Central government has sprung to action post state election debacle. The reform process which was slowing down a bit before the polls has suddenly got a booster dose. A number of executive actions have been taken to allow easy access to invest in various sectors in the economy, streamline processes and fine tune rules and regulations to augment investments in infrastructure projects, announcing the draft of the new petroleum exploration policy and last but not the least, Centre offered an effective plan to state governments to tackle the woes of their power sector.
All these in totality are steps which can improve the competitiveness of the Indian economy over the longer horizon. Can it fix the immediate pain of economic slowdown? We do not think so.
A lot has been done by the new government in matters relating to opening up of the economy and allowing private enterprises a bigger share of the economy. However, a lot also needs to be done. We believe as a matter of priority the eight areas we can see more actions in the coming months and quarters are: 1) Land 2) Labour 3) Capital Markets 4) Environment 5) Energy and electricity 6) Tax system 7) Education and Skill development 8) Digitisation.
As far as tax reforms go, we expect the government to simplify the direct tax regime by doing away with most of the exemptions and reducing the tax rates. A simple tax structure with low tax rates can improve tax compliance.
Already the Finance Ministry has sounded out that corporate taxes would be reduced as well as exemptions will be phased out to make Indian tax regime competitive with the world standards. We also expect a similar move in the personal taxes as well. However, we need to understand that lower taxes cannot happen in isolation, they need to happen alongside the idea of a small government. The smaller the government’s share of expenditure in the economic activity, the lower the rates of taxes can be. So, if we believe in a lower tax regime we need to accept the fact that government has to significantly reduce its size of expenditure. Therefore, we believe the tax reforms in India will take time, as both the levers cannot be altered overnight.
With the winter session a couple of weeks away, we hope that Government is able to strike bonhomie with the regional parties and get legislative agenda going. Obstructive politics is detrimental to the Indian economy. GST Bill needs to be passed by both the houses and once it is done it can be a first step towards remodeling of the Indian indirect tax regime, which contributed half of the revenue receipts of the central government. There is a risk that Parliament session can be stalled, which if it happens, can slow down the legislative agenda quite a bit. This fear of a stalled Parliament session is weighing on the rupee, which has not been able to recover as much as other EM currencies have against the US dollar.
Rupee is also getting capped by the relentless sovereign intervention, as central bank is not keen on having an overly strong currency. In fact, in a recent report from Assocham, the main reasons for decline in exports during the recent months of 2015-16 are – (i) slower growth in world output and trade; (ii) appreciation of rupee against Euro making exports to Europe, which is a major market for India less competitive for Indian exporters; and (iii) steep fall in the prices of petroleum crude resulting in consequent decline in prices as well as export realizations for petroleum products. Assocham study has revealed that India’s export competitiveness has been eroded because of the steady real appreciation of rupee. Therefore they asked for a regime of inflation control (which is already underway) and 10% drop in the nominal value of the rupee. However, we do not believe the central bank governor shares the similar urgency of a sharp and quick drop in rupee value, as that, he believes, can upset inflation management and also augment financial risks. Therefore, we expect a continued effort to devalue the rupee in a slow and steady manner towards 67.00/68.00 levels over the next 5/6 months.
Trade deficit in October narrowed to USD 9.8 bn from USD 10.5 bn in September. October exports growth continued to remain deep in the red, printing (-)17.53% yoy against (-)24.3% in September. Total imports contracted further by 21.2% yoy to USD 31.1 bn in October against (-)25.4% (USD 32.3) in September. Cumulatively, export growth remains at (-)17.6% for the April-October FY2016 period. Cumulatively, import growth remains at (-)15.2% for the April-October FY2016 period. The contraction in the non-oil, non-gold imports (core imports) moderated, registering (-) 0.8%yoy from 5.4% in September, reflecting some traction in the domestic economic recovery.
Therefore, while the sluggish export and import momentum continues to point to the underlying weakness in global and domestic demand, core import growth shows some nascent signs of pickup, primarily in capital goods imports. Also, non-oil export growth remains supported by drugs and pharmaceuticals, textiles and electronics.
In order to provide some support to the MSME exporters, government has announced an interest rate subvention scheme of 3%. However, we do not believe it can dramatically alter the trajectory of exports. Indian exporters face high cost due to bureaucratic delays and higher turnaround time at ports. The cost of shipping goods from Indian ports is believed to be significantly higher than from ports of other countries in Asia. At the same time, even after considering for the interest rate subvention of 300 bps, cost of capital for the MSMEs would not be as competitive as their counter-parts in Asia and other EMs, who can access financing at mid-single digit rates.
In other news for the economy, we saw seventh pay commission submit the report. They have recommended a near 24% hike in compensation for government employees. We expect the government to accept the recommendation of the pay commission and as result we can expect an adverse impact on government starting next calendar year. This is not an one off impact, it will permanently increase the expenditure of the central government by 1.2-1.3 lakh crore rupees or 6-8% of total budgeted expenditure for FY15. It is estimated that it can add between 0.5-0.7% to the gross fiscal deficit of the central government. A similar impact can also be seen on state exchequer as state governments too enact their own version of pay revisions in sync with the revisions done to central government employees. Next year is going to be challenging for the government fiscal situation. Central Government had guided towards 3.5% GFD for FY17 and 3% for FY18. With higher expenditure on wage bill and then greater need to provide for recapitalization of PSU banks, government will find it extremely difficult to stick with the GFD target. This may cause some tough talk from rating agencies but we do not believe it may lead to any ratings action. However there is a positive impact of the same policy on the economy.
A look at the last few pay commissions suggests that the once-in-a decade pay commission tends to boost consumer discretionary demand. We can expect a positive impact on consumption sectors like automobiles, clothing, footwear, white goods and expenditure on services. At the same time, it has been seen in the past, especially after the 6th Pay Commission, that household savings in physical assets, viz., gold and real estate, tend to increase. However, we do not think it will be the case this time, as both the assets are undergoing a multi-year price decline, unlike 2009-10, when they were handsomely beating financial assets in ROI. All in all, Indian economic engine gets some boost, as it had been dragged by weak exports, low private capex, weak rural demand and floundering real estate market. The combination of higher capital expenditure from government, investment in the services economy and higher consumption demand from urban consumers is trying to counter the gravitational pull of the economic slowdown.
Over the near term, we expect Indian rupee to trade within a narrow band of 65.60/80 and 66.50/60, with RBI and global trajectory of US Dollar supporting the Greenback below 66.00 levels. Indian 10 year government bond is expected to find buyers on decline towards 7.70/7.75% zone on yields. At the same time, Indian Rupee can remain range bound against the Pound and the Yen and stronger against the Euro.