India’s Union Budget: key takeaways for investors

India announced its annual budget last week, with the deficit forecasts for the current and forthcoming fiscal tax years both higher than expected. This marks a change in tone from the government, as it relaxes fiscal prudence from the last few years.

Changes in accounting and planned asset sales mean additional spending in the near term is not as high as the headline deficit would suggest. But the future spending focus on the supply side of the economy, and promising steps towards financial sector reform, are supportive for medium term growth.

The impact now relies on solid execution. If medium term growth does not improve, the higher debt outlook would put pressure on India’s sovereign rating, which currently stands just one notch above junk. For now, rating agencies will likely give India the benefit of the doubt as it makes a welcome step towards fiscal transparency.

The latest budget relaxes fiscal prudence of recent years

In recent years India has been fiscally conservative, in an attempt to push government deficits towards 3% of GDP, in line with the fiscal responsibility act. As a result, limited fiscal support from the government has led to concerns surrounding the sustainability of India’s growth recovery.

The latest budget projects a fiscal deficit of 9.5% of GDP for the current fiscal year ending in March, and 6.8% of GDP for the fiscal year 2021/22. This is higher than 7% and 5.5% respectively that  investors had anticipated. Though this still reflects some fiscal consolidation, the deficit is still set to be 2.5% of GDP larger than the average deficit run in the last decade.

The government also announced that longer term fiscal consolidation is set to be more gradual; the long run deficit target for the fiscal year ending 2026 was pencilled in at 4.5% of GDP, which is around 1.5% higher than before.

How will this impact growth?

With positive steps on reform, no planned tax hikes, and more gradual fiscal consolidation in the coming years, the budget is positive for growth. However, a careful look at the numbers shows that the budget is more supportive for medium term growth instead of providing a material short term boost to activity.

The current fiscal year is almost over and the larger deficit now expected is primarily due to accounting. Food subsidies that were previously off the balance sheet have now been included. This accounts for roughly 2% of GDP and marks a welcome step towards fiscal transparency for India, but is not new spending. The rest can mostly be explained by poor tax revenue assumptions, as tax collection will almost certainly be higher than budgeted.

With no tax hikes pencilled in for the next fiscal year, the government is instead looking to raise revenue through an increase in asset sales as part of its divestment programme.

On the spending side, government capital expenditure is set to rise to 2.5% of GDP in the coming fiscal year from 2.3% in the current fiscal year and 1.7% last year. Additional spending will be focussed on the supply side of the economy, in areas such as infrastructure (by 0.4% GDP to 2% GDP) and healthcare (by 0.3% GDP to 1.8% GDP). Meanwhile, general spending is expected to fall to 10.3% of GDP, mostly due to food subsidies which are earmarked to be rolled back.

From a long run perspective, the shift towards capital expenditure should help India increase its capacity and raise potential growth, though reaping this reward will take years.

India continues to make the right noises around reform. There were more promises announced in the budget to clean up the banking sector and divest from two state banks. It remains to be seen if these are fulfilled, but these actions would improve the medium term growth outlook by helping to provide the credit necessary to lift private investment.

Overall the announcements in the budget are growth supportive, and alleviate some concerns over the boost to public sector investment in the coming fiscal year. However, the net impact on growth from the reforms announced in the budget and gradual fiscal consolidation will take some years to come through.

How does this impact inflation and the Reserve Bank of India?

Inflation has been persistently high in recent months, constraining the central bank, the Reserve Bank of India (RBI), from cutting rates, which have remained unchanged at 4% since the middle of last year. Against this backdrop, additional public spending ought to add to inflation. However, given the absence of budgetary measures to significantly boost short term growth, the inflation outlook should not change materially either. Inflation should fall from 6.6% in 2020 to 4.6% in 2021 as food prices fall and core inflation softens as the economy recovers and supply constraints ease. In the long run, if the announced measures help to alleviate supply side constraints and raise potential growth, this would act to lower inflation.

The most immediate consideration for the RBI from the budget is the increased government bond issuance. This puts upward pressure on government bond yields and therefore tightens  financial conditions. In its post-budget meeting the RBI left the policy rate unchanged and retained its accommodative stance. The central bank also announced a gradual roll back of the previous 100bps of cuts in the cash reserve ratio – the share of deposits that must be set aside for reserves. The central bank said this would leave room for future liquidity injections but there were no details around specific intervention in Open Market Operations and its US Federal Reserve style Operation Twist programme.

Going forward, the RBI will have to more carefully balance inflation and government borrowing needs. In the coming months, we expect the central bank to provide more liquidity as promised. However as the economy continues to recover later this year and into 2022, the central bank may have to withdraw this liquidity faster than currently expected.

What does this mean for investors?

Equities have reacted well to the budget. There were few measures in the budget to boost short term growth. However, India’s economic recovery is gaining momentum and the absence of tax hikes coupled with the commitment from the RBI to remain accommodative is positive for the corporate earnings outlook. Meanwhile, the spending focus on the supply side of the economy, and promising steps towards financial sector reform, are supportive of medium term growth; and these now rely on execution.

Stepping back, the budget comes at a time when India not only seems to have escaped a second wave of Covid-19, but its vaccination programme is ahead of many of its peers. Putting all this together presents an attractive top-down story for Indian equities, leaving the eye-watering aggregate market valuation the main challenge.

For bond investors, the budget should not add to short term inflation concerns and the RBI will likely provide more liquidity as promised. However, underlying inflation has proved persistent and as the economy continues to recover, the central bank may have to withdraw liquidity faster than currently expected.

In the medium term, India is relying on public spending to boost private sector growth. If this strategy is unsuccessful, higher debt puts pressure on India’s sovereign rating which currently stands just one notch above junk. Credit rating agencies will probably err on the side of caution and give India a pass as it takes positive steps towards fiscal transparency. However, investors should bear in mind that the Modi government does not have a strong track record in its execution of reforms.