India has no room to deliver populist budget

It is still a good year into the next general elections, yet India’s two main political parties have already set the stage for a showdown. The opposition Bharatiya Janata Party is closing in on the Congress party, according to opinion polls. Even though it is still early days, this puts even more pressure on the ruling party.

Last autumn, the Congress had a change of heart with its policy priorities, having realized that dithering on industry reforms would be a safer way of losing votes than pushing ahead with unpopular measures. It ploughed through opposition to liberalise foreign direct investment, and it mainly succeeded, although progress on fiscal housekeeping, such as raising power tariffs and cutting diesel subsidies, has come at a much slower pace. Other potential measures did not happen at all. Nonetheless, the party has raised hopes and expectations that it can get India’s act together.

When the government announces the budget for the new fiscal year on February 28, it could be a platform to show that it has the long-term thinking to do the right thing and forsake the traditional, populist, pre-election budget the country can now ill-afford. Not only is India’s economic growth far below potential at this point; perhaps more important is that price inflation, which could trigger mass discontent anywhere in the world, has reached uncomfortable levels.

History has shown that inflation becomes an issue when a government increases borrowing and the central bank monetises a large part of this debt, effectively bankrolling spending by printing money. The Indian government now has a choice between handing out unearned goodies and jacking up price expectations, or exercising discipline and helping keep inflation in check, ultimately supporting growth and job creation.

Our expectation is that the budget will be driven by economic reality. The least we assume is that the spending cuts that have taken effect over the last three months will carry on. These measures have only contributed to savings for about a quarter of the current fiscal year ending 2013, and so they should make a full year’s contribution in 2014 — all the better for the country’s credit profile.

One encouraging fact is that the spending cuts have started across the board, and even the military has not been spared. The number of state-sponsored schemes is likely to get drastically reduced, with a particular focus on areas with inefficiencies and wasteful spending. Therefore, the deficit target of 4.8 per cent for 2014, after the 5.3 per cent set for 2013, looks within reach. Whether or not the 2013 target will actually be met will ultimately not matter for stock markets.

Another thing we look forward to from the budget is the government raising its tax intake — another necessary, if unpopular, move. It would not be too ambitious to expect personal tax rates and excise duties to be increased, but it would be folly not to expect tax loopholes to be closed. The biggest wildcard is the countrywide goods-and-services tax (GST), which, by supplanting lower-level taxes and levies, will reduce red tape, oil the revenue-creation process, and ultimately promote growth.

We know that the GST has failed to make strides for several years now. Thus, any hint of intention to pursue it — an implementation roadmap, for example — would instil investor confidence in the government’s resolve to fix its fiscal house.

All told, if the budget turns out to be rooted in reality — not one that makes vote-fishing promises that may not be kept or, worse, potentially create inflation and hurt India’s economic future — it is likely to be well received by investors. For the equity investor, such an outcome would favour the sectors with exposure to the domestic investment cycle. To be clear, more concrete steps would need to follow. But the government should not let pass this opportunity to send a clear signal that last year’s days of lethargy are gone for good.
(This article was sourced from the Reuters blog)