Net borrowings will work out higher than budgeted

The keenly watched Union Budget on February 28 announced headline numbers on fiscal consolidation in line with expectations, but the composition of the reduction – based on optimistic revenue increases rather than spending cuts – was a disappointment. That, along with no new major reform proposals, suggests that the Budget could have a short-term negative effect for Indian equities, bonds, and the rupee.

That said, the fiscal trajectory has materially changed for the better over the past few months due to a frontloading of consolidation, and the government’s debt ratio remains on a declining path. Our estimates of fiscal impulse suggest a lower negative impact on demand of 0.2 per cent in fiscal year 2013-14 compared to 0.7 per cent in 2012-13.

Hard target

While the Budget has fiscal deficit numbers in line with market expectations, the composition of the consolidation is less than ideal, in our view. The lower fiscal deficit is based on high revenue growth assumptions, rather than spending cuts, which exposes the Budget to risks in case the necessary buoyancy in revenues does not materialize.

The Budget envisages increase in revenue to tax of 0.5 per cent, which is optimistic in our view. Taxes were increased for one year for the high income bracket (a 10 per cent surcharge for incomes above Rs 1 crore), and on larger companies (surcharge raised from 5 per cent to 10 per cent, for companies with taxable income of Rs 10 crore). The assumptions for privatisation receipts and telecom receipts are also optimistic (Rs 54,000-40,800 crore, compared to our expectations of about Rs 35,000 crore).

Moreover, one-time increases in revenues are being used to fund increases in spending, which could affect medium-term fiscal sustainability.

The government has budgeted for a significant increase in expenditures of 16 per cent, with higher-than-expected increase in non-subsidy current spending. While subsidies have been reduced significantly, there could be some upside to them, especially to food subsidies if the Food Security Bill is passed. Fuel and fertilizer subsidy provisions are adequate, and realistic in our view, even given some rollover of spending from the previous year. Capital spending has been increased by a large 37 per cent to give a boost to the investment cycle.

In terms of spending priorities – there was a significant increase in rural and agricultural spending, infrastructure, and social spending — as can be expected in an election year. The government also set aside Rs 14,000 crore for recapitalizing public sector banks.

In terms of structural reforms, the budget made the expected pitch for a move towards the Goods and Services Tax and the direct tax code, though it did not provide a clear timeline.

There were proposals to boost investment (investment allowance of 15 per cent for companies investing more than Rs 100 crore in plant and machinery), to incentivise a move to financial savings (extending tax incentives to enable first-time retail investors to invest in mutual funds and listed shares for a period of three years; introducing inflation-indexed bonds), and infrastructure (allowing more infrastructure companies to raise funds by issuing tax-free bonds, extending tax holiday for power plants).

Given the proposals in the budget, the government deficit may be 5 per cent of GDP instead of 4.8 per cent of GDP. Therefore, the net borrowing requirement may be higher than budgeted.

Impact on growth

The Budget may be negative for bond yields due to the higher-than-expected net market borrowing requirement. The RBI may need to do a significant amount of open market operations (OMOs) to finance the deficit and inject liquidity into the system.
With our expectation that consolidation in fiscal 2014 may be less than budgeted, the negative impact on growth may be more muted.

Based on estimate of the deficit, fiscal consolidation could lead to a reduction of 0.2 per cent of GDP from aggregate demand. In fiscal 2013, we estimate the negative fiscal impulse to demand to be 0.7 per cent of GDP.

The increase in corporate tax surcharge for large companies will have a negative impact on the equity market. Our sector analysts think that the Budget will be positive for agriculture (due to interest rate subsidies and higher credit availability for the sector), infrastructure (due to allowing more tax-free bonds), financials (due to tax breaks on housing loans) and negative for consumer goods (increase in excise duties for cigarettes) and autos (increase in excise duties for SUVs).

The Budget may be negative for investor sentiment and for the rupee, at least in the short term. With risks to the net borrowing requirement from the Budget to the upside, and no major proposals to reduce current account deficit (CAD), there are depreciation pressures for the rupee in the near term. Our 3, 6, and 12-month USD-INR forecasts are 55, 53 and 52, with risks of further depreciation beyond 55 in the near-term.

While the Budget may have disappointed relative to optimistic market expectations, the fiscal path has changed materially over the past few months. The government’s debt-to-GDP ratio has been declining – from 75 per cent in fiscal 2007 to 67 per cent in fiscal 2013, largely due to high nominal GDP growth. Therefore, the high recent fiscal deficits have not impacted the general trajectory of the debt ratio, which may continue to decline going forward due to higher nominal GDP growth.

(The author is Managing Director and Chief India Economist, Goldman Sachs)