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Government talks fiscal consolidation - Outside View

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Government talks fiscal consolidation
Mar 1, 2011

Key Highlights

  • Fiscal Deficit to GDP pegged at 4.6% of GDP - which means lower market borrowing and hence lesser pressure on long term interest rates
  • Foreign Investment in corporate bonds under infrastructure sector increased from the current USD 5 bn to USD 25 bn.
  • Foreign nationals can now invest in domestic equity mutual fund schemes directly on meeting KYC norms
Fiscal Deficit to GDP pegged at 4.6% of GDP - which means lower market borrowing and hence lesser pressure on long term interest rates

We have been highlighting the need for the government to come back to the path of fiscal consolidation. With the economy having recovered to its pre-crisis level, it was increasingly imperative for the government to 'EXIT' its stimulus measures and get back on the path of controlling its fiscal deficit. High fiscal deficit in the absence of strong supply side measures has led to a rise in inflation and inflationary expectations. The RBI has reacted to the rising inflation by raising interest rates and tightening liquidity. A continued high fiscal deficit would have fuelled inflationary expectations and an increase in interest rates which would have had serious repercussions on the sustainability of the economic growth.

The government has chosen to tread the path of fiscal consolidation and have announced a lower than expected Fiscal Deficit number of 4.6% of GDP as against the mandated number of 4.8% of GDP and lower than market expectations of between 4.8% - 5.2% of GDP. As a standalone number, this looks very impressive and should help rein in inflationary expectations and any possible spike in long term bond yields. If the government can achieve this number by the end of next year, it would be a major achievement and will have a positive impact on the Indian economy going forward. The reason we say so is because this number is based on assumptions of high tax revenue growth and low expenditure growth - which if they are able to bring about, would be a great achievement. But there would be a big question mark on whether they can achieve it and we list out the reasons
  • Higher Revenue Growth: They have assumed a tax growth of 24% Y-O-Y - this has been based on their assumptions of a 9% Real GDP growth. This has a very aggressive assumption at a time when inflation and interest rates are high and liquidity is tight. We do not believe GDP growth would be at 9% and we would be more comfortable if tax revenue growth is moderated to around 18-20%. That seems more realistic

  • Major cuts in expenditure: Total Expenditure is budgeted to grow at 3%; with only 4% growth assumed in revenue expenditure. This we believe will be quite a task to manage and the government is likely to overshoot this number

  • Subsidies assumed lower: Oil subsidies have been budgeted at only INR 23,000 cr. This is very optimistic assumption especially when Oil prices are hovering at USD 100. This can be done only on a significant increase in retail fuel prices or on a substantial drop in crude oil prices.
Overall, given the above, we would continue to assume that fiscal deficit would be at 4.9% of GDP, which would mean higher market borrowing and thus if oil prices remain high and food inflation remains sticky, we would expect long term interest rates to remain at current levels or go up marginally from the current levels. Also, as things pan out over the year, as government slips on its targets, the prospect of higher market borrowing would anyways lead to higher interest rates. We say this with a caveat that, if during the course of the year, oil prices do fall and domestic inflation eases, the pressure on rise in long term interest rates would ease.

In some other announcements which would have a big impact over the long term are the relaxation on foreign investment rules

Foreign Investment in corporate bonds under infrastructure sector increased from the current USD 5 bn to USD 25 bn

  • This is a good move to attract long term funds into the infrastructure sector. Also, on certain notified debt funds, the withholding tax (read as TDS) would be reduced to 5% from the current 20%. But this investment to fructify would take a long time. But from an investors and issuers perspective, it is comforting feeling that the government has already allowed such a large investment limit. This if utilized properly will go along way in developing a robust long term bond market in the country
Foreign nationals can now invest in domestic equity mutual fund schemes directly on meeting KYC norms

  • This was amongst the recommendation made by the Foreign Investment committee. This would allow foreign nationals to participate in the Indian equity market through mutual funds. Currently, only investment vehicles which are registered with SEBI as FIIs and/or sub-accounts can invest into Indian capital markets and mutual funds. This move would allow a foreign national, subject to meeting KYC norms, to directly subscribe to the local domestic equity mutual fund scheme.
All in all, this was a budget which focused on keeping the fiscal deficit and moving towards fiscal consolidation. So the government has 'Talked' the path, it remains to be seen whether they can 'Walk' the path.

Disclaimer:
Arvind Chari is Fund Manager -Fixed Income at Quantum Mutual Fund. Views expressed in this article are entirely those of the author and should not be regarded as views of Quantum Mutual Fund, or Quantum Asset Management Company Private Limited. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader.

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