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Jehangir Aziz: Living on a prayer

Relying on a narrow set of adjusters is plain risky

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The Finance Minister has presented a budget that appears to balance the need to consolidate without having to withdraw the stimulus provided in the last two years on the ground that the recovery is still fragile. No one can argue against this logic. Recent data flow has rudely reminded us that material economic and policy risks abound in the global economy. At the same time almost all demand indicators in India have turned hot and despite the deficient monsoon, FY2010 will likely top 7 percent. And all this without India’s biggest growth driver, corporate investment firing. If this happens, as one expects, FY2011 GDP growth could go well above 8 percent. This will inevitably stretch capacity and raise core inflation, which has already started to pick up. Thus, it was important for the government to join the in moving policy stance from easy to neutral quickly, sacrificing near-term growth to extend the medium-term expansion and minimise any concerns of a hard landing in the second half of the year.

Two weeks back, I had written that the government would target a deficit of 5.5 percent of GDP. The budget did that that and more, targeting 4.8 percent in FY2012 on the way to meet the FY 2015 target of 3 percent as recommended by the 13th Finance Commission. This is a good thing as it once again frames the budget in a medium-term framework.

But then why do I get the feeling that things may not turn out the way they should? I was concerned that in trying to reach the 5.5 percent deficit target, the government would base the consolidation narrowly on a few adjusters, such as the cyclical upturn in the economy and divestment, and not reverse more of the cuts in indirect taxes. Sadly, that’s what the budget does. It expects tax revenues to grow by 18 percent when nominal GDP is projected to grow at 12.5 percent. The buoyancy of taxes is high when an economy is coming out of a downturn and the budget expands the base of service tax, which is another positive since this is the largest sector of the economy. But if the government truly thinks that the recovery is fragile, wouldn’t it have been wiser to be more conservative as it was last year?

The budget assumes Rs76, 000 crore in disinvestment and 3G license fees –a whopping 1.1 percent of GDP. This may well be realised, but it again it would depends on continued strong foreign inflows and benign risk-aversion among investors. Separately, in a bold move the FM promised to do away with off-budget bond issuance for oil and fertilizer companies and move all subsidies in the budget to a cash basis. What is surprising is the budget of just Rs 3,000 crore in oil subsidies. This may be sufficient if oil prices remain below $80/barrel or the government reforms the retail petroleum products pricing policy. We saw the entire opposition walk out during the budget speech for a Re 1 increase in excise duty. I wonder how they will react to the freeing of oil prices.

As we have seen recently, the global recovery can turn up nasty surprises and create enough anxiety to keep domestic financial markets volatile. Relying on a narrow set of adjusters is plain risky. If a few things go wrong, the budget will look shaky.

But beyond the numbers there were several positives. The budget reaffirmed that the direct tax code and the national GST would be rolled out by April 2011. The service tax base was expanded to include real estate, air and rail travel. This may be a negative for these sectors in the near-term, but for the economy expanding the base rather than the tax rate is always a better alternative. On the financial sector, increasing the number of private banks will improve competitiveness that is sorely needed to reduce the cost of domestic financial intermediation. Increasing the capital base of PSU banks will also help to provide greater stability to the system, but one hopes the government uses this as an opportunity to also consolidate public sector banks. The creation of the Financial Stability and Development Council to oversee systemic financial and corporate macroeconomic stability and provide a forum for more formal inter-regulatory coordination went almost unnoticed in the media and the market. This can turn out to be a critical step in ensuring financial market stability in the future.

The last budget disappointed the market because it was expecting a lot after the government had just won a decisive electoral victory. This time we had come to expect less. The stock market cheered up as the budget delivered a bit more than expected. The bond market hasn’t really reacted because it is looking for the devil in the detail. So in the coming months we will be living on a prayer for continued high growth, high global liquidity, low global risk aversion and low oil prices.

Jehangir Aziz, India Chief Economist, JP Morgan Chase
These are the author’s personal views

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