Monday, July 13, 2009

Economic Impact Analysis: Union Budget 2009-2010

We expect a sick but recovering patient (Indian economy) to begin by climbing hills, and not mountains.

Are we past mid-night?

Borrow to pay interest….

On July 6th, Mr. Pranab Mukherjee unveiled the budget with biggest expenditure of 10 lakh crore in Indian history, against earnings of 6 lakh crore with fiscal deficit at 4 lakh crore (6.8% of GDP). Of this 4 lakh crore, 2 lakh crore would be used to pay the interest!!! Add off-balance sheet items (i.e. specific bonds on fertilizer and oil) + state level fiscal deficit (now allowed up to 4% of GSDP) … we are talking about funding gap of 7 lakh crore (overall deficit at 11-12% of GDP).

…but where is the money

As on June 19, bank credit stood at 30 lakh crore and investments by banks in G-sec at 14 lakh crore. Incremental deposit growth to banking sector is about 7 lakh crore (22% growth rate annually), and the money supply growth is at 8 lakh crore (20% growth rate).

In such scenario, almost every additional rupee added to the system would get sucked by the government borrowing. What would be then left for the corporate sector borrowing? NIL! That is why we are concerned over the rising fiscal deficit!!!

How RBI can find the money

At the risk of being innovative, one option is to utilize the gains on foreign assets (managed by RBI). For example, RBI holds US treasury in its foreign reserves, with yield falling off the cliff from sub 4% levels to near zero (0.25%). The value of those US treasury holding would have jumped by 13 times. However it doesn’t get reflected in our reserves since the MTM valuation is done only for the losses and not the gains. RBI could monetize such gains and pass it on to the government in form of dividend. Though there is no such precedence to back this argument and it’s more of theory!

Other option: RBI could indirectly purchase G-sec (since under FRBM Act RBI isn’t allowed to directly purchase G-sec, resulting in monetization of the debt) and leave the liquidity in the system for corporate borrowings. Negative side of such move would be the high rates of price increase. As system is already flush with liquidity (recently about 1.5 lakh crore is getting parked with RBI under LAF window), adding more money in the system would push up the prices of both consumables and assets. The government is placing higher importance on the growth than on the price levels, we expect government to live with high inflation levels and stay focused on growth. We believe future policy decision & rate changes would be increasingly determined by growth and not by inflation (as was the case before).

Under reporting of income…..

In our view, the government has under budgeted its revenue on both tax and non-tax revenue front.[1] Government has budgeted 35,000 crore for 3G spectrum and mere 1120 crore from disinvestments proceeds. We expect the non-tax revenue to be at much higher levels than budgeted on account of higher disinvestment proceeds and NELP-VIII auction. If the economy recovers as expected then we would also have higher tax-revenue resulting in lower deficit numbers than the budgeted one. Government has also not accounted for increase in tax revenue due to higher MAT.

…with huge subsidy bill

In FY09, subsidy burden was over 2 lakh crore amounting to 40% of net revenue receipt of the Government and 4.1% of GDP. Though the government is expecting the subsidy bill to come down in FY 10 by 14%, it is expected to remain over 1 lakh crore in current fiscal.

Subsidy Bill

RE 2008-09

BE 2009-10

Major Subsidies






Indigenous (urea) fertilizers



Imported (urea) fertilizers



Sale of decontrolled fertiliser with

concession to farmers



Total Fertiliser Subsidy



Petroleum Subsidy



Interest subsidies



Other subsidies



Total Subsidies



Does not include off-budget subsidies (Fertilizer bond: Rs. 20,000 Cr; Oil Bond: Rs. 75,942) in FY09

We do not expect India’s sovereign ratings to get downgraded

India enjoys sovereign rating of BBB- from Fitch and S&P and Baa3 by Moody’s. S&P had revised the rating outlook to Negative in Feb’09; Fitch retained the neutral outlook while affirming the rating in Nov’08; and Moody’s in Aug’08 affirmed the rating with stable outlook on local currency and with negative outlook on foreign currency rating.

Though all the rating agencies have raised their concerns on higher fiscal deficit, they maintain that it is within the expected level and unless corrective measures are not taken in medium term the ratings may be downgraded. In our view, the sovereign rating of India would not be downgraded until the Budget of FY11. Why? Because, rating agencies put higher emphasis on the stability of the rating and even more so for border line cases, as India’s rating is lowest in Investment grade, i.e. a downgrade would make India’s rating sub-investment grade (which has wide reaching ramifications). Rating agencies may re-look at the outlook of the rating after the recommendations of the 13th Finance Commission are submitted by October. However, if the government fails to provide a reasonable plan of action towards fiscal consolidation in the next budget then we are certainly at the risk of getting downgraded. Please note that the next budget is only 6-7 months away and not one year!!

Interest rate

We do not expected significant hardening in the rates in near term, as RBI is expected to maintain surplus liquidity in the system. We expect G-Sec yields to be ~7%, and rates to harden quickly post Oct/Nov. All said and done volatility in the interest rates are here to stay, which makes it much more difficult task for corporates to manage their borrowing requirements.

Crude Oil

In view of world economy contracting this year by 1.9% (first time since 1930), we retain our earlier forecast of the crude oil prices to remain in range of $60-$70/barrel.

Currency and BoP

We expect current A/C to be in surplus on account of relatively stable invisibles and fall in trade deficit (on account of both the contraction in export/import and fall in crude prices, coupled with new hydrocarbon discoveries in India). The overall currency movement would largely be dependent on capital flows in the economy.

Huge fiscal deficit, contraction in export/import and flow of foreign money in the domestic economy provides support to our earlier estimate of rupee appreciation in medium term (9-12 months). However in the short term we may witness rupee depreciation. Though we expect the rate and magnitude of change to be muter than the ones witnessed in past.

Enough to eat if monsoon fails…

Wheat procurement in the current wheat season crossed 250 lakh tonne mark. This represents an increase of 23 lakh tonne over the procurement made in the season 2008-09 (226.89 lakh tonne). However, uncertainty over the monsoon (likelihood of drought), fall in sowing area and lower productivity could pose challenges. The budget has estimated the GDP deflator at 3.5% for FY10. In our view, with economy growth being the foremost target of the government, high WPI/CPI may be allowed to stay. Possibility of revision in the index itself and shift to longer reporting window (monthly from weekly) are on anvil.

Future Policy Direction

In light of the above, we expect quite a significant amount of policy announcements towards fiscal consolidation in form of divestments, and policy reforms to increase private investments.

Next Monetary policy review is due on July 28, 2009. We expect RBI to announce measures for smooth execution of government’s borrowing program and continue with expansionary monetary policy till Aug/Sep, government is also likely to front load its borrowing requirement. In view of the above we expect further reduction in CRR/SLR by 50bps, and no change in Repo/Reverse Repo rates.

The situation could get worrisome if the government’s borrowing program isn’t done with in time; and the economic growth remains subdued. As the inflation would start rising sharply post Sep’09 and could be in double digits by end of the CY 2009.

We expect:

· Currency to depreciate in near term (next 3 months), and appreciate in medium term (9-12 months)

· GDP growth to be subdued in 1H (Apr-Sep) and pick up in 2H, recording FY10 growth at 6%.

· Expansionary monetary policy to continue until large part of government borrowing is complete.

· Interest rate is likely to remain in lower territory for the near term, and to harden in CY2010.

· Low likelihood of sovereign downgrade in CY2009.

· Private investments to be subdued likely to be off-set by the public investments.

· Consumption growth to be the driving factor of the economic recovery.

· Government to try and push disinvestments wholeheartedly.


· RBI to manage smooth execution of government borrowing.

· Global growth to pick-up post Sep, revival in trade and hence stability on Indian growth front.

· Monsoon to not play a spoil sport, delaying the recovery.

· Efficient execution of the proposed large government expenditure.

[1] The Gross Tax Revenue as a percentage of GDP increased from 9.2% in 2003-04 to 13% in 2008-09. Estimated tax revenue is at 10.9% of GDP in 2009-10. Non-tax revenue increase is budgeted at Rs. 28,000 Cr.