Why has India's budget disappointed investors?
Few government budgets generate as much investor and media attention as India’s. With a slowing economy, all eyes were on the newly elected Modi government to see what strings were to be pulled in an effort to revive growth.
As it turned out, this budget focused on fiscal restraint, long term and not near term growth, and efforts to paper over certain cracks in the financial system.
Trying to bring down the cost of capital
The key theme was an attempt to bring down the cost of capital. The first step was the surprising revision down of the fiscal deficit target to 3.3%, from a previously budgeted 3.4% (in Feb 2019). The fiscal deficit is the difference between a government’s total revenue and total expenditure.
As with most Indian budgets a number of revenue assumptions look optimistic, which means that reaching the target will be difficult. The main point, however, was that this government will not move away from its focus on reducing the fiscal deficit.
This is good news for bond markets, as evidenced by the slight fall in the country’s 10-year bond yield since the budget was announced.
Another means of bringing down the cost of capital it to attract capital flows. On that point the government has committed, for the first time in India’s history, to raise foreign currency debt. This means issuing bonds denominated in foreign currencies such as the US dollar or euro.
Relative to domestically raised debt (i.e. denominated in rupees) this will save a few percentage points in interest costs, because of the lower interest rates in developed markets and the lower risk of currency devaluation.
It appears an attractive option, as interest costs are projected to currently make up 24% of central government expenditure for the fiscal year 2019/20.
The move could also result in an increase to India’s weight in the major global fixed income indices where it is currently under-represented relative to the size of its economy.
Note, however, that any reliance on foreign debt can raise risk given its ability to be rapidly withdrawn.
On the equity side, the government has proposed that the market regulator look into raising companies’ minimum free floats. This refers to the proportion of a listed company’s shares that must be held by public investors.
This will both increase market liquidity and raise India’s weight in the various indices. The near term impact of this move would be the requirement of those companies below the threshold to cumulatively sell $51 billion of stock into the market. In addition, the government may reduce its stake in certain state-owned enterprises as part of its divestment plan.
Supporting the financial sector
Three further measures announced in the budget were: i) a 700 billion rupee ($10 billion) recapitalisation of state-controlled banks ii) a one-time guarantee for the purchase of high-rated assets of financially sound non-bank finance companies (NBFCs) and iii) moving the regulation of Housing Financing Companies from the government to the central bank.
The first measure is designed to help support growth in a state banking sector which makes up 65% of the financial system. The second is to provide liquidity to NBFCs, whose funding sources dried up following the bankruptcy of infrastructure finance company IL&FS last year.
In our view, the benefits of the first two both measures is marginal. The large book of problem assets at state banks is likely to consume a lot of capital. Meanwhile, the better-rated companies in the NBFC sector are already finding the funding environment has markedly improved since the lows of September 2018.
Mixed signals on taxation changes
In a protectionist move, custom duties have been levied on a range of products including a number of auto components, as well as gold and silver.
Taxes on the highest earners have been increased from 35% to either 38% or 43%, depending on income levels. Furthermore, taxes on share buybacks have been introduced at 15%, bringing them in line with taxes on dividends.
Finally, additional tolls of 1 rupee per litre of petrol and diesel should raise $2.1 billion. All these taxes either raise costs or reduce the spending power of consumers.
On the positive side, an additional interest deduction has been provided for first time home buyers taking out a mortgage before the end of the tax year 2019/20. This is provided that the stamp duty of the property is less than 4.5 million rupees.
The change takes the effective cost of home ownership as low as 5.5%. It is likely to see good take-up. 140,000 participants took up the government’s previous and less generous scheme.
The initial response of equity market participants to the budget was disappointment given the lack of a pro-growth stimulus. That said, should the government execute on its stated objective of bringing down the cost of capital, the long term benefits will far outweigh any near-term worries.
For now Indian’s short term macroeconomic outlook remains challenging and its stock market expensive. If the current equity market weakness persists this could provide opportunities to invest in companies at more reasonable valuations.
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