Policy under construction: Our big-picture reading from the Budget statement is that policy makers are moving in the right direction toward cutting back on redistributive policies and reviving investment sentiment. However, we believe that the reform agenda remains under construction. The government will have to provide the finer details and implementation plans of the Budget announcements and will need to articulate its plans on other critical reforms. In this context, we would continue to keep a lookout for more policy announcements from the government over the next three to six months to assess if more policy reforms would be taken up that would help to improve the macro outlook.
From a stock market perspective, the investment push in the Budget, both directly via government spending as well as tax cuts together with higher FDI limits in insurance and defense and a bunch of steps to ease taxation, should augur well for the progression of the share of profits in GDP, which is at a multi-year low. We are raising our Sensex target for June 2015 by 9% to 28,800 based on Sensex earnings growth of 13.5%, 22.7% and 23.4% for FY2015, FY2016 and FY2017. Our portfolio strategy remains geared towards cyclicals and stocks with GARP characteristics. The key risks for Indian equities are global monetary policy shifts, policy momentum at home, a rise in oil prices, bunching of equity supply and the richer valuations that equities trade at.
Tracking fiscal consolidation and measures to improve investment sentiment
How to evaluate the Budget?: The Budget for FY15 is the first major policy statement by the new government. We were watching the Budget for measures in two key areas:
(i) Pull back less-effective redistributive policies,
(ii) Revive overall business as well as infrastructure investment growth to boost job growth.
Our big-picture reading from the budget statement is that policy makers are moving in the right direction. However, we believe that the reform agenda remains under construction. The government will have to provide the finer details and implementation plans of the finance minister?s announcements and will need to articulate its plans on other critical reforms such as amendments to the Land Acquisition Act, regulatory changes in the power sector, reductions in fuel and fertiliser subsidies, recapitalisation of state-owned banks, gas pricing, auctioning and privatisation of coal blocks. In this context, we would continue to keep a lookout for more policy announcements from the government over the next three to six months to assess if more policy reforms would be taken up to improve the macro outlook.
A. Cut back on redistributive policies
Policy makers have had an intense focus on implementing redistributive policies without boosting productive growth, which have resulted in a high inflation environment in India. Given the sub-optimal outcome of lower growth and higher inflation that has prevailed over the past few years, we were looking for the new government to announce plans to cut back on such redistributive policies.
1) Fiscal deficit ? reduction in headline deficit figures but still projecting a rise in expenditure
What was announced: The government has maintained the interim budget target for the government?s fiscal deficit at 4.1% of GDP. Over the medium term, the government has reiterated its commitment towards fiscal consolidation by targeting a fiscal deficit of3.6% for FY2016 and 3% for FY2017.
Our view: While the FY15 fiscal deficit target of 4.1% would appear to be a fiscal tightening to the tune of 40bps (relative to last year?s fiscal deficit of 4.5%), we note that spending is still projected to rise by 14.8% y-o-y (year on year) to 13.9% of GDP in FY15 compared to 10.9% y-o-y and 13.8% of GDP in FY14. However, the government seems to have worked towards a slight improvement in the expenditure mix by keeping capital expenditure growth higher than revenue expenditure. Within revenue expenditure, the less-effective spending, such as subsidies and allocation towards the NREGS, is expected to decline to 2.28% of GDP, from 2.54% of GDP in FY14.
We believe the fiscal deficit estimates are optimistic as they are predicated on assumptions of high growth in tax revenue and non-tax receipts including divestments, dividend payments from RBI and nationalised banks. We estimate the underlying fiscal deficit for FY15 will be 4.5% of GDP compared to the Budget estimate of 4.1%.
As we highlighted in our Budget preview note, we believe that the underlying fiscal deficit for FY14 is 5% of GDP, and hence a 0.5% reduction from that starting point would have been a more realistic assumption. However, the Budget has not restated the FY14 fiscal deficit, and has chosen to keep it at 4.5% as the starting point. In other words, considering that underlying fiscal deficit for FY14 is at 5%, we believe a more realistic estimate for FY15 fiscal deficit should have been 4.5% (instead of 4.1% as now budgeted).
(ii) Managing rural wages in line with productivity
What was announced: The finance minister has marginally reduced the allocation for the NREGS from 0.29% of GDP in FY2014 to 0.26% of GDP in F2015. The finance minister also stressed the need to link the scheme to create more productive rural assets.
Our view: We believe that these policy actions will keep rural wage growth on a decelerating path and lift the productivity of the agriculture sector, both of which will improve the inflation outlook sustainably. As we highlighted previously, the rapid acceleration in rural farm wages ? especially since the implementation of the NREGS ? has been one of the key factors behind India?s high food inflation and overall inflation.
While nominal rural wages growth has been gradually decelerating over the last few months, the pace of ~14% y-o-y is still higher than nominal GDP growth of around 12% y-o-y. In our view, rural wage growth will continue to decelerate as the one-time catch-up effect to NREGS wanes and Thursday?s policy announcement of the marginal reduction in allocation to the scheme will only help to keep that effect in play. Moreover, the finance minister?s indications that the government will push for the creation of more productive rural assets from the scheme should help to lift productivity growth in the sector, thereby helping to reduce the inflationary effects.
Policy reforms to boost investment growth
FDI
What was announced: FDI in defence and insurance sectors increased to 49% from 26% currently, relaxing FDI regulations related to real estate sector.
Our view: We believe that this is a positive development and was in line with our expectations.
Infrastructure/urbanisation investment
What was announced: The following measures were announced:
n To increase investment in roads, ports, airports rail, and urban infrastructure with an emphasis on PPP model.
n Investment spending for roads at R378 bn for national highways.
n Set up airports in all tier I and II cities with public private partnership (PPP).
n Proposed 15,000km of gas pipeline though PPP.
n Proposed to award 16 new ports in FY15.
n Power sector investments tax break extended to March 2017.
n Present corpus of Pooled Municipal Debt Obligation Facility to be enlarged to Rs500 bn from R50 bn.
n Allocate R70.6 bn for smart cities.
n Proposed to set up seven industrial smart cities in seven cities.
n Proposed to construct metro rail links in all cities with more than 2mn population. The budget speech also proposed to encourage low- cost housing, with a possibility of including FDI investments in the same.
n Investment allowance at the rate of 15% to a manufacturing company that invests more than R250 million in any year in new plant and machinery. The benefit will be available for three years i.e., for investments up to March 2017.
Our view: The Budget statement reiterated the government?s intention to push for infrastructure investment. While some measures have been announced in this direction, we await further details on the actual implementation plans. We believe that there needs to bea concerted effort to accelerate investment in the electricity, roads, railways, and mining sectors via addressing the challenges related to environment approvals and clearances, amendment to the Land Acquisition Act and other regulatory changes.
Capital market-related measures
What was announced: The following measures were announced:
n Ongoing process of consultations with all the stakeholders on the enactment of the Indian Financial Code and reports of the Financial Sector Legislative Reforms Commission (FSLRC) to be completed.
n Introduction of uniform KYC norms and inter-usability of the KYC records across the entire financial sector.
n Introduce one single operating demat account.
n Uniform tax treatment for pension fund and mutual fund linked retirement plan.
n The liberalised facility of 5% withholding tax is extended to all bonds issued by Indian corporate abroad, extending validity up to June 2017.
n A more liberal Bharat Depository Receipt (BhDR) scheme was also announced. International settlement of Indian debt securities will be allowed and revamped the Indian Depository Receipt (IDR) scheme.
n Liberalisation of ADR/GDR regime is also proposed for depository receipts.
n Income arising to foreign portfolio investors from transaction in securities will be treated as capital gains (this will allow fund managers investing in India to operate from India).
Our view: We believe that these measures are confidence building measures for capital markets.
Goods & Services Tax
What was announced: The government will give a thrust to GST implementation and try to reach a consensus during the course of the fiscal.
Our view: We believe that the implementation of GST will increase the efficiency of the tax system, widen the tax base, increase compliance due to its simpler nature and lead to efficient allocation of factors of production and will improve competitiveness of domestic manufacturing and support GDP growth. However, implementing this law is complex as state governments are resisting the loss of fiscal autonomy with the implementation of GST.
Recap of state-owned banks
What was announced: The finance minister in the Budget speech acknowledged the large capital requirement at PSU banks of R2.4 trillion to comply with Basel III requirement; however, the budget has provided for R135bn in F2015 (vs. R40bn in F2014). The FM?s speech only indicated that capital for PSU banks will be raised through local share sales.
Our view: There was no concrete roadmap for capital infusion from government. We believe that considering the capital requirements of the state-owned banks is large, while this issue was not addressed in the budget, the government is likely to take it up in the coming months
Retrospective taxation:
What was announced: The government has announced that it will not make any retrospective tax changes in future, but did not repeal the retrospective law change taken up in 2012. However, the government assured ?all fresh cases arising out of the retrospective amendments of 2012 in direct transfers will be scrutinised by high level committee to be constituted by the CBDT before any action is initiated in such cases.?
Our view: The promise from the government not to make any retrospective changes to the tax law is a positive, in our view. However, it is still unclear at this point as to how the government will address the claims arising from the 2012 amendment.
?Morgan Stanley
