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Indian Budget 2007-08

The basis test of any policy reform revolves around the kind of reform initiatives it undertakes. India's latest budget fails this
Rohit Chawdhry

The tenth anniversary of Chidambaram's dream budget was presented by a person who is ten years older, now past 60. The tragedy is that it shows. There was so much he could have done, but he chose to take the safe, well-travelled route. A route travelled by only those who believe in eternal, glacial gradualism. A gradualism that means that you can even walk backwards, while all the time claiming that you can walk on water. This particular finance minister has always had a stubborn streak. He brought in some ingenious taxes like the fringe benefit tax and the cash transactions tax, and he was not only going to keep them, but also enhance them.

The budget, with its populist overtones and lack of market-oriented policy initiatives, did little to cheer the Indian markets, which sold off on global cues. The run-up to the budget had been rather volatile, with market participants fearing that price caps and export bans on certain commodities to control inflation could be announced as part of the budget. While such negative measures were not announced, neither were there any positive measures on tax incentives, despite buoyant tax revenues for FY2006-07. Instead, the offe-ring was significant increase in spending, with special emphasis on education, health, unemployment, welfare schemes, agriculture and rural development.

So what did the finance minister introduce in the budget? He had buoyant tax revenues and the fiscal deficit was on target for 2.5 per cent of GDP. He provided 3.7 per cent for 2006-07. Where did he make the adjustments? He increased the expenditure, not the capital or productive form but the unproductive form. The subsidies were increased by 15 per cent over budgeted figures while capital expenditure was slashed by 1.5 per cent over the budgeted figure. Instead of decreasing corporate tax rates he gave them a status quo and indeed increased the dividend distribution tax to 15 per cent, ie more tax burden on the Indian corporates. Further, he also brought ESOPs under FBT, an open-ended liability for India Inc. Bottomline: the effective tax rate for corporates went up to 38 per cent. Besides a reduction in the peak customs tariffs from 12.5 per cent to 10 per cent, tax rates have been unchanged but an additional surcharge of one per cent has been imposed for funding secondary education.

What this budget has brought, in the tradition started in February 2005, is more and more anti-reforms, tinkerisation, and back-pedalling while all the time claiming that we are moving ahead. Consider the intervention on cement. Are the prices too high? Why, they must be, because of bad industrialists who are gouging the poor consumer.

The appropriate policy is to bring in price controls, ostensibly via tax incentives. The prevailing price today is close to Rs210 per 50kg bag, and there is an excise tax benefit of Rs12.5 per bag. So, with the benefit, the price can drop to Rs197 per bag. But to avail of the benefit, the bag has to be sold for less than Rs190. May be I am missing something here. Or there is little rationale for this intervention. Bottomline is, the more you go and dig deeper into the sta-tements, the more you understand the naivety of all this.

To be fair to the finance minister, the budget did seek to address some of the supply-side constraints visible in the food grain economy of India. Growth in India's agriculture sector steadily decelerated to an annual average of 2.5 per cent over the FY1996-FY2006 period, from 3.5 per cent during the five years ending FY1995 and 4.6 per cent during the 1980s.

This deceleration has been a concern among policy makers for quite some time and was a focus area in the budget announcement. Also, the food-price inflation had risen by nine per cent over the last year or so. The budget announced some measures targeted at impro-ving conditions in the sector. To help improve public sector capital expenditure (capex) in the agriculture sector, the government plans to increase spending on irrigation by 54 per cent and on the Bharat Nirman programme (which covers power, roads, telecom and housing in the rural areas) by 38 per cent.

Both these measures will cumulatively result in additional capex of US$2.2bn (0.14 per cent of GDP) in FY2008. In addition, the Indian government is targeting a net disbursement of US$7.8bn (or 0.4 per cent of GDP) in farm cre-dit by the end of next year. The government added that it would take action on the recommendations of the Committee on Agricultural Indebtedness as soon as they are received. It announced more measures to train farmers and also launched a subsidised insurance scheme for rural landless households. To that extent, policy reforms were taken.

To conclude, the budget has been kind of a boo-boo one on an aggregate basis. While the macro story of India still remains robust and despite a non-reform oriented budget, India's growth momentum is likely to be supported by other factors such as rising incomes, increasing credit penetration, increasing business investment as manufacturing competitiveness improves and high capacity utilisation. But that is the structural story. In the short-term (6-12 months), the case for a downside in the Indian stock market is becoming more compelling. While global cues such as unwinding of the yen carry trade and stretched valuations are the more dominant theme, an uneventful union budget should provide the excuse for institutions to hammer the market down.

Though the Indian stockmarkets have corrected by quite a bit in the short-term, a pullback from here on should be used to lighten up. The following section will give an idea of how deep this correction can get.

Sensex, India's benchmark index, traded at 12,800 levels (as of March 2, 2007) and could easily correct down to 10,000 over the next 6-12 months. That is a likely downslide of 20-25 per cent. Other markets could correct by 15-20 per cent. Contrarian indicators such as peak M&A activity (Tata Corus and Hutch Vodafone being the prominent ones) and new highs in art prices are also suggestive of the same. With interest rates already at peak levels, the economy should show signs of slowing just a tad. But it would result in a steep adjustment in terms of valuations. Bottomline: Indian economics/markets – structurally bullish, cyclically correcting.