'Prudent and Progressive': Why India's New Budget Gets More Cheers Than JeersPublished: March 11, 2010 in India Knowledge@Wharton
The release of the Union budget on February 26 has left many India observers relieved by what Finance Minister Pranab Mukherjee didn't do: He avoided throwing the country's economic recovery off course. The widespread view is that he has handled two major issues -- the fiscal deficit and the withdrawal of stimulus support -- with aplomb.
According to Chanda Kochhar, managing director and CEO of ICICI Bank, the budget for the next fiscal year, which begins on April 1, "presents a balanced approach to long-term economic planning and short-term considerations of sustaining ... the momentum in economic recovery." Meanwhile, Madhabi Puri Buch, managing director and CEO of ICICI Securities, says, "The budget reflects confidence and clarity." Pankaj Razdan, deputy chief executive (financial services) of the Aditya Birla Group, describes the budget as "prudent and progressive." And the weekly business magazine Businessworld called the budget's "rollbacks, reductions and rationalization ... pragmatic and practical."
In presenting three budgets in his role as finance minister between 1982 and 1984, Mukherjee was as populist as they come. Today, his approach is different. "Fiscal policy has to be guided by the required framework for fiscal prudence," Mukherjee said as he unveiled the budget, which reflects a fiscal deficit of 5.5% and targets deficit reductions to 4.8% and 4.1% for the next two years.
"The overall focus of the government on improving its fiscal position and increasing fiscal transparency is highly commendable," ICICI's Kochhar says. "The finance minister has articulated bringing items like oil and fertilizer subsidies, so far considered as off-balance-sheet, into direct fiscal computation." Moving toward better fiscal management and transparency would mean a number of benefits, Kochhar adds, including increasing the efficiency of the economy, improving India's attractiveness as an investment destination and providing the government greater fiscal flexibility if -- or perhaps when -- it has to deal with future economic shocks.
The finance minister has done "a decent job" of reining in the fiscal deficit even though "it is not yet in red-flag territory," says Jitendra Singh, a Wharton management professor.
Wharton management professor Saikat Chaudhuri likes the budget's focus on inflation and agriculture; food inflation surged 17.87% compared with a year earlier in the week ended February 20. What's more, the alignment of political interests in the country's coalition government helped pave the way for otherwise unpalatable measures following the government's stimulus packages introduced during the economic downturn. Although "not as bold as the 1991 budget," which yanked India out of a closed economy, the latest budget may lay the foundation for bolder measures in coming years, Chaudhuri says.
'Boring Bits' Pass the Test
However, it is often the budget's less bold and often "boring bits that matter the most," says Abheek Barua, chief economist at HDFC Bank. That is, "the reams of tedious fiscal arithmetic that go into determining whether the various commitments that the finance minister makes in his budget speech can be easily funded from the exchequer or hinge on some preposterously optimistic assumptions." On this criterion, the budget "fares rather well." While the country loses "some money in reworking the income tax slabs," Finance Minister Mukherjee "more than makes up for it by hiking the excise duty rates, re-imposing customs duties on oil products and bringing more services into the tax net."
If the budget were to unravel, it may be on the gasoline front. Gasoline, diesel and particularly the "poor man's fuels" -- kerosene and cooking gas -- are heavily subsidized in India. Mukherjee's budget restores the duty on gasoline and diesel to 7.5%, which had been reduced to 2.5% as part of the stimulus package. Additionally, there is a new excise duty of 1 rupee per liter of gasoline and diesel.
The entire Opposition walked out of Parliament when the increased fuel duties were announced. The government's allies are restive. Union Railway Minister Mamata Banerjee, leader of the Trinamool Congress, asked Prime Minister Manmohan Singh and Congress President Sonia Gandhi to roll back the fuel-tax hikes. The chief minister of the state of Tamil Nadu, M. Karunanidhi, another key ally, has written to Singh, Mukherjee and Gandhi that "any increase in the price of diesel will have a cascading effect on food prices as well as prices of other essential commodities."
Mukherjee, however, asserts that his budget will contribute to an increase of only 0.41% in the country's Wholesale Price Index. He is sticking to his guns, but political expediency has forced dilutions of duty hikes before. One of Mukherjee's predecessors, Yashwant Sinha, was known as "Rollback Sinha" because he often buckled under political pressure to roll back tax hikes. If the current finance minister becomes a "Rollback Mukherjee," optimism about the budget could be tempered, experts say.
Increasing gasoline taxes "is a tough call," Wharton's Singh says, but he reckons "the time is right" for the partial rollback of the stimulus. "You don't want to stimulate too much demand because that is how inflation goes up." It will be important to see how the gasoline duties play out, he adds, because they are budgeted to bring in US$5.7 billion, which is a significant component of Mukherjee's revenue-raising plans.
Give and Take
Other measures are partial rollbacks of the three stimulus packages announced at the height of the economic crisis. Excise duties have been raised across the board from 10% to 12%. This was not only expected, but also welcomed as a measure of fiscal responsibility.
To critics of Mukherjee's stimulus rollbacks, Wharton's Singh responds: "Keep in mind that we in America would kill to be in the position India is in, to grow at 7% or 7.2%." India has endured the economic downturn with modest impact, and its economy "grew well" in 2007 and 2008, "so let us not worry too much" about stimulus rollbacks, he says.
According to Chaudhuri, increasing duties to pre-stimulus levels "needed to be done" because "the money has to come from somewhere" to finance the budget's simplified and reduced tax structure for individuals and businesses. Yet he wonders whether it could have been done in stages, especially given that the economies of India's big export markets -- the U.S. and Europe -- have not recovered enough to generate much of an increase in domestic consumer confidence. The Indian economy "will have to stimulate sufficient demand internally" to offset some of the slack in the West, he predicts.
Mukherjee has maintained relief for some sectors. For example, the service tax stays at 10%, compared with a pre-stimulus level of 12%. But he is bringing other services, including brand promotion and some health services, under the service tax umbrella, which is estimated to net an additional US$650 million over the year.
The debate about whether or how to phase out subsidies isn't resolved easily. "With the skewed income distribution, the budget-makers' challenge will constantly be: How do you meet the needs of the many versus prudent policies for the country as whole?" says Wharton's Singh. "This is where subsidies come in. In the long run, they have to be phased out, but you cannot do it overnight, and you need to come up with a migration path, until [the salaries] of lower-income people begin to rise."
Meanwhile, individual income tax rates have been rationalized. Some tax payers will pay a lower rate; no one will pay at a higher rate. The surcharge on corporate tax has been reduced from 10% to 7.5%, though the minimum alternative tax (MAT) has been hiked from 15% to 18% of book profits. Indirect taxes will bring net revenues of US$10 billion for the year, the bulk being from gasoline-related tariffs. All told, the budget calculates a reduction in the country's revenues of US$5.64 billion from direct taxes. "Taking into account the concessions being given in my tax proposals and measures taken to mobilize additional resources, the net revenue gain is estimated to be Rs. 20,500 crore (US$4.4 billion) for the year," according to Mukherjee.
The other big portion of money will come from divestments. According to Mukherjee's calculations, the government should raise an estimated US$5.4 billion in 2009-2010 and US$6.7 billion in the new budget year. Such a large disinvestment target in the forthcoming fiscal year will give investors an opportunity to buy into "good, long-term, high-quality public-sector companies," says Vikram Kotak, chief investment officer at Birla Sun Life Insurance. Aditya Birla's Razdan adds that the revenue estimates from disinvestments "look achievable given that the government has over-delivered in this area this year. We expect strong domestic and [foreign institutional investor] inflow. The latter is likely to cross US$35 billion to US$40 billion this year."
And while the capital markets don't seem to be "at their peak," they are liquid and this is a good time for disinvesting, Wharton's Singh says. "It strengthens the confidence of the public in the capital markets. It's okay if you let the stockholding public make some money. [Also], there will be pressure on better governance as these companies start to go public."
Focusing on the divestment of public-sector companies is well timed, Chaudhuri says, "because the partners in the coalition are more amenable to such moves, and India's capital markets ... are ready." He notes that Mukherjee's US$6.7 billion disinvestment target is not overly ambitious, especially if some of the top public-sector assets, such as Coal India, are divested.
India is addressing foreign direct investment (FDI), too. The government wants to make FDI user-friendly by consolidating regulations and guidelines into one document. "This will enhance the clarity and predictability of our FDI policy to foreign investors," Mukherjee says. He expects foreign investors to bring in big money -- an estimated US$7.6 billion -- thanks to the auction of 3G telecom licenses, which was postponed last year.
Another significant feature of the budget announcement is that the Reserve Bank of India (RBI) will soon issue new banking licenses. Although it remains to be seen whether the RBI will approve licenses for non-banking finance companies, a number of big companies are waiting in the wings. Neeraj Swaroop, regional chief executive (India and South Asia) of Standard Chartered Bank, calls the provision for new licenses "a welcome surprise," particularly in an economy that's expected to grow 7% to 10% over the next few years and will need new banking players to meet growing demand.
'A Source of Joy'
If Mukherjee has his way, India's GDP will grow well beyond current expectations. One of his priorities is to revert quickly to the high-growth path of 9%, then find the means to hit double-digit growth. "The economy stabilized in the first quarter of 2009-2010 itself, when it clocked a GDP growth of 6.1%, as against 5.8% in the fourth quarter of the preceding year," he said in his budget speech. "It registered a strong rebound in the second quarter, when the growth rate rose to 7.9%. With the advance estimates placing the likely growth for 2009-2010 at 7.2%, we are indeed vindicated in our policy stand. The final figure may well turn out to be higher when the third- and fourth-quarter GDP estimates for 2009-2010 become available." He expects growth in the next fiscal year to be 8.5%.
Many things do indeed seem to be going his way. The growth rate in manufacturing in December, for example, was 18.5% -- the highest in two decades. There are also signs of a turnaround in merchandise exports, with growth in November and December after a decline for 12 successive months.
But the budget is, in some respects, a throwback to the past. In an earlier era, newspapers on the day after a budget announcement would publish lists of which products would be more or less expensive, because every budget raised an excise rate here and lowered one there. This year, Mukherjee made toy balloons exempt from central excise. ("Toy balloons are a source of joy to millions of children. To bring a smile to their mothers' faces, I propose to fully exempt them.") He also cut the excise tax on rhodium (which is used for polishing jewelry) from 10% to 2% and slashed customs on magnetrons for microwave ovens from 10% to 5%. And he allotted US$45 million for the restoration of Goa's beaches.
But on or off the beach, not everyone has been left smiling. "As far as the automotive industry is concerned, the budget did not meet the expectations, as the sector is yet to recover fully," says Karl Slym, president and managing director of General Motors India. "We were not expecting any hike in excise duty [or an] imposition of duty on petroleum products." Consumers will be unhappy, too, as automobile prices surely will increase.
Mukherjee's budget has its share of missed opportunities, Wharton's Chaudhuri says. For instance, it avoided raising FDI caps in the insurance and retail sectors, "which could have been done in a calibrated approach." Allowing more FDI in insurance would have directed more funds to Indian infrastructure projects. Meanwhile, increasing FDI in the retail sector could cause "large and widespread displacement," Chaudhuri says, given that home-grown companies such as Birla, Reliance and Future Group have demonstrated that the country "doesn't necessarily need FDI to get quality and scale in the retail industry."
For his part, Ananda Mukerji, managing director and CEO of Firstsource Solutions, a business process outsourcing (BPO) firm, says, "A clear disappointment is the lack of extension of the Software Technology Parks of India (STPI) benefits, given the huge role that midsized IT and BPO companies play in employment generation in the country. This clearly has the risk of reducing India's attraction as a global outsourcing destination." The tax benefits under the country's network of technology parks are available until March 1, 2011. "We would have appreciated more clarity in terms of the extension of tax exemption under STPI," adds Anuj Puri, chairman and country head of Jones Lang LaSalle Meghraj, a global commercial real estate firm.
There are other uncertainties. Barua of HDFC Bank observes: "If indeed the economy continues to recover and private demand for credit picks up, the competition between private borrowers and the government is bound to push up interest rates. Then there is always the risk of some of the projections going a little awry and resulting in a higher deficit than planned." What could make those projection go awry? For one thing, he says, the global investment appetite for India's divestments; for another, the 3G license auction staying on schedule. And perhaps more importantly, the government has to stand firm about pruning subsidies.