Budget 2011-12 Preview: Motilal Oswal

Motilal Oswal has come out with a report on Budget 2011-12 Preview.

Budget 2011-12 Preview:

"One-off performance" or "One of performance"?

Low expectations amidst macroeconomic headwinds:

Union Budget 2011-12 comes against the backdrop of high inflation, tight liquidity, high interest rate, industrial slowdown, delayed reforms and negative market sentiment. Thus, expectations from the budget are, in general, muted. The positive is that FY11 fiscal deficit target of 5.5% of GDP will be over-achieved. But without one-off revenue sources like 3G, meeting the FY12 fiscal deficit target of 4.8% is a challenge [our estimate 5%; gross (net) market borrowing of Rs 4.7t (Rs 4t)]. Clarity on reforms such as DTC, GST and oil/fertilizer subsidy is the key watchout.

Backdrop: Union Budget 2011-12 comes amidst macroeconomic headwinds:

Union Budget 2011-12 comes at a time when the Indian markets and economy are facing critical headwinds on multiple issues, both domestic and global:

1. Inflation at decadal high; no signs of meaningful moderation yet
2. Tight liquidity and rising interest rate environment
3. Few early signs of industrial slowdown
4. Stalling of reforms process
5. Persistently high global oil and other commodity prices
6. ~14% correction in equity markets; India has been the top underperforming market in 2011 amongst top-10 global markets.

Repeating FY11 fiscal performance will be a challenge in FY12:

We expect FY11 fiscal deficit to be significantly lower than the 5.5% budget estimate (BE). Absolute fiscal deficit will be somewhat lower than BE as gains of (1) 3G/BWA bonanza, (2) tax buoyancy, (3) stimulus withdrawal and (4) lower Plan expenditure were substantially eaten up by bloating oil and fertilizer subsidies. However, second highest nominal GDP growth of 20.3% helped in a sharp drop in fiscal deficit/GDP ratio.

Repeating FY11 performance in FY12 will pose a serious challenge in view of (1) ballooning subsidy bill on the back of rising international oil prices, and (2) no 3G-like bounty. We expect FY12 fiscal deficit/GDP ratio at 5%, translating into gross (net) market borrowing of Rs 4.7t (Rs 4t).

What to watch out for:

• Rationalization of oil pricing/subsidy structure by a combination of (1) customs/excise duty cuts, and/or (2) measured price hikes
• Any steps to reduce the fertilizer subsidy
• Aligning direct and indirect tax rates with eventual DTC and GST framework
• Kickstarting the reform engine with implementation clarity on GST and DTC, etc.
• Any specific measure to boost revenues (divestment target, one-time revenue generators similar to 3G in FY11)

Union Budget 2011-12 comes amidst macroeconomic headwinds:

Union Budget 2011-12 assumes significance on many counts. First, inflation is at its decadal peak and has remained high despite a series of monetary/fiscal policy actions. The prospect of drought in China could mean higher cereal prices and uncertainties in the Middle-East could lead to further increases in oil prices. A gradual move towards re-aligning to international oil prices appears more certain in FY12, which would lead to one-time release of suppressed inflation, preventing dramatic decline in inflation in FY12 on high base.

Second, as a response to emerging inflationary risks, RBI has successively hiked policy rates effectively by 300bp since the exit of stimulus measures in October 2009. This was accompanied by a quantitative tightening by restricting money supply far lower than the credit demanded by the government and the private sector. As a result, interest rates hardened fairly quickly. Further, as liquidity remained severely stretched for an extended period of time, the interest rate pressures acted more on the shorter end first by flattening the yield curve and second by inverting the private sector yield curve (with the one-year CD rates ruling ahead of 3-year AAA and in turn over 5-year AAA, and so on).

Third, with heightened inflation and interest rates, the capacity to live with macroeconomic risks appears stressed, with definite signs of slowdown in industrial production. A variety of factors has contributed to this, including higher international commodity prices, higher interest rates, a spate of corruption issues creating a circumspect atmosphere, environmental clampdown, and issues of land acquisition and water availability.

Under the prevailing circumstances, Union Budget 2011-12 assumes significance that goes far beyond the government's normal income-expenditure statement. Over the years, the budget has become a key policy tool to rejig growth, enhance macroeconomic stability, address sectoral imbalances, ensure inclusive growth and in general articulate the medium term development strategy for the government. Union Budget 2011-12 would therefore carry great expectations of addressing the current exigencies as highlighted above. The budget also comes on the heels of a spate of corruption issues that have been highlighted in the media and currently being redressed through various executive, legal and parliamentary mechanisms. Hence, the issue of governance that has been mentioned as the third pillar of strategy by the government along with growth and inclusive growth in the recent years comes in sharp limelight. Needless to add, rolling of the reform engine is an absolute must for India at this juncture.

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Key expectations:
Repeating FY11 fiscal performance will be a challenge in FY12:

FY11: Expect Fiscal deficit/GDP at 4.6% Post the crisis phase of the fiscal stimulus, the government has moved back to consolidation mode. The trend during the current financial year up to 3QFY11, for which data has been made available, shows robust revenue growth helping the government to keep the deficit within target. The revenue target has been achieved mainly on three counts (1) high real and nominal GDP growth has increased direct tax revenue even after announcing tax benefits, (2) indirect tax collection has grown very significantly on rollback of tax concessions from the stimulus levels, (3) 3G/BWA bonanza of Rs1t as against budgeted Rs350b. Thus, overall revenue receipts are likely to reach Rs8t v/s the budgeted Rs6.8t (see Annexure I on page 6).
 
Non-plan expenditure growth has largely been on track while some softness is visible on planned expenditure. As planned expenditure usually rises in 4Q and a major subsidy overhang (estimated at Rs 600b) looms on account of oil and fertilizer bill, overall expenditure is estimated higher at Rs 12t v/s the budgeted Rs 11t.
 
This leaves us with a somewhat lower fiscal deficit of Rs 3.6t v/s Rs 3.8t budgeted. While the market borrowing program has largely proceeded on course, improved revenue position has resulted in significant cash balances of ~Rs1t with the government in recent months. The nominal GDP has grown by a record 20.3% as against 12.5% assumed by the budget. The combined impact of higher revenue, slower planned expenditure and higher GDP base is likely to take fiscal deficit/GDP ratio to as low as 4.6% during FY11.

FY12: Clarity on reforms is a key watch-out: We have placed our FY12 real and nominal GDP growth at 8.3% and 14%, respectively. As the direct tax is very highly related with nominal GDP growth, we have assumed 15% growth in personal tax and 18% growth in corporate tax. Major concessions in direct tax have already been advanced in FY11 and we are near the revised direct tax code (DTC) threshold. Also, various concessions given in the final DTC draft placed in the Parliament have restricted fiscal space for the government to reduce tax rates dramatically as envisaged in the original DTC draft. We expect only marginal enhancement in personal tax slabs (Rs 175k from current Rs 160k of minimum threshold). Stricter enforcement may result in enhancement in tax revenue.
 
On the indirect tax front, the government has serious intentions to introduce goods and services tax (GST), which is set to replace the complicated indirect tax structure currently in place at the central and the state level (see Annexure III). While no agreement has still been reached between the center and key states opposing it, it is hoped that an agreement can be reached with suitable modifications of the existing proposals. Though GST is not expected to follow the ideal course in its final form, most sources place the revenue neutral GST rate of 8% at the central level if a unified rate is implemented (unlikely) and 5% and 10% under a dual rate structure for merit goods and general goods, respectively. The tax net for services sector is expected to be widened to cover all services and service tax per se is envisaged to be brought under GST. However, it needs to be emphasized that many matters of principle (like autonomy of states) as well as detail (like tax rates, exemption list, rules for inter-state tax credit and transfer, compensation for revenue loss of states, etc) are still being evolved. While the ideal GST structure would elude us given the complexity of issues, an agreement between a compromise formula and a complete letdown would be a highly reasonable starting point. Somewhat unexpected inclusion of GST in the bills to be introduced in the parliament in the budget session itself indicates, however, the government's resolve in this regard.

There would however, be no one-time accretion of 3G/BWA revenue in FY12. The financial position of the telecom companies also indicates rather limited possibility of incremental revenue from the auction of additional 2G spectrum with the existing players. Hence, we expect FY12 non-tax revenue to be sharply lower than FY11 and fall back to its trend. Taking all into consideration, our revenue receipts estimate for FY12 stands at Rs 8.4t.

Medium-term fiscal consolidation plan looks promising: We expect the government to largely remain within the fiscal corrective course set by it. While FY11 fiscal deficit target of 5.5% is likely to be over-achieved, the FY12 target looks a bit challenging at the outset. However, the overall direction of the second phase of fiscal consolidation including a reduction in public debt is unmistakable. Notably, India's achievement in this regard stands out vis-

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