Betting too high on Budget

Even if the Budget delivers, there are chances that the market may fall

This weekend, a large number of investors will be sitting around on Mauritius's beaches, sipping their pina coladas and wondering whether they should put more money into India. Another group of investors will be wandering around the fleshpots of Mumbai, celebrating the advent of the monsoon, and asking the same question. In fact, all across India, individuals will be asking versions of the same question. They will all hope that Mr Jaitley will provide reasons for them to reach for their chequebooks on Thursday.

Of course, the Mauritians, also known as foreign institutional investors (FII), are actually far more likely to be based in New York or London, with only an accommodation address located in the Indian Ocean/tax haven. Most individual Indians are more worried about tax/excise hikes and the impact of possible subsidy reductions than looking for potential avenues of investments. Most domestic institutions have tended towards caution in the recent past.

Poetic licence apart, the FIIs, the DIIs and retail Indian investors don't have a great deal in the way of constructive things to do until the Budget is released. This Budget will indicate the likely direction of policy for the next five years. There are no clues to the new finance minister's style of functioning, or his economic predilections. This first Budget is also the best chance that the new government has of coming clean about the real state of government finances; it can blame all sorts of economic missteps and problems upon the previous government.

FIIs, DIIs and retail will probably process the information that comes their way differently. Their needs are different. The FII perspective is relatively simple. They allocate a certain amount of money to emerging markets (EMs). That money is then divided between the EMs that they consider most likely to yield gains. As of now, FIIs are strongly positive on India. But the optimism is based on hopes and guesses about the likely policy trends. This Budget could confirm or challenge the positive assumptions.

India has some inherent advantages as an EM destination. It has offered returns of more than 22 per cent in dollar terms since January. It is a deep enough market to absorb large corpuses and it is a diversified economy with enough in the way of listed companies across multiple sectors. It is also relatively politically stable - far more so than most of its peer economies. The disadvantages to investing in India are also well-known: it has a rapacious, corrupt political establishment and bureaucracy, complicated laws and regulations, and a justice system that is incredibly slow.

The new Prime Minister has a reputation as a clean, efficient administrator at the state level. He hails from a business community and has generally shown himself to be capable of smoothing out the obstacles to doing business in Gujarat. That can-do attitude should filter through in the Budget even if it's not being managed directly by Modi.

Setting financial policy for India is a very different matter from managing the finances of a single state. Jaitley will have to walk a very narrow path. He must ensure fiscal prudence to make sure deficits don't go out of control. He cannot cut subsidies (that result in high deficits) beyond a certain point because these are "politically sensitive". He cannot raise taxes or excise rates substantially because that would be business-unfriendly. He has to fend off the illiterate demands for "swadeshi" (that is, increases in customs imports and restrictions on IMPORTS) from a certain section of his own party.

He also has to set a schedule for rationalising taxes. Something like the GST (Goods and Services Tax) needs the cooperation of the states. The current government has a reasonable chance of pushing it through. By analogy with the VAT, even a partial adoption of GST would be useful since more states would come on-board if the early adopters received benefits.

If the Budget delivers on some of the areas mentioned above, well and good. As of now, the FIIs and retail investors are gung-ho while DIIs are cautious. If all three sets of investors align in one direction, that would mean a big trend. One issue is that expectations appear to be very high. That could lead to a market fall even if the Budget delivers.