Budget Review 2013-14

One of the overarching vision in this year’s Union Budget is fiscal prudence. At first glance, Union Budget for FY2013-14 looks unattractive. However, a closer look does reveal that the Finance Minister has indeed walked a tight rope considering the precarious maco-economic scenario we are in. While the government has made resolute efforts to arrest fiscal slippages and announced some bold policy measures in the recent past, growth continues to slow alarmingly; the current account deficit remains unsustainably high; the investment cycle is showing no signs of revival; and inflation, despite some moderation, remains well above RBI’s comfort zone. In fact, the latest GDP figures for Q3 (at 4.5%) is no less than a horror tale. However, one should feel relieved that the budget has not been exceptionally populist. Despite a reasonably sensible budget with stable tax, stock markets were left confused over the retrospective changes suggested in Section 90A of the Income Tax Act relating to existing tax relief to foreign investments from countries having a Double Taxation Avoidance Agreement (DTAA) with India. Following an uproar, it was later clarified that TRC (tax residency certificate) will be accepted as sufficient evidence of residence including investors routing money through Mauritius to claim tax benefits under DTAA. In fact, there is a possibility that the offending sentence “not sufficient “could be dropped altogether when the finance bill is debated in the Parliament.

Finance minister P. Chidambaram’s target of lowering the fiscal deficit to 4.8% of gross domestic product (GDP) in the next financial year is based on assumptions of robust growth in tax receipts and compression of the subsidy Bill, but experts are a little apprehensive about his arithmetic calculations, since the calculation is based on the premise that large money could be raised through spectrum auction (which looks difficult) and divestment. He should be applauded for containing the fiscal deficit for the current year to 5.2% of GDP, a tad lower than his own revised target of 5.3%. He achieved this reduction by brutally cutting plan expenditure meant for developmental projects by Rs.91,838 crore. Finance minister however failed to curb non-plan expenditure, which includes defence expenditure, interest payments and salaries, which rose by Rs.31,738 crore and thus received some kudos from comrades. Despite his valiant efforts, Revenue deficit, or the difference between current expenditure and current receipts, as a portion of GDP has actually risen in 2012-13 to 3.9% from the budget estimate of 3.4%. In 2013-14, Chidambaram is targeting a revenue deficit of 3.3% of GDP.

Although, there has not been significant populist measure to jeopardize Govt.’s fiscal consolidation plans but equally impressive is the political salience of the budget. Chidambaram passed over on the chance to spend his way to the next general election in this budget, like he did in 2009 with the Rs.60,000-70,000 crore farm loan waiver probably because of the weak economy, which would otherwise have crumbled out of the populist measures. Yet, he managed to appeal to the Congress party’s traditional constituencies—poor, minorities, scheduled castes and scheduled tribes—by leaving spending on them untouched, and also appealed to the party’s emerging constituencies such as young people and women.

            Where the FM intend to keep squeezing?          Where has the FM increased spending?

Finance Minister also expressed his serious concerns over burgeoning current account deficit and placed it at a higher priority than fiscal deficit. He was also critical of the declining savings and investment rate in the country. The announcement of an additional investment allowance of 15% for capex of Rs 1billion or more during FY14-15 for the corporate sector is a major boost to them. To boost the infrastructure sector, funds have been created but just the 2 years window is a extreamly impractical capex phase & FM should consider it extending to 5 years for getting any serious capex commitment from India Inc. However, a lot remains to be done on the reforms front to carry on the show. On the personal income tax front, there have been no change in tax slabs and at the same time tax credit of Rs 2000 will be distributed between income slab of Rs 2-5 lakh. At the same time he could have done a little more on this front considering “aam admi” is under the brunt of heavy inflation. Taxing the super rich (income over Rs 1 crore) with a 10% surcharge can again be considered a prudent decision. There are 35 million total tax payers and roughly 42,800 tax payers who are super rich. Thus, it is almost clear that in a country with population of 122 crore, the tax network is very thinly penetrated and there is rampant practice of tax evasion. More clarity on GST and DTC is however still required and implementation of it seems to be a herculean task in the near future.

                                                        

                                               Freezing social-sector spending?

Overall, given the limitations, there were very few steps that the Finance Minister could have taken to impress each and everyone. In fact, the theme of the budget was “responsible” and the minister has lived upto the expectations. But more could have been done because the current Finance Minister understands the economy much better in any given condition. It is prudent to see fiscal prudence even on announcing populist measure such as food security bill or allocation funds to MGNREGS programmes. The planned expenditure has budgeted to grow 29% while the revenue receipts have been budgeted to grow 21%. The figures look optimistic, considering that much has not been done to boost tax revenues while maintaining expenditure to GDP at almost constant levels. The fiscal deficit for the current year has been restrained at 5.2% but it has been largely done by scaling down the planned expenditure in the last half of the fiscal year. However, with the election drawing near Government finances may come under strain and pressure to boost government expenditure will mount. Thus, there’s every chance that Finance Minister’ planned expenditure might go haywire for FY13-14 and stance on fiscal consolidation and prudence will be really tested then. Besides, the subsidies (fuels, fertilizers and food) have been pegged lower by 11% at Rs 220,971 crore with oil subsidies projected at Rs 65,000 crore for 2013-14 against the revised estimate of Rs 96,880 crore in 2012-13 fiscal. However, these optimistic calculations largely depend on the partial decontrol of diesel and under-recoveries which again depends the global crude oil prices. Further, Govt. also expects to garner around Rs 56,000 crore in total from divestment and ~Rs 40,000 crore from telecom auctions, which are very optimistic projections and doesn’t look practical to materialize. These are the potential risks which might throw Mr. Chidambaram’s fiscal consolidation plan out of the blocks. However, given the latest GDP figures, we can only rely on RBI that the easing of the interest rates will continue and be more aggressive in the coming quarters.

                                                       BUDGET STATISTICS

                       

Disconnect between Equity markets and GDP growth

"till the time perception doesn't changes into a consensus the rally will keep building up year over year amid bumpy rides. And a phase comes when macro economic data catches up and starts justifying the prices and convinces even the dumbest person on earth that the economy is on a strong footing, as a result of which retail participation starts increasing and volumes starts gaining traction. And a strong indicator of a perception building into consensus is the newspaper headlines and electronic media making bullish commentary and thereby sucking in more retail and hot money. A herd mentality starts building up and thereafter we know the consequences! At first it will just be a trickle. Then the trickle will become a stream. Eventually, the stream will become a river and finally a flood. These all phenomenon takes its own sweet time to fructify, probably a couple of years till we reach the climatic stage. What I am trying to highlight is the fact that rally in equity market is build up on behavioral finance and expectations and later on fundamentals. Economic indicators are a poor tool and a distinct lag indicator to judge the direction of the market and there has always been a stark disconnect between the equity market and the GDP growth."

We are at an interesting crossroad where on one side the bulls justify the unfolding of a major up-trend on optimism of an improving economic outlook despite of bad macro indicators and the bears keep singing the tune of a collapse any time soon as the rally is not supported by strong fundamentals. And if we hear the commentary of both bulls and bears, it’s the negative commentary which will look more convincing. The economic data as it stands now truly reflects the same, not only in India but across the globe. Then despite of it, why the markets are showing a great disconnect from the real economic state? If we read the history of financial markets, we will come to know that the GDP growth rate doesn't have a mindful impact on the equity markets, otherwise Chinese stock market should have been at a multi-year high. Despite of a slowdown, the Chinese economy is growing at a speed which is relatively unmatched in the global context. But the fact remains that China is far below its historical highs in comparison to other emerging market peers like India and developed markets like US to name a few. If the economic indicators have had any meaningful influence on the global equity markets, we should not have seen equity markets world across registering good gains last year. 

If we specifically look at India, it’s amazing to see the market scaling heights at a time when the real GDP is hitting 5.3% growth in September Quarter, which we haven’t seen for a long time. All macroeconomic indicators and others, whether we take current account deficit, fiscal deficit, political instability, scams, interest rates, high inflation, GAAR issue, corporate profitability or capex cycle, its all hitting straight at the face of the equity market and such dire economic conditions should have potentially blown the lights off of any bull rally emerging. But the equity markets choose to behave the other way round. If you start analyzing the equity market, you will find number of easy reasons for why the rally should terminate at this juncture but you will find very few sound and strong reasons for a secular bull market and a new all time high. Yes, of-course the most strong bull case could be concluded by most of the market savvy investors is the fact that liquidity remains extraordinarily strong because of Helicopter Ben’s QE’s or Europe’s LTRO or for that matter latest in the fray is of Japan targeting 2% inflation and stimulating its economy with massive money printing. Domestically, reforms kicked in by the UPA-II have strongly helped in supporting the bull case, but the market started marching much ahead of the reform process. But most Bulls out of experience are being noticed as perennial buyers in any given condition and a different breed who can even justify the worst of economic indicators being factored into the price and hence things to improve. They can even justify with the fact that despite of GDP slowdown, there are companies who can sail through tough times by managing their resources exceptionally in India and downsizing their expenses to generate profit even in tough times. 

But to my mind, it’s the perception and expectation of earning cycle which decides the fate of markets. Expectations usually remain abysmally low at the early stages of a bull market and hence valuation remains historically low at this stage. Otherwise how a market is about to hit a new high despite of all macro variables remaining weak and real GDP growing at a snail’s pace. When you hit the rock bottom, the only way is the up-way. Macro economic factors once worsened will take time to recover and come back growing, but the perception gradually changes with the fact that coming quarters and years could not be as worse as it is today and market starts building gains on expectation despite of bad news floating. Any untoward incidence knocks back the market, but till the time perception doesn't changes into a consensus the rally will keep building up year over year amid bumpy rides. And a phase comes when macro economic data catches up and starts justifying the prices and convinces even the dumbest person on earth that the economy is on a strong footing, as a result of which retail participation starts increasing and volumes starts gaining traction. And a strong indicator of a perception building into consensus is the newspaper headlines and electronic media making bullish commentary and thereby sucking in more retail and hot money. A herd mentality starts building up and thereafter we know the consequences! At first it will just be a trickle. Then the trickle will become a stream. Eventually, the stream will become a river and finally a flood. These all phenomenon takes its own sweet time to fructify, probably a couple of years till we reach the climatic stage. What I am trying to highlight is the fact that rally in equity market is build up on behavioral finance and expectations and later on fundamentals. Economic indicators are a poor tool and a distinct lag indicator to judge the direction of the market and there has always been a stark disconnect between the equity market and the GDP growth.

It is the expectation of the pace of growth in Corporate earnings, which decides the stock prices and the P/E multiples and other valuation metrics. In a bad economic phase like the one we have seen last couple of years, causes low expectations which finally culminates into lower valuations for equity as an asset class. CAGR growth in Sensex EPS from FY-08 to FY-13 (5 years of low growth in earnings) has been at 8% and in comparison to it when the Sensex had stupendous bull market from FY-03 to FY-08 (5 years of earning expansion) the CAGR growth in EPS was at 25% after which the great financial crisis in US punctured the synchronized bull rally in global markets. Growth in earnings is the greatest driver for markets and expectation of it drives the prices higher and expand the P/E multiples to stratospheric heights even before the earnings growth is registered. Sensex CAGR EPS growth during FY-93 to FY-96 was at 45% and thereafter a long dry spell of a CAGR EPS growth of 3% was witnessed from FY-96 to FY-2003 (for almost 7 years).

  

Period	Sensex EPS Growth     (CAGR %)	Sensex Return           (CAGR %)	Average GDP Growth Rate (%)
FY1993-1996	45%	21.5%	6.8%
FY1996-2003	3%	-1.6%	5.3%
FY2003-2008	25%	50.5%	8.9%
FY2008-13E	8%	6.5%	7.3%

Recently, in India, if we try to gauge the sentiment of the market and the participants we will find that though we are at a kissing distance from an all time high, the rally is becoming narrower and there are few stocks which are keeping the Nifty afloat at such high price levels. Retail participation is practically negligible and neither are they convinced enough to put money into equities yet. More to their disenchantment is the fact that virtually most of the midcaps are closer to their all time lows and some of them are even registering newer lows and high quality stocks with sound financial metrics are beyond their reach. Moreover higher inflation is eating into their income and hence allocation to equity remains low at this point in time. They will probably come in once their income level starts rising and market hitting newer highs and most importantly midcaps starts moving with break-neck speed. Low retail participation in the market is generally an indicator of low return expectation from the retail investors and is generally good for the long-term health of an emerging bull market which is low profile at its early stage. 

One striking thing which has been noticed is the fact that top corporate executive of many companies also projects a pessimistic picture at a time when things are already bad and capex building remains cheaper. But most of the companies would probably be coming and committing large projects once the economic data reflects resilience and market is at its top in a few years from now. Very few smart entrepreneurs would be busy building up here…. 

RBI, finally cutting Repo rate by 25 basis points and CRR by 25 bps on back of moderation in growth outlook, inflation peaking off, and consumption demand starting to decelerate. RBI’s Dr Subbarao guided that further monetary easing to happen if Current account deficit abates and inflation moderates. RBI finally is changing its stance to promote growth and anchor inflationary expectations rather than its earlier hawkish stance to fight inflation in isolation. Substantial easing of core inflation suggesting inflation has come off its peak. GDP growth projections have been scaled down to 5.5% from 5.8% projected earlier. Inflation estimates have also been scaled down to 6.8% from 7.5% projected earlier. Non-food manufacturing products prices have eased off but food article prices still remains a sticky issue for households. CRR cut was primarily to enhance banking liquidity to spur credit growth in an otherwise flagging economy. It is clearly evident from the recent action and changing stance of RBI is that it is more reactive to the set of economic data rather than proactive and hence RBI becomes an extremely lag indicator in signaling economic trends. Though elevated interest rates for a longer period has done one good thing to INR is its appreciation in recent months. Higher interest rates leads to foreign funds flocking to Indian shores for higher yields and thereby rupee appreciating on back of foreign fund flows into India. 

Lowering of inflationary expectations along with growth flagging would certainly bring down interest rates and hence spur growth and support earning momentum. Expectations of declining interest rates always improves the earning yield to bond yield ratio and thereby re-rates equity markets as a better place for higher returns compared to fixed income groups.

Paras Bothra

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