity growth in the rural economy and risk creating an environment of
continued dependence on such schemes. Consumption demand draws support from this
fiscal stance and the impact of interest rate policy on inflation may be largely neutralised.
Another factor is that some of the possible measures to reduce the fiscal deficit could
be inflationary in the short run – such as increasing the administered prices of diesel,
cooking gas, fertiliser, power, etc., to reduce subsidies. The RBI is likely to support
such a fiscal correction because in the medium term those price changes should
reduce demand and bring down inflation. However, in the short run, it is important to
ensure that inflationary expectations remain anchored, even while price corrections
occur. The March monetary policy statement will be released just a day before the
budget. This could make the choice of monetary policy action even more difficult.
FY12 – A year of considerable slippage
The FM is likely to confirm substantial slippage from the budgeted FY12 fiscal deficit
target. Against a budgeted fiscal deficit of 4.6% of GDP, we think the government is
likely to end FY12 with a fiscal deficit of 5.8% of GDP, not very different from the 6%
fiscal deficit witnessed in FY09. Several factors, both on the revenue and expenditure
fronts, have contributed to this slippage. We discuss these in detail below.
Net tax collection has been hit: Despite a reduction in excise duty and customs
duty on petroleum products at the beginning of FY12, indirect tax collection (excise,
customs and services and other taxes account for 42-43% of total tax generation)
has held firm. Growth of 15.1% y/y FYTD (April-January FY12) is not far from the 17%
y/y growth targeted for FY12 as a whole. Indeed, with almost 80% of the targeted
collection already with tax officials, much in line with the historical performance, the
government is set to achieve its revised target of INR 3.92trn from indirect taxes.
Gross direct tax collection remains relatively unscathed. Personal income tax
collection growth has been robust, at 20% FYTD, much in line with targeted growth.
Corporate tax collection (which accounts for c.38% of total tax collection) has grown
by 12%, much lower than the budgeted growth of 20%. However, this is likely to
improve in the next two months. Close to 30% of corporate taxes are collected in the
last quarter of the fiscal year. Thus, even as direct tax growth has slowed to 14.6%
y/y FYTD, far lower than projected growth of 20% y/y for FY12, we believe significant
slippage here is unlikely as we end FY12.
The biggest worry for tax collection arises from the huge tax refunds this year. For
the first 10 months of FY12, tax refunds stood at INR 790bn, almost two-and-a-half
times more than the previous year. Given such huge refunds, 9% growth in net tax
collection versus the 20% targeted does not surprise us. According to official
estimates, refunds for FY12 as a whole will be INR 200-250bn higher than in FY11,
making it difficult to meet the tax collection target. Hence slippage of INR 203bn (0.23%
of GDP) in net tax collection looks highly likely in FY12.
Non-tax revenue will not provide respite as it did in FY11: Unlike FY11 when
spectrum auctions generated extraordinary revenue of INR 1.05trn (1.3% of GDP),
which helped fiscal deficit consolidation, little support is expected in FY12. In fact,
given the lack of clarity on regularity policies regarding spectrum auctions, the
government is set to miss the targeted INR 140bn of revenues which it expected to
raise via this route. Such a loss should be partially offset by additional dividend
receipts from state-owned enterprises. However, the expected increase in dividend
payments is not a consequence of better company performances. It is more a result
of government persuasion to push such enterprises to raise the dividend payout to
the government as revenue proceeds were expected to be below target. While INR
65bn of higher dividends have already been confirmed by some companies, we
believe another INR 40bn of dividend receipts is likely. Nevertheless, marginal
slippage of INR 52bn (0.06% of GDP) on non-tax revenues cannot be ruled out.
Disappointment on divestment prompts a change in strategy: With little progress
on the divestment front – the government has collected INR 11bn versus a targeted
INR 400bn – considerable slippage looks likely. The government now proposes to
use the auction route rather than the IPO route to divest its stake in a state-owned oil
company. If successful, this could partially bridge the gap, but we expect slippage of
at least 0.30% of GDP on the budgeted divestment proceeds. Overall, we expect a
total revenue-collection shortfall of 0.6% of GDP.
Burgeoning subsidies to bloat expenditure: The FY12 budget targeted a 12.5%
decline in subsidies; instead they look likely to rise significantly. Given the weaker
Indian rupee (INR) and increasing oil prices, oil companies’ total losses are likely to
be c.INR 1.4trn. If the government bears 40% of these losses, subsidies are likely to
exceed the budget estimate by INR 600bn (0.5% of GDP). Indeed, the government
announced INR 450bn of subsidy payments to oil companies in the first nine months
of FY12. Similarly, fertiliser subsidies could be INR 100-120bn higher than the INR
500bn target in FY12. They already breached the targeted amount by INR 50bn in
the first nine months of FY12. Hence, subsidy expenditure is at risk of exceeding the
target by as much as 0.8% of GDP.
However, the finance ministry has instructed other ministries not to spend more than
33% of their budgeted spend in Q4-FY12, to avoid bunching up of expenditure in the
last quarter of the fiscal year. Given that several ministries were slow to spend in
the first nine months, expenditure for the full fiscal year could be INR 300bn lower.
Even factoring this in, expenditure is likely to be higher by 0.6% of GDP in FY12.
The fiscal deficit in FY12 is likely to be at 5.8% of GDP, much wider than the initial
target of 4.6%.
FY13 – Back to fiscal consolidation
With such substantial slippage in the FY12 fiscal deficit target, it will be imperative
that the FY13 budget puts India back on the path of fiscal consolidation. This needs
to be achieved both by boosting revenues and curtailing expenditure.
Measures needed to support tax collection: A slower nominal GDP growth (we
expect it to be 14% y/y versus 15.7% in FY12) could weigh on revenue generation.
Therefore the government will be conscious that fiscal austerity should not
substantially dampen growth. While we do not expect a reduction in tax rates owing
to fiscal constraints, an increase in the individual income tax exemption limit could be
considered in order to offset inflationary pressures. This could provide some respite
to private consumption. Growth in private consumption (which accounts for 60% of
overall GDP) slowed to 6.5% y/y in FY12 from 8.1% y/y in FY11. Current talks
indicate that the government is considering increasing individual tax exemption limits
in the range of USD 415-2,500 per person. Assuming the number of tax assesses at
34.8mn, as was the case in FY11, this could provide a direct stimulus of 0.1-0.5% of
GDP and have a multiplier impact on the overall economic activity as personal
disposable income increases. While a corresponding loss in revenue will be
inevitable, this should be offset to some extent as other tax collection improves on a
higher level of economic activity.
The government could also garner some resources by withdrawing some of the tax
stimulus provided post the financial crisis. A 1ppt increase in excise tax to 11% is one
such widely mooted measure. This alone could boost revenue collection by c.0.2% of
GDP. Given the impending implementation of GST, such a measure would have to
be coupled with a similar increase in services taxes, currently at 10%. However, as
the services tax collection as a percentage of GDP (0.9%) is half that of excise tax
collection, the corresponding impact of a 1% increase in services taxes would be an
additional contribution equivalent to c.0.1% of GDP to the tax coffers. Under GST there
will be only a small list of services which will not be taxed, but ahead of this the FM might
want to bring more services under the tax umbrella in FY13 and increase service tax
collection. An increase in customs duty is also under consideration. However, this could
have a significant impact on price pressure and might not be favoured by policy makers.
Non-tax revenues and divestment proceeds could be better: Overall revenue
collection is also likely to receive some support from higher non-tax revenue collection.
Specifically, spectrum auctions in FY13 are likely to provide the government with
relatively higher proceeds than FY12. According to our equity analysts, spectrum
auctions in FY13 are likely to generate INR 160-320bn (0.2-0.4% of GDP) of revenue.
Similarly, capital receipts could be higher, as revenue realisation from divestment
proceeds could be boosted by improved global economic conditions, especially in
H2-FY13. It is highly likely that the government will once again target divestment of
INR 300-400bn (0.3-0.4% of GDP) when it presents FY13 budget on 16 March.
A reduction in recurrent expenditure is necessary: While the government might
have limited room to manoeuvre on most of the rigid and recurrent expenditure
(interest payments, defence, subsidies and salaries), it could still take certain
measures – especially related to petroleum products – to cap the overall subsidy
burden. Our equity team estimates that every USD 10/bbl increase in crude oil prices
increases the petroleum products subsidy burden by 0.3% of GDP. Since the Indian
crude basket is expected to stay at elevated levels – we expect it to be USD 118/bbl,
8% higher than FY12 – oil company losses could be higher than the INR1.4-1.5trn
recorded in FY12. If the government does not pass on any of the burden to
consumers, the petroleum subsidy could once again be high, at 0.7% of GDP in
FY13. However, if the government decides to increase diesel prices by INR 2/litre,
kerosene by INR 1/litre and cooking gas prices by INR 50/cylinder, the fuel subsidy
burden could be lower by 0.14% of GDP. Similarly, some respite is likely as the
government plans to increase the price of urea and link it to the price of gas in an
attempt to reduce its burgeoning fertiliser subsidy bill. For a start, it is considering
increasing urea prices by a flat 10%. If the new fertiliser subsidy scheme is
implemented the government could save c.0.11% of GDP.
Such savings on subsidies (up to 0.25% of GDP) are necessary to free up resources
for additional subsidies which are likely to be introduced in FY13. For instance, while
full implementation of the Food Security Act is unlikely in FY13, recent talks suggest
that the government will allocate a token amount of INR 50bn (c.0.06% of GDP) to
start this plan. More importantly, resources will be needed to provide funds for the
national electricity fund (NEF) which, in turn, will subsidise the interest rate on loans
taken by State Electricity Boards (SEBs) for cutting distribution losses. The SEBs
have accumulated bank debt of INR 1.8trn because of huge losses incurred from
selling electricity below cost and various other inefficiencies associated with
electricity distribution. Given the size of this debt, SEBs are finding it difficult to raise
working capital at reasonable rates. Thus we expect the government to provide them
with financial support via an interest-rate subsidy of INR 250bn in the next two years.
This subsidy will be performance-linked and aimed at an efficient distribution system.
If implemented, it could increase the subsidy burden by c.0.13% of GDP.
Gross budgetary support might grow at a slower pace: Although the planning
commission is seeking an 18% increase in gross budgetary support (GBS) – financial
assistance provided by central government to planned schemes, such as the
employment guarantee scheme and Bharat Nirman project – fiscal constraint might
restrict this to just 11% as reported by newspapers. In FY12, the GBS increase was
targeted at 16% y/y. However, as this is the first year of 12th FYP, the government
might be under pressure to allocate a sufficient amount to infrastructure development.
Our baseline projection for the budget: Details of the budget can be finalised up to
a few days before the budget. State election results due on 6 March may influence
the tone of the budget statement. However, at this stage we expect the FM to
announce a FY13 budget deficit target of 5.3% of GDP, marginally lower than our
initial estimate of 5.5% of GDP. Our expectation is based on the assumption that the
government is able to raise the gross tax collection-to-GDP ratio to 10.8% of GDP
versus 10.4% in FY12 via a combination of indirect tax increases and improved
economic activity. Also, higher proceeds from spectrum auctions and divestment
plans should support overall revenue collection. On other hand, we assume
expenditure will remain at 14.8% of GDP (14.75% in FY12). This is because any
reduction in the subsidy burden is likely to be absorbed by fresh subsides and
infrastructure expenditure requirements.
Risk scenarios: We also look at two alternative scenarios in which the FM could
forecast a fiscal deficit target either higher or lower than our core case. For instance,
if excise and services taxes are increased by 2% instead of 1% each this would
reduce the fiscal deficit by additional 0.3% of GDP from our core case of 5.3% of
GDP. Also, if the government increases administered product prices by more than
we have assumed above or provisions for a lower subsidy burden at the beginning
of the year, projecting an expenditure-to-GDP ratio of 14.5% instead of 14.8% as
in our core case would not be difficult. Hence, a fiscal deficit of 4.8% of GDP could
easily be managed.
Similarly, if the government opts for a more populist budget, a fiscal deficit projection
of 5.5% of GDP would be inevitable. For instance, if it allocates a higher amount to
the Food Security Act or fails to implement the new urea policy in the budget, we
could easily see additional strain on the fiscal deficit equivalent to 0.2% of GDP.
Government borrowing to be the same as last year but
markets expect a lower amount
In FY13, our estimates of fiscal financing indicate that government borrowing will be
at the same level as last year. We believe the government is unlikely to end FY12
with a cash surplus significantly higher than INR 300bn, which is required to redeem
c.INR 260bn worth of GoISecs maturing on 6 April 2012. In the absence of a cash
surplus cushion, the government is likely to follow its historical pattern of financing
c.85-90% of the fiscal deficit via market borrowing (see Table 2). This – in our most
probable scenario – implies net market borrowing of c. INR 4.3-4.5trn (INR 5.2-5.4trn
gross) via GoISecs and c.INR 200bn via T-bills (note that the amount of outstanding
T-bills increased by c.INR 1.16trn during FY12). Our FY13 market borrowing
estimate is close to the actual level the government borrowed from the market in
FY12 (INR 4.36trn). Even with a market borrowing estimate similar to last year’s
we believe RBI support will be important to balance the demand-supply equation in
FY13, albeit less than in FY12. With c.95% of FY13 redemptions due in H1-FY13,
the market borrowing calendar is likely to be front-loaded in H1-FY13. As such, we
expect reinvestment demand to limit the impact of a front-loaded issuance calendar
on GoISec yields.
The rates market expects FY13 net market borrowing in the range of c.INR 3.8-4.2trn
(INR 4.7-5.1trn gross), close to our optimistic scenario. We believe an announcement
closer to the lower end of this range would boost sentiment in the immediate term
and soften yields; we would expect the benchmark 10Y GoISec to soften by c.10bps.
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