India’s finance minister, Palaniappan Chidambaram, is known to be a little enigmatic; his real message sometimes appears in the fine print or between the lines. The country’s Union Budget 2008, unveiled in Parliament on February 29, is apparently a collection of freebies with the forthcoming general elections in mind. But if you look closer, it changes shape.

The proclaimed focus of Budget 2008 is farmers, taxpayers and voters. “This is a 100% political budget,” said former finance minister Yashwant Sinha in a press conference recently. “The budget document should not be treated as a political manifesto.” His view — and that of many others — is that the budget could signal early elections. These are supposed to be held in May 2009, but it is widely expected that the date could be advanced by several months.

“The budget is a fine economic and political balancing act with emphasis on continued growth and moderate inflation,” notes K. Ramakrishnan, executive director of the Chennai-based investment bank Spark Capital Advisors, in a statement. According to Amit Mitra, general secretary of the Federation of Indian Chambers of Commerce and Industry (FICCI), “The budget is good for long-term sustainable growth.”

The main highlight of this Budget is the Rs. 600 billion ($14.8 billion) waiver of farm loans. The other major feature is the range of concessions to individual taxpayers. “The finance minister has passed on the benefits of high growth rates by providing direct relief to the needy through the agricultural debt waiver,” says Nandan Chakraborty, head of research at investment advisors and brokerage house Enam Securities. “He has put more money into people’s pockets (through the tax relief), and this should increase consumption. This budget is about inclusive growth.”

Surprise, Surprise

If international investors were looking for incentives, the budget must have come as something of a disappointment. Budget 2008 does little to encourage foreign investment — possibly because these investments have been pouring into India. For global investors, there was actually a small shock in store. Early in his speech, the minister indicated that capital inflows posed a challenge. “In the short term, it is our responsibility to manage the flows more actively,” he said. “(The) government will, in consultation with the RBI (Reserve Bank of India), continue to monitor the situation closely and take such temporary measures as may be necessary to moderate the capital flows consistent with the objective of monetary and financial stability.”

The “temporary measures” were not spelled out, but Chidambaram’s remarks brought back memories of October last year when the stock market watchdog, the Securities & Exchange Board of India (SEBI), announced a ban on participatory-notes (p-notes). These are instruments used by foreign funds, not registered in India, for trading in the domestic market.

SEBI had a twofold objective: first, to moderate capital flows and, second, to keep a watchful eye on foreign investors. Over the years, the use of p-notes had increased from Rs 671 billion ($17 billion) — representing some 25.7% of the cumulative net investments in equities by foreign institutional investors (FIIs) at the end of June 2005 — to Rs 353,000 crore ($88 billion), or 51.4%, by August 2007.

The SEBI move sparked a market collapse, the indexes began to head south, and trading had to be suspended. The markets recovered only after the finance minister clarified that he did not intend to impose an overnight ban; the p-notes were to be phased out over 18 months.

No one wants a repeat of that crash, particularly now that the Indian markets are extremely jittery because of the global economic situation. But, to the credit of SEBI, it must be said that it has speeded up its clearance of new FIIs. In January, the world’s largest hedge fund — Manhattan-based Renaissance Technologies, which manages assets worth $35.4 billion — got SEBI’s approval as an FII. This followed approvals for investment firms such as D.E. Shaw ($29 billion) and Och-Ziff Capital Management ($28.6 billion).

India has a problem of plenty on the foreign exchange front. As Chidambaram noted in his budget speech, “In the period April-December 2007, foreign direct investment (FDI) was $12.7 billion and foreign institutional investment $18 billion.” This has resulted in a 12%-plus appreciation of the rupee against the dollar, hurting exporters and stoking inflation. The “temporary measures” for damage control could well end up damaging the FIIs.

Understanding these fears, Chidambaram immediately embarked on a different damage control exercise. He assuaged the trepidations of U.S. investors during a videoconference. “We have several kinds of inflows,” he said. “We have FDI, we have remittances, we have tourist earnings, we have FIIs, we have private venture capital. We are not singling out anyone. We have not singled out anyone in the (budget) speech.”

Happy Times

The FIIs actually have reasons to be happy with the budget. Many of them are registered in countries like Mauritius and Singapore, with whom India has double-taxation avoidance treaties. Chidambaram has increased the short-term capital gains tax on shares from 10% to 15%. While this will impact local traders, the FIIs registered in tax-friendly countries are not affected.

There’s more. For a long time now, opinion has been building that the Mauritius and Singapore registered FIIs should also be brought into the capital gains tax loop. Indian investors have argued that the short-term capital gains tax — which they have to pay if they hold equities for less than a year — creates an uneven playing field. But Chidambaram has ignored their representations. “Against the general apprehension of taxing FIIs coming through the Mauritius route, the finance minister has maintained status quo, which is a great relief to market sentiment,” says Sunil Godhwani, CEO of Religare Enterprises, an integrated financial services provider.

If FIIs can heave a sigh of relief because of Chidambaram’s inaction, the situation is somewhat similar on the FDI front. No one really expected much; foreign capital is anathema to the Leftists, on whose support this government depends. There were no announcements of new sectors being thrown open to foreign investment, or the enhancement of limits in those already open to FDI. But, then, these do not have to be part of the budget.

“Life was indeed simple when we banned FDI, when we closed the door to FDI,” Chidambaram told business channel CNBC-TV18, after the budget. “The point is, we had a closed-door regime. We are opening the doors and the windows. We are opening [them] as fast as we can. But there are problems. There are political objections; there are domestic sensitivities. There is a need to protect domestic industry. So, when we open some doors, we cannot open them fully. When we open some windows, we have to open them partially.”

Chidambaram did offer some incentives to Indian investors. More central public sector enterprises (CPSEs) would be listed, he said, adding that “44 CPSEs are listed today. It is the policy of the government to list more CPSEs in order to unlock their true value and improve corporate governance.” In a post-budget interview with The Economic Times, Prime Minister Manmohan Singh stated: “We want to move forward on this more aggressively.” There may be an unstated reason: The proceeds of the this privatization initiative could help pay for the farm loan writeoffs.

One gray area does exist for foreign investors — the capital gains tax on cross-border mergers and acquisitions. The fine print of the budget seems to indicate that the capital gains tax may be made applicable when the underlying asset is in India, though the sale is between two overseas entities.

Consider an example. Last year Britain-based Vodafone bought 52% of Indian telecom services provider Hutchison Essar from the Hong Kong-based Hutchison for $11.1 billion. Such transactions could now be subject to tax, with the buyer being responsible for deducting tax at source. The provision is being made applicable retrospectively from June 2002, which means others could get into the net, too. Among them are the Oracle purchase of i-flex ($1 billion) and the $900 million buyout of software company Flextronics by KKR, an affiliate of the U.S.-based private equity firm Kohlberg Kravis Roberts. Vodafone, against whom the tax demand had been made earlier, is now fighting the issue in court.

Winners and Losers

Following Chidambaram’s presentation of the budget last week, several firms have released statements mentioning industries that stand to gain or lose. Brokerage firm Prabhudas Lilladher is positive on automobiles (excise on small cars has been reduced), aviation, capital goods, fast moving consumer goods, media, pharmaceuticals and textiles. It is negative on cement and financial services (increase in capital gains tax). Emkay Share and Stock Brokers are negative on cement and IT (tax concessions have not been extended beyond 2009).

Emkay is negative also on public sector banks. (“The [farm debt] waiver amounts to 4% of total bank loans.”) Prabhudas Lilladher, on the other hand, is positive. (“The government is likely to reimburse the banks over a period of three years.”). These differences reveal that confusion and controversy continue to dog the  big-ticket item of the 2008 budget. Defending the $14.8 billion farm loans writeoff, Chidambaram said in his speech that “(the) government estimates that about 30 million small and marginal farmers and about 10 million other farmers will benefit.” He added that the total value of overdue loans being written off was Rs 500 billion ($12.4 billion) while the remaining $2.4 billion represented a one-time waiver of overdue loans.

The confusion arises because the budget says nothing about the source of this money — and Chidambaram has so far been unwilling to spell out where it will come from. “You will have to be patient,” he told journalists who asked about details after the budget. “Allow us some intelligence that we have done our homework.”

Analysts say one extreme view is that the banks will be left holding the bag; many of the loans are anyway classified as non-performing assets (NPAs). This will hit their bottom lines. Another view is that government will find a way to finance these write-offs — perhaps through bonds as is done with oil companies and fertilizer manufacturers. A mix of bonds and cash — the most likely solution — will help clean up bank balance sheets.

While applauding the social significance of helping indebted farmers, many observers have expressed growing concerns about the financial implications of the farm debt waiver. Bankers feel the amount could grow to $20 billion. The other problem is the moral hazard, or the risk that the existence of such safety nets could worsen the problem in the future. “A complete waiver vitiates the lending climate and does damage to farm loan discipline,” says an editorial in The Economic Times. “It penalizes borrowers who have honored their loan commitments and creates a moral hazard since farmer-borrowers are likely to assume future dues will also be written off.”

In addition to the agricultural debt write-off, the budget is unclear about how some other “expenses” will be funded. The first is the oil and fertilizer bonds. These are instruments issued to companies to compensate them for selling fuel and fertilizers at subsidized prices. But, in fairness to Chidambaram, no finance minister so far has added this bill to the budget finances. The second is the cost for pay increases for central government employees. The Sixth Pay Commission report is due by the end of March. It is estimated that this will add another Rs 20,000 crore ($5 billion) to the government’s expenses. Global credit rating agency Standard and Poor’s (S&P) has warned that India’s credit rating may be lowered after the pay panel report. “The primary threat to India’s fiscal consolidation efforts stems from the Sixth Pay Commission,” says S&P in a statement. Chidambaram, however, has said he is confident that higher revenues will take care of this additional expense.

Despite these concerns over the budget, most people are reassured by India’s booming economy, which has few peers among emerging markets. While the GDP growth rate has slowed marginally it’s much higher than most countries. “Our batting average is 8.8%,” says Chidambaram.