FW: India’s Budget Preview: looking for a paradigm shift

[Kuppam, Sudheer K]

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Sudheer


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From: Sajjid Z Chinoy
Sent: Monday, February 23, 2015 1:27:35 AM
To: Kuppam, Sudheer K
Subject: India’s Budget Preview: looking for a paradigm shift


[J.P. Morgan Logo] Asia Pacific Emerging Markets Research
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India’s Budget Preview: looking for a paradigm shift



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Rarely has a Union Budget been met with as much expectation as the NDA government’s first full Budget to be presented on February 28th
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We expect the Budget to lay out the government’s vision for the economy over the next few years and, in so doing, undertake several paradigm shifts
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A greater thrust on public infrastructure and manufacturing is expected to be the leit motif of the Budget; we expect a significantly higher allocation for capital expenditure on the Budget along with a plethora of incentives to boost infrastructure and manufacturing by the private sector and public sector undertakings (PSUs)
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The second paradigm shift is likely to involve setting out a path to transform all product subsidies into electronic cash transfers over the next 2-3 years
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The third shift is expected to entail a significant decentralization of tax revenues and expenditure control to the states
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In addition, the Budget speech could also institutionalize the monetary policy framework and make advances on the setting up of a monetary policy committee along with other announcements such as the setting up of “Finance SEZs”
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Key to the revenue side will be whether the Budget breaks with recent tradition and realistically budgets tax and non-tax revenues
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Realistically budgeting revenues while boosting public investment and PSU bank recapitalization funds raises questions about whether the government will keep to the fiscal deficit target of 3.6% of GDP, per the fiscal road-map
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We believe the government will stick to the 3.6% target, though it remains a very close call; we will not be surprised if the target is slightly relaxed (to, say, 3.9% of GDP) to accommodate greater capex spending

The macroeconomic backdrop to the Budget
Macroeconomic stability in India has been strongly reinforced by oil developments over the last few months. Despite some firming of prices in recent weeks, the Indian oil basket is still almost 50% below its September levels. This has contributed to the collapse of the current account deficit, opened up much-need fiscal space to help the government meet its budgeted fiscal deficit target of 4.1% in FY15 (which we believe will be met) and contributed to a faster-than-expected disinflation in India, even though food dynamics have played a critical role on that front. Lower food and oil prices, in turn, boost household purchasing power and we expect a modest consumption lift – particularly in the urban areas – in the coming months. That said, current demand conditions remain depressed, manifested in the fact that corporate earnings in 4Q14 were amongst the worst in recent years.
But key to a sustainable growth lift in India is private investment. And there is little to report on that front, notwithstanding the sharp revisions to historical and contemporary growth rates over the last fortnight. The new government appears to be chipping away at reducing implementation bottlenecks on the ground. The current coal auctions, for example, provide hope that domestic coal supply could increase materially, though it could take about 18-24 months for a material increase in supply to manifest itself. But land acquisition still appears to be a binding constraint (our analysis a few months ago had found it was a key constraint in 55% of the 100 largest stalled projects on the ground) and all eyes are on whether the ordinance which streamlines the acquisition process can be converted into parliamentary law in the upcoming session.
But even as implementation bottlenecks should gradually reduce over time, financial constraints remain as binding as ever. Balance sheets in the infrastructure appear grossly over-extended and the mirror image of this is high and rising non-performing assets and restructured loans amongst public sector banks. Unsurprisingly, credit growth to the infrastructure sectors appears depressed.
It is against this macroeconomic backdrop that the Budget needs to be viewed: stable macro-economic conditions but weak growth, and an increasingly dire need to boost infrastructure spending given the current logjam. Normally, the predominant focus surrounding every budget is what the targeted fiscal deficit will be. But given that this is the new government’s first full budget, the focus is much more thematic: what this Budget will reveal about the government’s priorities over the next few years. We therefore expect the Budget to be characterized by several paradigm shifts
Paradigm shift 1: a big push towards infrastructure and manufacturing
Foremost among these paradigm shifts is an expectation that there will be a significant push towards public investment and infrastructure both (i) directly on the Budget and (ii) through a slew of incentives to promote infrastructure and manufacturing off the government’s balance sheet, in keeping with the government’s “Make in India” thrust. Some of these initiatives are expected to include:

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A significant increase in capital expenditure allocation on the Budget. Over the last five years, non-defence capex spend on the Budget has averaged just 1% of GDP, half the average between 1992 and 2008. We expect this to be increased from 1% to about to 1.5% of GDP in the next fiscal year. An even higher capex budget is possible, but questions will arise about the state’s capacity to spend it effectively.
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Within this capex envelope, look for significant increases to the National Highway Authority of India (NHAI’s) budget for roads and highways, and funds for railways, low-income housing and renewable energy
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We also expect a potentially material increase in allocation for PSU bank recapitalization, given that financing has become a binding constraint on infrastructure development
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In addition, we expect the Budget to announce various off-Budget mechanisms to boost infrastructure and manufacturing spend. These are expected to include:
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A hybrid annuity model for roads, wherein the private sector would contribute a share of the cost but be insulated from some of the risks (e.g. traffic projection and toll collection risks)
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Finding ways for public sector enterprises with large cash surpluses to invest that into public infrastructure creation
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Tax incentives/exemptions for infrastructure bonds to divert savings into that sector
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Lowering the minimum alternative tax (MAT) for infrastructure projects, special economic zones, and small and medium enterprises (SMEs)
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Accelerated depreciation on capital goods for a finite period of time to incentivize private investment
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Potentially reducing import duties on gold to boost gems and jewellery exports
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Tax exemptions to incentivize investments in low cost housing
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Potentially allowing FDI in infrastructure development funds (IDFs) set up by NBFCs and widening permissible assets under IDFs
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Increasing viability gap funding to attract more investment into urban infrastructure

Paradigm shift 2: moving from product subsidies to cash transfers
Over time, however, any sustained thrust in public investment will have to be financed through savings from other parts of the Budget, given the medium term fiscal consolidation imperative. Key to this will be an expenditure re-balancing that uses technology-based solutions and cash transfers to better target the delivery of subsidies and thereby reduce leakages. Use of electronic cash transfers results in both fiscal savings (through de- duplication) and reduced distortions arising from dual pricing, without necessarily reducing subsidies for deserving beneficiaries.
LPG subsidies have already been transitioned to a “direct benefits transfer” (DBT) by combining the unique identification program (UID) with electronic cash transfers. We expect the current budget will therefore present a framework to gradually transition all subsidies to a direct-benefits transfer, with the focus on how food and fertilizer subsidies are handled, since fuel subsidies have reduced dramatically on account lower oil prices and the deregulation of diesel prices.
It is important to remember, however, that this is a process more than an event. Therefore, we look for the Budget to lay out a multi-year plan to transition subsidies from products to cash transfers. The more specific the timelines and modus operandi, the more credibility any such announcements will have.
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Paradigm shift 3: decentralizing resources and programs
The third paradigm shift is expected to occur in the resource allocation and transfers between the Center and the states. The new government has repeatedly displayed an inclination for greater decentralization of powers. We believe the Budget will put some meat on those bones. While the 14th Finance Commission recommendations are not public, it is expected that it will call for a much larger sharing of tax revenues with the states. Currently, states receive 28% of all gross taxes received by the Center. That number could easily go up to 40%.
However, simultaneously, we expect that funding for many centrally-sponsored schemes will also be incurred by the states or the programs themselves will be proportionately reduced with the states being able to decide how to use the additional resources -- such that the whole process is fiscally-neutral on the Center’s Budget. In other words, states will likely have more ownership and control of resources so that they can adapt and create programs to their local needs rather than adhere to boiler-plate programs of the Center.
Monetary policy framework, finance SEZ could be amidst other Budget announcements.
The July Budget surprised pleasantly by announcing the government’s support for a “formal, modern monetary policy framework” (read: inflation targeting). It revealed a welcome coordination between fiscal and monetary policy. We would therefore not be surprised if, in that vein, the Budget speech goes a step further and announces the government’s intention to work with the RBI on formalizing the inflation targeting framework and the setting up of a monetary policy committee.
Additionally, one could potentially expect announcements regarding the setting up of “Finance Special Economic Zones (SEZ)” in India, with an aim to generate/re-attract financial services activity in India but which would need a significant liberalization of capital controls, and reforms to the legal, regulatory and dispute resolution framework.
A key source of uncertainty and risk to the central government’s finances would be the recommendations of the 7th Pay Commission that are expected to go into effect in January 2016. Recall the 6th Pay Commission resulted in a higher wage bill of 0.4% of GDP.
Credibility will be key on the revenue side
A constant over the last few Budgets has been a significant over-estimation of tax revenues and disinvestment proceeds that expectedly do not materialize. On the tax front, this is typically the upshot of overestimating both nominal GDP and tax buoyancy on any given nominal GDP growth. The hope is that things will change this time around, and that both tax and non-tax revenues will be more realistically assessed. The faster-than-expected disinflation has deprived the government of the inflation tax and with inflation expected to be relatively contained, nominal GDP growth and therefore tax revenues would need to be accordingly assessed.
If the government plans to be bold and creative on the asset sale front – as we hope – that will bode will for the revenue side (though, technically, asset sales should be below the line). If, however, there is no such intention, but the revenue budgeted from disinvestment is pegged to be high, it would diminish the Budget’s credibility.
Given the tight fiscal situation, there is no space for large tax cuts. But we expect some “feel-good” steps such as increasing the exemption limit slabs for personal income taxes and increasing the tax-exemption limit (from, say, Rs 1.5 to 2 lac) under Section 80C to promote greater household financial savings.
To offset this, we expect an opportunistic increase in some taxes, including crude oil imports and tobacco.
Pegging FY16 fiscal deficit at 3.6% of GDP, but it’s a very close call
Even as markets are focusing primarily on the government’s economic vision implicit in the Budget, they will also be cognizant of how the government plans to balance the need to boost public investment with that of continuing the fiscal consolidation process. For FY16, the question is defined more acutely: can the government budget tax revenues more realistically, increase public investment and bank recapitalization funds, and still keep to the fiscal deficit target of 3.6% of GDP.
We believe it can by exploiting the windfall savings from oil prices (which we estimate results in extra fiscal space of 0.7% of GDP in FY16 -- year ending March 2016 -- over FY15) and by undertaking an asset swap on its balance sheet. We have written about the latter in some details (see, “India’s Budget: how to get around the impossible trinity,” MorganMarkets, January 28th, 2015) which entails a programmatic plan to sell assets (PSU stake, SUUTI holdings, spectrum , land) over the next three years and commit those resources to the creation of the next wave of public infrastructure. Whether it is done directly on the Budget, or both asset sales and asset creation are done though a separate fund are economically equivalent. For this year, however, increasing asset sales by 0.5% of GDP – the quantum by which the government has to reduce the deficit – would also mean that the fiscal consolidation will not be contractionary, and the underlying fiscal stance will be neutral. The table below lays out the sources of uses of fiscal space for this year, for example.
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Even if this approach is not followed, we continue to believe that the government will stick to the fiscal deficit target of 3.6% of GDP – under the medium term fiscal path – though it remains a very close call. Other ways to get to 3.6% of GDP could include (i) a lower boost to public investment directly on the Budget and a greater emphasis off the balance sheet through incentives; (ii) finding other savings to pay for higher public investment; or (iii) budgeting tax revenues more buoyantly. The third approach would dent the credibility of the fisc.
There is, therefore, a very real chance that the government could relax the fiscal deficit target for FY16 to , say, 3.9% of GDP. If this is accompanied by realistic revenue assumptions, increased quality of public expenditure, and a firm commitment to continuing fiscal consolidation in the coming years, markets may not be too fussed. Ideally, of course, if the government can undertake the paradigm shifts within the fiscal envelope of 3.6% of GDP, both equity and bond markets are likely to cheer.
Going forward, the government could well strip out both asset sales and capital expenditures and focus more on the revenue deficit (the difference between current expenditures and revenues) but this is expected to be consistent with the current fiscal path that pegs the FY17 fiscal deficit at 3% of GDP.


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