India's budget posts a pleasant surprise: HSBC Global Research

29 February 2016

The government posted a pleasant surprise by sticking to the pre-announced fiscal deficit target of 3.5 per cent of GDP from 3.9% in FY16. This move is likely to have a far reaching impact on the macro economy by preserving stability.

More importantly, today's show of fiscal discipline makes it easier for the RBI to continue with its accommodative stance. This was not easy for a government which was trying to protect growth as well as preserve macro stability. Yet, it bit the bullet.

HSBC expects a 25 basis point post-budget repo rate cut. The combination of high carry and robust fundamentals should better support the rupee, especially after its weaker start to the year. Amongst other themes, as expected, the government put its weight behind rural revival, capex and bank reforms. There was some disappointment with the lack of increase in bank recapitalisation funds and certain tax increases. But overall, we are positively surprised.

While we had long argued that 3.5 per cent fiscal deficit would be an optimal decision, over the last few weeks we had begun to believe that the government will opt for a wider deficit of 3.8 per cent, which in our view would have eroded hard won stability. As such, today's decision comes as a pleasant surprise.

The deficit target of 3 per cent for the next year has been retained. But it could just be a placeholder for now as the government has decided to revisit and re-haul the FRBM Act.

Credibility of numbers: Nominal GDP growth of 11 per cent y-o-y, gross tax revenue growth of 11.7 per cent y-o-y and tax buoyancy assumptions of 1.1 look broadly achievable. However, the spectrum sales target of Rs990 billion is a tad rich.
As expected, the budget focused on the "three Cs":

Countryside revival: Rural India got a substantial push with increased outlays across investment (roads and irrigation) and rural safety nets (crop insurance and MGNREGA). The move to allow 100% FDI in marketing food products are also likely to contribute to farmer welfare.

Capex: The government gave a push to roads (including rural roads), railways and even ports. Alongside, it outlined its desire to rework PPP contracts.

Continuation:  The budget focused on themes the government has championed since last year. Financial sector reforms in the form of strengthening ARC (Asset Reconstruction Companies), setting up the Bank Board Bureau and providing INR 250bn of bank recapitalization were discussed. Many in the market were expecting larger outlays on recapitalization and may be a tad disappointed.

Amongst other things, the government also reiterated its desire to see through key bills- the GST bill, Bankruptcy Code as well as the formation of the RBI MPC.

Several tax measures were taken. A 50 basis point surcharge in the service tax was broadly in line with our expectation. The corporate tax rate was not reduced as expected, but the commitment to do so over the next few years was retained as the government continues to reduce exemptions. The increase in the Dividend Distribution Tax and Securities Transaction Tax (STT) took the equity markets by surprise.

A better macro mix: In our view, today's decision on the fiscal deficit will lead to a better macro mix. Gross borrowing of the central government will be lowered to 4  per cent of GDP (from 4.3% in FY16). Our previous analysis shows that sticking to the fiscal consolidation target of 3.5% will place the government's public debt ratios in a "sustainable zone".

To the extent government borrowing remains contained and bond yields soften on the margin, further "crowding out" would be prevented. This would improve the mix between government and private sector as drivers of growth. The thrust on rural India would also help balance growth contribution from urban and rural sectors. Overall, today's budget is likely to drive better quality recovery in the economy. We continue to expect that GDP will grow 7.4 per cent y-o-y in FY17 (same as in FY16).

Finally, today's fiscal outcome makes us more confident on our long standing call for a 25bp post-budget rate cut by the RBI.
Forex reaction:

The Indian rupee traded in a choppy fashion in the aftermath of the government's budget announcement. But overall, it has reacted positively to the fact that the government will stick to its original fiscal deficit target of 3.5 per cent for FY17. More recently, we believe that some concerns were building that fiscal slippage would emerge as the government was potentially aiming to boost GDP growth.

While India's fiscal consolidation is certainly important, we are less convinced that this is sufficient enough to turn foreign investment sentiment around. Lately, portfolio outflows have been working against the INR, causing it to become one of the main underperformers in Asia this year. India has seen about USD3.3bn of portfolio outflows year-to-date, and more from Indian equities than debt ($2.5 billion and $0.8 billion, respectively). We believe there were both "push" (out of India) and "pull" (into other EM) factors involved.

We believe the Reserve Bank of India (RBI) has been 'leaning against the wind' to offset portfolio outflows recently. Although its weekly FX reserves data suggest that reserves have risen by nearly $4 billion between 15 January and 19 February (latest data available), we believe that valuation effects (given the appreciation in the EUR and JPY during that period) explain the increase. But it is possible that the RBI may have intervened less compared to the period in August-September, when the INR also came under stress. In our view the RBI may have become more concerned about INR competitiveness - its estimate of the INR REER hit a 5-year high in Q4 2015. The RBI publishes its intervention data with a 2-month lag.

The combination of high carry and relatively robust fundamentals (narrow current account deficit, decent domestic growth momentum) are seen few and far between amongst EM currencies in this current low-growth, low-inflation global environment. As such, we believe the INR should be better supported by these factors, especially after its weaker start to the year. Our year-end USD-INR forecast is 69.

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