Budget: India on the growth path

Overall, the budget was in line with expectations and we would rate it as reasonably positive given the constraints on the fiscal side and the government's commitment to growth. Having been elected last year the government has a tough balancing act as it continues a reform agenda whilst also keeping different parts of the electorate happy. In particular was the need to help agriculture and boost the infrastructure whilst at the same time not hindering growth by adding to the tax burden. Thus the key message was a commitment to a path of stability with no additional tax burden on any of sectors at a macro level. This indicates that the social aspect of development will be met with clear, well-defined and practical projects such as a focus on employment-intensive sectors such as textiles and irrigation as opposed to less efficient subsidies and loan wavers. This meets the long-term objectives of the Common Minimum Programme.

There were three main areas in the budget and we consider them each in turn here: (a) the broader macroeconomic outlook for 2005/06; (b) the fiscal implications; (c) the broader policy recommendations. We conclude by looking at the likely market impact.

b(a) Macroeconomic Assessment

We believe the budget did a reasonable job of creating the platform for propelling the economy onto a sustained growth trajectory. The budget assumes a nominal GDP growth rate (at market prices) of roughly 12%. This takes into account real GDP growth of 7% and an inflation target of 4.5-5%. We believe this growth target for 2005/06 is realistic. Growth in 2005/06 is likely to be driven by sustained growth in corporate investment, coupled with an improvement in foreign direct investment inflows, a supportive policy environment, a reviving rural sector after a year of sub-par rains and export expansion helped by a removal of trade barriers (especially textile quotas). Inflation is likely to remain low due to the base effect of the previous year's inflation and hence will support a tame interest rate environment. We believe that in the upcoming monetary policy announcement, the Reserve Bank of India (RBI) is unlikely to hike the reverse repo rate and will at most hike rates by 25bps towards end of the year.

(b) Fiscal implications

The biggest disappointment for the markets is the higher than expected fiscal deficit. This deficit is to a large extent the result of a lack of an effective commitment to fiscal consolidation under the Fiscal Responsibility and Budget Management Act (FRBM). The deficit target for 2004/05 has been raised to -4.5% of GDP from -4.4% budgeted earlier. In addition for the New Year 2005/06, deficit targets are higher than expected at -4.3% of GDP and 11.9% higher year on year. At the same time, the government projects revenue deficit unchanged at -2.7% of GDP, which is a key cause for concern. The higher deficit is due to greater transfers to the state due to revenue losses for the latter on account of implementation of the Value Added Tax (VAT).

This translates into a higher net borrowing target of INR1.25trln (USD28bln) against a lower INR950bln expected by Standard Chartered - and consensus. The government is assuming a 40bp reduction in the cost of borrowing during the year. Given the inflation outlook this makes sense, although there is an element of wishful thinking as well. The authorities clearly hope inflation and rates stay low. Yet, despite this, the higher deficit has not gone down well with the rating agencies and they have called persistently high public debt (68.6% for central government) as a key deterrent for higher credit ratings for the country.

Indeed, the use of foreign exchange reserves, albeit in only a small way, to fund spending and a very stiff expenditure target will add to existing concerns about the underlying fiscal situation. The government is targeting a very modest rise in expenditure (1.2% y/y) to USD114bln on the back of lower lending to state governments and a modest rise in subsidy burden. Clearly, from a fiscal perspective, India needs the "growth dividend" to continue - in the sense that strong underlying growth will keep revenues high and prevent the fiscal situation turning out to be even worse.

(c) On the broader policy front, we have picked the following key themes out of the budget:

A clear focus on agriculture, rural development, and employment generation - The key emphasis is on generating 120mln new jobs in irrigation projects, enhanced tele-density and electrification in rural areas. In addition, due emphasis is also given to flow of credit to agriculture - banks are expected to raise agricultural credit by 30% to USD32bln in 2005/06. These measures were in line with expectations given the government's firm desire to develop the rural economy and its commitment to the CMP. Further, the budget recognised the need to create more jobs in sectors such as textiles, small and medium Industry, irrigation works and agricultural development.

Enhanced Infrastructure spending - The government aims to use just over USD2.2bln (INR100bln) in FX reserves for infrastructure development. The mechanism for this would involve setting up a Special Purpose Vehicle (SPV), which most likely would issue securities to the RBI in exchange for the reserves. This will increase public debt. The interest burden for this will be funded through the fiscal deficit. On the RBI's balance sheet, this will involve replacing FX reserves with government securities. Near term, this measure will be liquidity neutral, however, clear identification of potential projects and implementation will be key. In our view, the near-term impact on the INR and on inflation should be muted as this money represents a modest amount in relative terms and it will be spent over a period of time. Total capital outlay on investments is budgeted at USD65bln, up 9% y/y.

Tax realignments - Corporate tax rates have been reduced to 30% from 35% for domestic corporates and a 10% surcharge has been levied. Net-net, this translates into a 3% lower effective tax burden for corporates. Lowering of corporate tax rates will improve the cash flow of the corporates and hence increase funds available for future investments.

Peak customs duty has been reduced to 15% from 20% and duty on crude oil imports has been slashed to 5% from 10%. Further reductions in customs duties on cooking gas and kerosene imports are likely to be inflation-neutral near term given a modest rise in prices on petroleum products. At the same time, the measures to realign taxes will help enhance the competitiveness of Indian industry. A greater number of services are now being brought under the service tax net, but contrary to market expectations the service tax rate was left unchanged.

Enhance banking system efficiency - Proposed changes to the banking regulations are a clear positive especially the State Liquidity Ratio (SLR), Cash Reserve Requirement (CRR) and allowing banks to raise preference shares. This last can help banks raise capital and at the same time ensure minimum dilution for stakeholders especially banks in the public sector domain. We believe the measures such as flexibility in CRR and SLR rates together with greater autonomy given to RBI to do repo and reverse repo operations will go a long way in deepening the financial markets together with drawing the roadmap for further liberalization of the capital account.

Capital market changes - These measures have both positive and negative aspects. On the negative side is the modest increase in securities transactions tax. At the same time the emphasis on the development of corporate bond markets, OTC derivatives and the securitization market are clear positives. In addition the likelihood of increased FDI limits in specific sectors and the implementation of state level Value-Add Tax (VAT) are further positives.

Market implications - We believe the budget achieved a fine balance between higher spending needs and the objective of boosting growth. While a higher budget deficit target is clearly a negative for bond markets, low inflation and the likelihood that rates will be left unchanged near term should support sentiment. As a result we do not see yields rising significantly from current levels and expect benchmark 10-year yields to be no more than 50-75bps higher by March 2006 from current levels of 6.55%.

The budget should be neutral to modestly positive for the INR as it should help to sustain portfolio inflows, thus supporting a healthy balance of payments position. We continue to believe that broad USD weakness will persist near term. As a result, Asian currencies will remain firm against the USD and hence the bias remains for the INR is still for it to appreciate. We maintain our end-year forecast for USD-INR of 43.50.

Shuchita Mehta
India Economist, Standard Chartered