India's Budget balances politics and prudence

India's new government presented a budget balancing the political demands of its coalition partners with fiscal prudence. Fiscal and revenue deficits were targeted lower at 4.4% of GDP and 2.5% of GDP respectively, in line with the reduction set out in the Fiscal Responsibility and Budget Management Act (FRBM). With current expenditure held steady in real terms, increased revenue is earmarked for capital expenditure, focusing on areas outlined in the Common Minimum Program (CMP)-agriculture, education, healthcare and infrastructure. Increased revenue is to come from robust growth and some tinkering with tax rates. GDP growth is forecast at 7-8% for 2004/05, consistent with our forecast of 7%.

More widespread tax reform is needed if India is to resolve its deficit problem, but the finance minister has laid the first steps. Tax on the service sector has been increased and extended, and further steps have been taken to align excise duties towards a central VAT rate to be implemented in 2005. A more extensive tax review is promised for the next budget. The inclusion of INR 40 billion for proceeds from divestment in the budget, and the creation of the Board for Reconstruction of Public Sector Enterprises (BRPSE) were positive signals that privatisation will continue in some form. The budget also raised the limits on foreign direct investment (FDI) in the telecom, civil aviation and insurance sectors, reinforcing commitment to foreign investment.

Markets reacted badly to the imposition of a sales transaction tax on securities. The benchmark Sensex index ended down 2.3% and the 10-year government bond yield rose by almost 13bps, ending the day at 5.85%. Trading volumes in the government bond market are at risk, given the narrow bid-offer spread. The government has already indicated its willingness to review this specific proposal, and once this issue has been resolved, the budget should be viewed positively. The government has not allowed its spending plans to derail the commitment to narrow the fiscal deficit, albeit slowly. The fiscal tightening should encourage the Reserve Bank of India (RBI) to leave interest rates on hold for longer, and policy rates are now less likely to rise before the end of the year.

More extensive reform is needed if India is to overcome its structural constraints, but this was unlikely to be possible in this first budget given the constraints of the coalition. Overall the budget was undramatic, but sent appropriate signals to stakeholders. The test as always will be in the implementation.