The Centre needs to raise borrowing by 0.4% of GDP to fund the corporate tax rate cut. RBI should issue an OMO calendar to comfort the G-SeC market
By Aastha Gudwani & Indranil Sen Gupta
In an unexpected move, the finance minister announced steep cuts in corporate tax rates to support growth. This comes as a follow-up to a slew of other measures that were announced recently, with the same objective. This fiscal push will cost the government $20 bn (0.7% of GDP), and should be apportioned in a 58:42 ratio between the Centre and the states. While the growth impact of this move is likely to come over a period of time, funding it is an immediate task. In our view, if funding this stimulus results in a higher resetting of G-Sec yields, and, thus, lending rates, then the intended push to growth through this move may not fructify in its entirety. We, thus, suggest that a large part of this additional borrowing (by the Centre) can be absorbed through higher OMO purchases by RBI, or using the additional dividend transferred by RBI, or through drawing down the surplus balances the Centre has with RBI, etc. We await the October-March government borrowing calendar to get more clarity.
Finance minister Nirmala Sitharaman’s announcement centred on:
Effective corporate tax rates for existing domestic companies being cut to 25.17% from 34.94%. In effect, the corporate tax rate will be 22% for domestic companies, if they do not avail of any incentive or concession. They will also no longer be liable to pay any minimum alternate tax (MAT).
Corporate tax rate being cut to 17.01% from 29.12% for new domestic companies, which will be incorporated after October 1, 2019. They are required to start production by March 2023.
Companies availing the lowered corporate tax rates after expiry of tax holidays/concessions they avail of now.
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We have always argued for a counter-cyclical fiscal policy. We expect growth to go up by a cumulative 65-200bp over 2-3 years on the corporate tax cut. Most studies place the fiscal multiplier between 0.9-2.5x, depending on the degree of investment.
Experience suggests that there is little point in cutting the fiscal deficit without normalising liquidity. Lower fiscal deficits have recently been offset by liquidity tightening. As a result, crowding out (i.e., fiscal deficit/incremental M3) is actually rising (see graphic).
Also, a higher fiscal deficit can hardly be inflationary given excess capacity. After all, the Centre’s fiscal deficit, at 3.8% of GDP, is still below the medium-term average of 4.5%. Just as importantly, growth drives fiscal deficits, rather than the other way around. High/low growth drives up/down tax collections, and pushes up/down the fiscal deficit.
With the reduction in corporate tax being apportioned between the Centre and states in a 58:42 ratio, as recommended by the Reddy 14th Finance Commission, the former’s fiscal deficit will likely rise by Rs 841 bn/$12bn/0.4% of GDP (see graphic). This will likely be funded by higher borrowing that should show up in the Centre’s October-March borrowing calendar, to be released shortly. States will see a drop of Rs 610 bn/$8.6bn/0.3% of GDP in transfers from the Centre.
This will likely be offset by a drawdown of states’ investments in T-Bills (currently, Rs 950 bn) that will cut down the Centre’s surplus cash balances with RBI (Rs 1,227 bn, as of March 31, 2019).
Another option is to further utilise RBI’s surplus reserves. Former RBI Governor Bimal Jalan recently told the media that RBI’s revaluation reserves can still be transferred to the fisc, if needed. A 20% appreciation cover (till Rs 57/$) will release Rs 1.7 trn/$20+ bn, which could take care of PSU bank capitalisation for 10 years.
In our view, the RBI OMO purchases can play an important role in absorbing a large part of this additional borrowing. RBI will likely have to step up durable liquidity through higher OMO ($30+ bn in FY20, $7.5 bn FYTD), and drawdown of the Centre’s surplus with RBI to clear the G-Sec market. An easy way to comfort the market is to issue an RBI OMO calendar as Governor Shaktikanta Das did in early 2019. Note Rs 1 of RBI liquidity will typically take six months to multiply into Rs 6.8 of money supply. This, in turn, will push up bank liquidity, step up bank demand for G-Secs, and reduce the need for durable liquidity in H2FY21.
The fiscal stimulus has pushed markets to bring down their terminal repo rate expectations. We, on the other hand, expect the RBI MPC to cut 35bp on October 4, with Governor Das characterising the FM’s corporate tax cut as a “bold measure”. The nudge to growth intended via this corporate tax rate cut can be difficult to come by if G-Sec, and, thus, lending rates reset higher (or their downward trajectory is hindered). To avoid such an unintended counterproductive impact, we think the MPC will continue with its easing bias. Our base case has the MPC cutting 35bp on October 4, and 15bp in December, pausing as inflation rises on base effects.
Edited excerpts from BofAML’s
‘How to fund the unexpected fiscal stimulus?’ report (Sept 25, 2019)
Sen Gupta is Chief India economist, & Gudwani is India economist, BofA Merill Lynch. Views are personal