1st March 2016
In yesterday’s Annual Budget, Arun Jaitley (India’s Finance Minister), maintained the fiscal deficit target of 3.5%/GDP for the Fiscal Year 2017. Whilst it may well be a challenging target to meet, as the saying goes, ‘where there’s a will, there’s a way’. That the government have demonstrated the will to stay on course from a fiscal perspective is a clear positive from our point of view.
As outlined in our earlier commentaries, from a growth, sentiment and stability perspective, we were broadly looking for three things from this budget:
- The government to hold its line on the fiscal deficit number with credibility
- An increase in investments – especially in the rural economy
- Bank re-capitalisation
In our view yesterday’s announcement ticked two of these three large boxes. Not a bad result.
Bond Market Effect and Outlook
A display of fiscal rectitude was absolutely essential to demonstrate the government’s discipline and commitment to its policies. Ultimately it justifies the faith shown by investors, both domestic and foreign. Although we didn’t believe that an increase in the deficit target of 30/40 bps would have been catastrophic, the importance of sending a positive message to investors cannot be overstated, particularly given the difficulties India has experienced in the past due to poor fiscal decisions. We are relieved then, that the Modi Government has chosen to be prudent despite apparent pressure to revive the growth through fiscal compromise. Moreover, we believe the markets will look positively on this development. The bond markets have already responded to the news having been somewhat worried over the last two months by the prospect of a higher fiscal deficit. By retaining the target and at the same time announcing a lower market borrowing figure, the government has really stoked bond market sentiment. Bond yields, across the curve, fell by more than 10-15 bps with the 10 year government bond ending the day at 7.62%*. We believe there is more to come.
The lower borrowing figure should also substantially reduce the current term premium (risk premium) on longer dated bonds. As such, the pattern that saw the India 10 Year Bond Yield end the calendar year 2015 practically unchanged in spite of 125 bps in rate cuts (with 30 year bond yields undergoing 30 basis points of steepening), is likely to be reversed. With lower than expected supply and the clarity on ‘Uday’ – state power sector bonds – we feel that term spreads of 100bps over the Repo Rate (almost across the curve) remain rich. In addition, factoring in the increased likelihood of a rate cut by the RBI, the current term spread looks even better value. We expect a 25 bps rate cut by the end of this week (an inter meeting cut) in response to the government’s prudence. At a Repo Rate of 6.5%, we then expect the RBI to remain on hold until at least July/September to review the monsoons and its impact on CPI inflation. We believe the 10 year Indian Government Bond will be heading towards 7.25% by the end of the year, with a parallel shift in the curve, initially at least.
The Indian Rupee (INR) will continue to track the larger dollar movement and that of other EM currencies. However, given the fiscal commitment, foreign investors (especially) in the bond markets should revive their investments, thus supporting the capital account. INR entry points, at the current level within this scenario appear attractive.
Benefits for the Rural Economy
Long term investors should also take heart from the budget announcement for India’s rural economy. The desire to double farm income by 2022 is laudable. The distress in the Indian farming sector has been significant and there is a need for long term investment to ensure India’s farmers aren’t left out in the cold. It is our hope that the government gets serious about this issue and sets about achieving this objective. Let it not be forgotten that it was the strength of the rural economy which kept India going post Lehman as private capital expenditure stalled. Ultimately it is in the general interest to help revive India’s agricultural and rural economy.
That the government is trying to achieve this without fiscal largesse needs to be appreciated. Although it may result in this year’s spending tilting towards revenue in comparison to the higher capital spend witnessed last year, it also makes us believe that the investment-led growth recovery will be somewhat delayed. Total capital expenditure is set to grow by 3% YoY over the current year’s growth of 25% YoY. The government seems to have clearly favoured the rural economy over infrastructure capex. Perhaps this will, in some way, redress the emerging perception that the government is not ‘pro-poor’.
Indian Banking Industry and Positioning
The one disappointing aspect from our perspective was that of bank re-capitalisation, which remained unchanged. In all likelihood the weakness in the equity markets reflected this as an increase in allocation had been anticipated. The INR 250bln re-cap number is, in our belief, lower than required and that of market expectations. As such, the pressure on PSU banks will remain. In the ACPI India Fixed Income Funds we have always preferred AAA PSU investments. As a result, subordinated bank paper is an area we have consciously avoided in the past and will continue to do so in the future. Among other things, we have always felt that the spreads on offer have not justified the underlying risks and it may be the case that the market sees some spread widening to reflect this.
Budget Account Credibility
Broadly, the budget accounts seem credible. In our view, tax revenue estimates seem reasonable while expenditure targets seem realistic. The markets may question the estimate on revenues from telecom spectrum auctions and the higher dis-investment target. In addition the full implementation of the pay commission and the defence pensions could require higher amounts and the government may have under estimated the requirement for this. On the other side of the equation however they have failed to provide for any revenue from the Income Disclosure Scheme (IDS). Although this may create a moral hazard, the government is allowing citizens a one-time, three month window, to declare any undisclosed income by paying 45% tax on the amount. Should citizens disclose even 1% of GDP (a potentially conservative estimate given the current tax base in India) as income in this scheme, it would net the government about USD 10bln — enough to meet any fiscal shortcomings.
*Source: Bloomberg as at 29.02.16