Reserve Bank expected to hold on to rates

Govt set to cut spending as fiscal deficit hits 90% of estimate in first seven months of the year

The benchmark indices, BSE Sensex and Nifty, hit all-time highs on Friday on hopes of a rate cut. The bond markets are not factoring in any cut next week but the equity markets continued to rally hours before the second quarter GDP (gross domestic product) numbers were announced.

Dismal tax collection data for October has ensured 90 per cent of the Budget estimate for the full-year fiscal deficit has been reached in the first half itself. Though the market might have shrugged off these numbers, the Reserve Bank of India (RBI) is unlikely to do so. In fact, it will continue to keep policy rates at current levels to support the government's fiscal tightening.

The equity markets are being greased by falling oil prices but risk to India continues if the weakening rupee is anything to go by. The expected volatility in the rupee and a high fiscal deficit will prevent RBI from cutting rates. In the first seven months of FY15, gross receipts have grown 4.8 per cent, against 12.8 per cent a year ago. Gross tax receipts in the first seven months of the financial year are at 38.5 per cent of the full year's budgeted estimate.

Dhananjay Sinha, head of institutional equities at Emkay Global, believes fiscal policy will the remain tight, complementing tight monetary policy maintained by RBI. More, Sinha says, despite a falling crude oil price and record-high equity markets, the rupee has actually weakened gradually towards 62 against the dollar, indicating potential future volatility. This makes it even more unlikely for RBI to cut the policy rate next week and dilute the effects of ensuing fiscal tightening.

As the government is behind schedule on divestments, it will have to undertake sharp spending cuts if it has to meet its 4.1 per cent of GDP fiscal deficit target. With the economy expanding at a slower pace of 5.3 per cent in the September quarter, compared to 5.7 per cent in Q1, economists believe GDP growth in the second half would be impacted. The second quarter GDP growth is ahead of estimates but has been driven by one-offs like the agriculture sector and services. The subsequent two quarters are expected to witness slower agriculture growth, thanks to deficient rainfall. Manufacturing grew 0.1 per cent on weak industrial production but agriculture surprised at 3.2 per cent. Debopam Chaudhuri, chief economist, ZyFin Research, says: "Slowing government spending and exports during the quarter ended September contributed to this renewed slowdown in economic activity."

While economists are not yet revising full year GDP forecasts lower, the sharper spending cuts in the second half could push down growth for the full year. The government will need to undertake more than 10 per cent spending cuts in non-Plan expenditure if it has to meet the deficit target, says Emkay's Sinha. Economists also believe there could be a shortfall in the divestment proceeds, putting pressure on the fisc. The government has already asked some ministries to cut expenditure by 15 per cent. Clearly, challenges to the economy are not over.