Budget: India on the growth path (page 1 of 3)

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.