Budget 2015: Be careful what you wish for

February 24, 2015

(Any opinions expressed here are those of the author and not necessarily those of Thomson Reuters)

When Finance Minister Arun Jaitley presents his first full-year budget on Feb. 28, he will have to appease a vast number of stakeholders, including voters, corporate India, the RBI and also the financial markets. In what follows, we will primarily take the angle of the latter, while also considering the restrictions that all the former ones might pose.

Budget announcements have evolved over the years to become more than just a numeric outlook for the new fiscal year. Often, policy statements are made that are technically not related but provide an insight into the direction the administration aims to take.

For full coverage of the budget, click Budget2015

The main dilemma for the BJP and its allies is that it would like to start a new investment cycle but at the same time it is constrained by the highest debt-to-GDP level amongst major Asian countries, save Japan. If it goes all out on investment, that might please some in the financial markets, but arguably not for long. The reason is that a debt-financed buying spree might force the RBI on a completely different path from its recent loosening signals.

Investors should bear in mind that historically, bouts of inflation were triggered by rising government debt (which the RBI often bankrolled). Further, falling inflation in India leads to rising profit margins, which can later serve to finance private investment – the ideal source of long-term growth. Falling inflation is typically also the single most important macro-economic driver for India’s stock markets, even ranking ahead of strong GDP growth, which is an important take-away for investors when gauging the budget.

We believe that the government will resolve this predicament by mildly overshooting the previously set and re-iterated deficit targets of 4.1 percent for FY2015 and 3.6 percent for FY2016. Naturally, the former will not matter much to investors anymore. As for the FY2016 number, we believe a reading closer to 4 percent is still palatable, to the government as well as the RBI, if the spending mix moves away from subsidies and towards capital investments.

In fact, capital spending is currently so subdued that the government has room to raise it by a third. Infrastructure is one of the natural target areas, and the railway budget that gets published shortly before the national one may give clues in this direction.

In addition, we highlight that the administration has achieved more than many observers recognize. By June last year, the quarterly investment (state and private investment combined) of new industrial projects had dropped below 1,000 billion rupees ($16 billion) – a reading even more dismal than at the trough of the great financial crisis. However, in just six months, this number quadrupled, arguably on the back of revitalized approval processes.

In the area of subsidies, significant progress has been made with petrol and diesel, but a clear statement that such subsidies will not return when oil prices eventually recover, as we expect, will go a long way. The largest subsidy, which is for food (equivalent to almost 1 percent of GDP), is a political hot potato with voters, and existing laws also bind the government. Thus, it is rather unlikely to be reduced.

Fertilizer subsidies could see first cuts, and limitations on cooking fuels such as LPG and kerosene would be welcome. These can be substituted by raised efficiency via the direct benefit transfer (DBT) scheme, in which two-thirds of eligible households are already enrolled and thus leakage is limited.

Other key announcements investors should watch include taxation. Top of the list remains the nationwide goods and services tax (GST) that has been talked about for a good decade. It is a complex measure but can enhance India’s growth potential by about 1 percent by our estimates. An  introduction by April 2016, even if it comes with exclusions, would be promising, especially if we see the proposal waved through by parliament in the first half of this year and the state legislators follow suit soon after. Another area to watch is whether more funding will be provided to recapitalise state banks. Recent earnings reports suggest that in most cases asset quality is showing few signs of improvement. We do not expect a significant increase in funding, but we may be in for a positive surprise. It is difficult to see a sustainable investment cycle unfolding as long as lending capabilities of the majority in the banking system remain restricted.

All told, some market observers will likely be disappointed by a lack of massive stimulus and growth push, but a well-balanced approach that also considers inflation and the RBI would serve the market better. So be careful what you wish for.

No comments so far

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/