February 2017

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Feb
2

Union Budget and Markets

The Union Budget 2017-18 quelled market speculation and encouragingly stuck to a broader fiscal consolidation roadmap. FY-18 fiscal deficit has been targeted at 3.2% of GDP, a marginal deviation from an earlier laid roadmap of 3%, yet a positive outcome in light of demonetization related pressure on the economy. We have always argued for fiscal prudence and more so in the light of 7.9% net household financial savings coupled with increased pressure on state finances next fiscal year.

Prima facie, the overall fiscal arithmetic looks credible. The size of the budget is pegged at Rs. 24.5 trillion, thus leading to 6.6% growth in total expenditure. As the central government is largely done with financial burden of VII pay commission implementation, it could once again restore its focus on capital spending (budgeted to increase by 10.7% in FY18). A high base from last year due to 7th Pay commission implementation helped the center to print a mere 6% growth in revenue expenditure.

The thrust of spending remains on infrastructure, rural economy and affordable housing. The budget refrained from an aggressive spend on bank recapitalization and that can be called as a disappointment. There is a crying need for faster resolution of the Bank’s NPA issues in the light of persistent weakness in private capital spending for three years now. Addressing the banking sector stress spurs both supply and demand of credit.

Tax projections look credible. On the taxation front, three strong positives came in the form of reduction of corporate tax to 25% for small business, no service tax hike and no increase in holding period for availing long-term capital gain tax. The budget refrained from any significant changes in indirect taxes and reasonably so as it prepares for GST implementation in the middle of the year. The income tax-slabs saw some changes while the government slapped further surcharge on high net worth individuals. It needs to be noted that surcharges and cess are not shared with the states and to that extent we see the central government increasingly resorting to these means to benefit the center’s kitty alone. Besides, we also see a tremendous focus on increasing the overall tax to GDP ratio.

The divestment target, as always, has been optimistically scaled up (Rs. 725 billion compared to FY16 RE of Rs. 456 billion). The government needs to enhance focus on strategic asset sales.

The budget resisted announcing a universal basic income scheme, which would have entailed a large fiscal cost. As it is, the sticky expenditure of central government (on interest payment, subsidies, pension etc.) run higher than 5% of GDP. Interestingly, the interest payment, for the first time in budget history, equaled the overall fiscal deficit. This will only become adverse in future which makes us re-emphasize the need to maintain fiscal prudence. An infrastructure deficit nation like India cannot afford to keep channelizing the tax payer’s money for unproductive purposes.

We credit the government for liberalizing FDI norms (FIPB envisioned to be abolished in FY18), inviting foreign investment, rationalizing its taxation measures on foreign investment at a time when the rest of the world is becoming more inward looking. Also we saw a small beginning where budget shifted its focus from outlays to outcomes such as quantifying the asset creation plans from MGNREGA spending, targeting the learning based outcome in education, targeting the elimination of certain diseases prevalent in India.

Rural India, in our view, is likely to be a structural theme for investors in India. Frictional hazards aside (such as implementation risks, heavy reliance on monsoon for agricultural income), the focus on agri-insurance, getting rural households into formal financial channel, better digital and road connectivity, rural electrification, direct transfer of benefits and employment generation (via MGNREGA) will structurally lift up the rural economy.

On the social sector front, the budget document mentions launch of Swayam, an education portal/app on the line of Coursera. The website is well designed. If executed and marketed properly, it can become a great bridge between large areas of the country where quality of colleges is poor.

While we concur with government’s thought on better digital infrastructure and higher public capital spending and agree that they have inherent employment generation potential, we also think that the government needs to increase its focus on job creation. Apart from MGNREGA and the intent to rationalize the labor laws, we did not find any other significant measures which enables job creation. Demographic dividend in the absence of adequate job generation creates a serious threat of social unrest in India.

The budget should be taken positively by consumption, agriculture, financial and infrastructure oriented sectors. Infrastructure status to affordable housing, increased interest subvention for housing loans, change in house size from built-up to carpet area (30 – 60 sq mt), lower holding period for indexation and lower tax incidence for low income assesses and thus higher disposable income, should be growth positive for construction related sectors and housing finance companies.

Overall, the government’s decision to stick to fiscal consolidation – despite the growth hit caused by demonetization and the upcoming state elections – is a positive signal from the macro stability point of view. Accepting the recommendations of FRBM committee, government has projected to not only bring down the fiscal deficit to 3% but also lower debt to GDP ratio to 60% by 2023.

With the event is now behind us, the focus will shift back to the execution of the budget, corporate earnings and global cues. In the months ahead, the up-coming state election, final construct of GST, elections in Europe, policy measures adopted in the US (by the newly formed Trump administration), and the consequent response by rest of the world may shape the market sentiment. However, we think that corporate earnings expectations and performance is the most crucial parameter to watch for equity market this year. Further, from the macro perspective, there is a dire need to spur the private investment and exports growth in India. In the last few years, the domestic growth is getting heavily skewed towards consumption and government spending which may not be sustainable. Government spending suffers with its own execution challenges and consumption spending is not without inflation concerns.

As an aside, we admit that Trump’s policy proposals thus far have been more negative for Indian markets than we envisaged. However, our detailed assessment suggests India is still relatively better placed compared to other emerging markets in depicting vulnerability to US’ trade, immigration and tax measures.

Prudent budget combined with contained inflation increases scope of monetary easing at the margin. Central budget managed to curtail the net market borrowing to Rs. 3.6 trillion as it increasingly resorts to small savings funds to finance the fiscal deficit. However, bond market may remain largely un-impacted by the budget given the overhang of higher SDLs, UDAY discom bonds and GoI serviced bonds on one side and global yield movement on the other side.

Navneet Munot, CIO – SBI Funds management Private Limited

February 1, 2017

(Mutual funds investments are subject to market risks, read all scheme related documents carefully.)

 

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