Budget 2016: Quality vs Quantity – don’t ignore the states

February 16, 2016

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

By Gautam Chhaochharia, Head of India Research, UBS and Edward Teather, Senior Economist ASEAN and India, UBS

Indian markets do tend to focus a lot on the annual budget as a key catalyst but history suggests generally limited impact on markets in the near term. However, we are looking at Budget 2016 as a material event for markets given it may signal a change in policy stance.

India’s broad policy stance has been of fiscal consolidation (both quantity and quality) with a view to reduce inflation and interest rates and thus a stable currency.

The government now faces the impossible trinity of:
i) fiscal consolidation;
ii) higher capital expenditure; and
iii) implementation of the 7th Central Pay Commission (CPC).

Will it come under pressure to revive near-term growth by tweaking policy stance through a loose fiscal policy (less tightening than roadmap or even expansion)? The 7th CPC is implicit to this, and Finance Minister Arun Jaitley’s recent comments may imply full implementation. His comments on the need for an increase in rural spending also reflect a focus on reflating demand. This will have implications for macro, which markets may be complacent about, in our view.

The central government can somehow manage to stick to the fiscal consolidation roadmap, at least on a headline basis, given an oil bounty and more aggressive asset sales. The states though are in no position to implement the CPC as the payout for them is much bigger (1.2 percent of GDP vs 0.4 percent for the centre). If this results in fiscal expansion (states allowed to expand beyond statutory limits), it may hurt macro stability (external balances, currency, inflation, interest rates).

An Indian one rupee coin is seen in this picture illustration taken in MumbaiFiscal consolidation despite CPC (states’ limits enforced too) may underwhelm market expectations of a boost to growth and consumption — as this would merely be a transfer from one section of the economy to another, with no boost in aggregate.

Historically, a boost from CPC was seen only in 2009 but not in 1990 and 1998 — the market’s expectations of a boost is anchored around the more recent experience, which also had lumpy arrears and quite a broad fiscal expansion driving the boost.

The quality of consolidation, not just the quantity, matters. CPC adoption does imply worsening of fiscal quality (lower proportion of spending on capex/health/education) whatever the deficit number is — this would hurt long-term growth potential. This also means less scope for monetary policy support – RBI Governor Raghuram Rajan has said that he is looking at the budget as an entire package, not just at the headline fiscal deficit, and has referred to the consolidated (centre + states) fiscal deficit number in the context of India’s macro parameters.

The macro backdrop is very different now compared to 2008, the last time India adopted CPC and expanded fiscally:

1) Central/combined fiscal deficit was 2.6 percent/4.1 percent vs 4 percent/6.3 percent now

2) The current account deficit widening was financed easily then given improving global liquidity/risk appetite

3) International investors in Indian government bonds were negligible vs $30 billion now – they arguably care more for macro stability vs near-term growth

4) GDP growth was slowing sharply vs a broadly recovering economy now

5) RBI Governor Rajan continues to advocate sustainable/quality fiscal consolidation. RBI cut rates in FY09/10 despite CPI rising and fiscal/current account deficit widening.

A broker reacts while trading at his computer terminal at a stock brokerage firm in MumbaiWe expect Budget 2016 to target a 3.5 percent of GDP deficit in FY17 – in line with the quantity of deficit consolidation called for by the medium-term fiscal framework, and also for states to stick to their statutory fiscal limits. However, we expect the quality of deficit reduction to deteriorate.

We expect real GDP growth of 7.4 percent in FY17, after an official estimate of 7.6 percent in FY16 and 25bps of RBI policy rate cuts in 2016. Any fiscal slippage (including states) would imply wider current account deficit, weaker rupee, higher inflation, and possibility of RBI raising policy rates. Growth might be quicker in the near term but ultimately weakening back to baseline or lower.

Recent correction has improved risk-reward for Indian markets clearly, with the Nifty trading at 1-y forward PE of c14x, near the five-year average and near our 2016-end downside scenario of 7,000. Poor-quality fiscal consolidation may affect long-term growth potential while value ascribed to long-term growth in India is still above the historical mean.

Select CPC beneficiary stocks have corrected over the last three months along with markets, but top-line and earnings estimates still appear optimistic from our top-down perspective.

FULL COVERAGE: Budget 2016

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