The constant dilemma of any Finance Minister during the Union Budget, is how to balance the conflicting requirement of persistent demands for higher resources from all sectors of economy and government (including the ruling party), while keeping the fiscal health of the economy in mind. The Budget is a test for the Finance Minister to balance economic necessities, while managing political sensibilities. The choices the FM makes in the upcoming Union Budget are especially pertinent with the backdrop of the current shift in the global political economy, with the rising trend of protectionism and de-globalization, even as the domestic growth outlook continues to remain weak.
Fiscal consolidation likely to be deferred: Given the muted growth outlook, relatively comfortable position of domestic macro-stability parameters (inflation, CAD, Fiscal deficit), and the political and economic fallout of de-monetization, the government is widely expected to provide a greater emphasis on growth in the upcoming Budget. The most likely course of action would be to keep fiscal deficit targets for FY18 unchanged from FY17, at 3.5% of GDP, compared to the consolidation road-map target of 3%.
Should the government take the route of a fiscal boost, it will likely be through a combination of higher spending in the rural/social sector schemes and tax cuts. Key areas likely to see increase in allocations include health, housing, rural roads, irrigation and MGNREGA. We note that there has been some decline in social spending as a percentage of GDP in the last few years and the upcoming budget is expected to revere that. Moreover, creation of a robust social security net though pension/insurance, and higher credit disbursal to SMEs and weaker sections is likely to remain in focus.
Domestic growth outlook remains muted: While in official growth estimates, India still maintains the tag of the fastest growing major economy, real macro indicators present a more somber picture. Real economic indicators like IIP, exports, imports and credit growth pointes to anemic growth. GFCF has been contracting for three consecutive quarters and the recent de-monetization has further soured sentiments with IMF downgrading India’s growth outlook by a full percentage point.
Moreover, global outlook is not encouraging and is likely to spill over through both trade and capital flow channels. Post GFCF, global growth recovery has been anemic and trade growth is even lower. Rising US bond yields increases the global risk free rate, raising the bar for investment into EM markets. The rising trend in protectionism can negatively impact Indian exports. Moreover, the bonanza of low commodity prices is likely to fade.
Currency stability amidst FII pull-out will be challenging: While one may justify some deferment of the fiscal consolidation road-map to address the current slowdown, the government needs to be aware of the risks. At a time when foreign investors are putting money back to US, any major fiscal slippage can have a negative impact on the INR trajectory, especially at a time when US growth prospects are looking bright and US yields are rising. FIIs have been consistently selling in both the equity and fixed income markets since November 8, with the net outflow of USD $ 6.2 bn (~INR 42,000 crores) in debt market and USD $ 4.2 bn (~INR 28,000 crores) in equity market (as on 23 January). The government has an extremely thin line to tread to ensure that INR continues to remain one of the most stable outperforming currencies amongst emerging market peers, as it has been in the last three years.
Besides the impact of the budget, we have a depreciating bias on INR and expect it to move lower, due to the following three factors:
Rupee outperformance over last three years (both relative and absolute): INR has been one of the best performing EM currencies in the last few years, resulting in significant outperformance of ~15% against EM basket and ~12% in REER terms in the last three years. This outperformance has largely been due to strong capital inflows in the euphoria post 2014 elections, sharp fall in commodity prices and improvement in India’s macro-stability indicators through painful repair of balance sheet. With little justification of this sharp REER outperformance in terms of productivity gains, tempering of investor optimism towards India and rise in commodity price, the outperformance is likely to reverse.
Moreover, the relative appreciation is taking a toll through weak exports performance with India underperforming in an already dismal global export scenario. With merchandise and services exports constituting nearly a quarter of India’s GDP and domestic growth scenario anyway looking bleak, there is likely to be greater clamor for a weaker INR among industry, and greater tolerance among policymakers for a weaker INR.
Headwinds on both current account and capital account front: BoP position is expected to be less benign in 2017 on account of headwinds to both current and capital account. On the current account front, we expect trade deficit to widen on the back of a rise in oil and gold imports. On the other hand, the outlook on both merchandise and services exports continue to look tough with an emerging global trend towards protectionism and prospects of likely competitive currency depreciation.
On the capital account front, we expect the fund flows environment to be less benign in 2017 amidst rising trend towards de-globalization and expected continuation of fund flows towards US. Rising US bond yields, rising USD, booming US stock market and bullish sentiments about US growth, augur ill for capital allocation towards EMs. While we expect India to be less impacted amongst EM economies, it will nevertheless not be left unscathed. Further, India also faces prospects of declining yield differential, which is likely to negatively impact fixed income flows.
China factor: We believe that the Chinese economy and particularly the emerging US-China relationship is likely to emerge as a key global risk. India runs a large trade deficit with China, and the likely depreciation in CNY will further exacerbate the lop-sided trade. Moreover, disorderly movement in CNY and Chinese markets also has a bearing on global markets and EMs in particular; thereby further exacerbating pressure on INR.
(This article is authored by Bhupesh Bameta, Head of Research, Edelweiss Forex & Rates)