Govt need to preserve macro-stability ahead of election year

Jaitley tables Union Budget on 1 Feb 2019.

Summary:

• The FY19 Budget mixes prudence with some populism, seeking to balance economic and political imperatives.
• The Budget measures carried a strong focus on the rural/agricultural and social sector (primarily health and education), along with an increase in infrastructure spending. Fresh sources of revenue generation were unveiled to balance the jump in spending plans.
• As expected, the outgoing year marked a fiscal slippage, with the government revising up the FY18 central government fiscal deficit target to 3.5% of GDP (vs targeted 3.2%). The FY19 target has been set at 3.3% (the medium-term fiscal roadmap had envisaged a deficit of 3% GDP). With local governments running more than 3% of GDP deficit, this means the consolidated general government deficit will likely remain over 6% of GDP for the time being.
• The primary deficit (excluding one-off revenues) is budgeted to narrow by 0.3% of GDP in FY19, suggesting a mildly contractionary budget, which may be hard to attain given the political calendar. This is especially the case since the government aims to increase tax collection by an ambitious 0.5% of GDP and cut total spending by 0.2% of GDP.

The Indian Finance Minister tabled the FY19 (year ending March 2019) Budget on 1 Feb 2018.

Ahead of a busy election calendar and need to preserve macro-stability, the budget mixed prudence with some populism, seeking to balance economic and political imperatives. Adopting a more modest consolidation path, the deficit targets for FY18 and FY19 were raised, but kept below FY17’s 3.5% threshold. While there was an emphasis on social sector and rural sector schemes, these were balanced with plans to raise revenues. The overall contractionary stance will see fiscal policy play a smaller role in supporting growth, though well-implemented reforms towards the farm and rural sector might prove to be a tailwind to the consumption turnaround.

The underlying fiscal math:

Along our expectations, the outgoing year marked a fiscal slippage, with the government revising up the FY18 fiscal deficit target to 3.5% of GDP (vs targeted 3.2%) – see here and here. The FY19 target has been set at 3.3% (the medium-term fiscal roadmap had envisaged a deficit of 3% GDP), assuming a nominal GDP growth of 11.8%.

The government remains optimistic on revenue collections in FY19, after a shortfall this year due to slower GST-related and non-tax receipts. As a percentage of GDP, gross tax revenues are forecasted to improve by 0.5% in FY19, while non-tax revenues and non-debt receipts (divestments) moderate. After consistently falling short of targets in recent years, divestment receipts were surprisingly strong this year. Notwithstanding this positive surprise, the government pegged the FY19 target at a conservative INR800bn, hinging on a busy pipeline of stake sales and bullish momentum in the capital markets.

Expenditure on the other hand is projected to moderate into FY19. Ahead of upcoming elections, however, plans to slow revenue spending (10% YoY in FY19 vs FY18’s 15%) and raising capital expenditure from a decline this year might be a challenge. The moderation in revenue expenses is likely due to lower compensation pay outs, as interest payments (under threat of the recent rise in borrowing costs) and subsidies (on higher food and fertiliser allocations) are projected to increase.

The primary deficit (excluding one-off revenues) is budgeted to narrow by 0.3-0.4% of GDP in FY19, suggesting a mildly contractionary budget, which may be hard to attain given the political calendar. This is especially the case since the government aims to increase tax collection by an ambitious 0.5% of GDP and cut total spending by 0.2% of GDP.

Highlights of key reforms:

Rural focus: The government has taken a holistic approach towards the rural sector, including the agricultural and allied services. This included plans to peg the Minimum Support Price (MSPs) for the kharif crop at 1.5x farms’ cost of production. An INR 20bn worth agriculture market infrastructure fund will be formed to connect rural markets to the e-NAM (Electronic National Agriculture Market). Plans are afoot to double farmers’ incomes by 2022.

Social sector push: Emphasis was on health, education and social protection. A national health protection scheme was unveiled which will involve INR500k coverage for 100mn families per year. Given the high costs involved, implementation will be watched closely. Schemes to step-up school infrastructure spending and funding support for students were also outlined.

Taxes: The Budget lowered the corporate taxes to 25% for companies with a turnover of up to INR2.5bn, which is expected to benefit a majority of corporates. This might result in INR70bn of potential revenue losses. Personal income tax slabs were left unchanged, whilst tweaking exemptions modestly. Education and health cess was raised by 1%, alongside an increase in import duties on selected electronic products.

Financial markets: The Securities regulator is expected to nudge companies towards the domestic debt markets, possibly mandating 25% of capital-raising through bond issuances. A decision to impose the Long-Term Capital Gains tax on listed equity shares came as a negative surprise; gains exceeding INR100k to be taxed at 10% and grandfathered till 31 January 2018.

Infrastructure: Budget allocations have been increased for FY19 to INR5.8trn, with additional funding to utilise investment trusts and special funding vehicles.

Medium-term outlook: The government announced plans to accept the Fiscal Responsibility and Budget Management (FRBM) committee’s recommendations for the central government to lower its debt to GDP ratio to 40% and adopt the fiscal deficit target as the operational target.

Policy implications

Gross market borrowings are pegged at INR6.1trn, lower than the market’s expectations of INR6.5trn. Despite this relief, bond markets weakened as 10Y yields rose towards our target of 7.5% on Thursday. Besides the modest miss in the fiscal targets, the bearish mood is likely a reflection of the sharp rise in developed market yields (key resistance levels are being tested). Expectations are rising that the Indian authorities might step in to calm the sharp rise in bond yields, with the recent widening of 10Y yields- repo rate spreads in part reflecting higher risk premia apart from tighter policy considerations.

On policy, the Reserve Bank of India is likely to factor in today’s modest fiscal slippage at its 7 February review. We expect the monetary policy committee to maintain a cautious stance, but the fiscal math is unlikely to tip the balance towards rate hikes as yet. With a revenue shortfall rather than an aggressive spending spurt behind the FY18 fiscal slippage, concerns over a spillover on demand conditions and generalised price pressures are premature at this juncture. We reckon that the evolving inflation path will be a more important determinant of policy action (see here). fii-news.com

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