5 key questions Chidambaram must answer in Union Budget 2013

Putting together Budget FY14 will be a tight rope walk for Finance Minister P Chidambaram as domestic growth conditions have deteriorated and are yet to respond to the slew of measures taken by the government to  boost local and foreign investor sentiment.

“The trouble is that while fiscal consolidation is ultimately beneficial for growth and should pave the way for private demand and investment to assume a larger role in the economy there is likely to be a phase of transition where government demand flags but private demand does not rise enough to pick up the slack,” say Abheek Barua, Chief Economist at HDFC  and Shivom Charravarti, HDFC economist.

HDFC has a set of questions that the finance minister needs to answer in presenting a credible budget for FY14.

1.  The budget math: How is a 4.8% fiscal deficit target possible?

With growth slowing down considerably from 6.2% in FY12 to 5.0‐5.2% in FY13, a fiscal deficit of 4.8% of GDP is an aggressive target. For one thing, it implies that much revenue buoyancy is limited.

A broadbased increase in tax rates (both direct and indirect) is most likely off the menu given that private spending is already subdued.

While attempts could be made to improve tax compliance and coverage and push up the tax/GDP ratio from its current level of 10.0% (it has fallen from 12.0% in FY08) through selective tax increases, tax revenue mobilization could still be constrained by subdued growth in FY14. The Finance minister is likely to show a somewhat aggressive tax revenue target for FY14 but there is a limit to how much tax revenues will be able to support the fisc next year.

Hence the  burden of fiscal consolidation is likely to rest on:

1)One-off receipts such as disinvestments and non-tax revenue  receipts from telecom spectrum auctions 2) Expenditure compression. In the case of public spending cuts the government is expected to target a modest increase in plan spending  through a reduction in allocations and better expenditure targeting through a streamlining in centrally sponsored schemes from 147 at present to 59.

2.Is this the best approach to fiscal consolidation?

Expenditure reduction has its pitfalls particularly when it comes in the middle of a severe slowdown. As it impinges on aggregate demand, it makes the task of revenue gathering even more daunting.  This preference for giving capital expenditures the chop is visible currently as the government battles on to reach its target of a fiscal deficit ratio of 5.3 percent of GDP. However, a bulk of expendture cuts have  fallen on capital expenditure in areas such as roads, railways, nuclear power, communications and information technology.

The bottom‐line is that this ‘type’ of expenditure compression could actually exacerbate the short term slowdown and over the medium term compromise the supply side of the economy. The question is: given the pressures to consolidate the fisc, could this be possible?

In HDFC’s opinion, the discussion on fiscal discipline has focused a bit too closely on the headline deficit while the real culprit is really the revenue deficit. They would prefer  the finance minister to commit to a binding target on the revenue deficit

Q.3. What is the likely outlook for domestic growth?

A. Fiscal consolidation and expenditure cuts are likely to weigh on headline growth in the near-term until there is a convincing recovery in private demand. The speed with which this happens in turn is contingent (at least partly) on how the RBI responds to slowing government spending, its knock on effects on private consumption and easing core inflation‐ signs of which are already visible. The evolving macro landscape and fiscal consolidation initiatives by the government are likely to see the RBI cut its repo rate by another 50-75 bps in 2013-14.

However. fiscal consolidation and lending rate cuts do not guarantee a revival in private investment and it is essential that the government’s attempts to iron out policy impediments such as land acquisition hurdles, delay in environmental clearances and raw material shortages gather further traction. It is also imperative that the government step up project awards and execution which has been held back in recent months.

Q4. How credible is the 4.8% of GDP fiscal deficit target?

While the target announced by the government next week could  appear reasonably credible ,risks of slippage remain. In particular an overshoot in the budgeted subsidy bill. While partial deregulation of diesel prices could help bring the FY14 oil subsidy bill lower to Rs 54,000 cr this does not account for arrears worth Rs 40,000 cr. Besides, under‐budgeting is likely for both food and fertilizer subsidies the arrears for which already total Rs 68,000 cr from FY13. The food subsidy bill in particular could see slippage from the implementation of the National Food security bill that is likely to create an additional drag of Rs 20,000-25,000 cr on the fisc.

It is also likely that the subsidy estimates in the budget will account for efficiency gains from an expansion in the coverage of direct cash transfers (the coverage could extend from 21 districts at present to 700 districts and could include major subsidy payouts towards food and fertilizers). It remains to be seen however if these gains actually materialize given that the infrastructure for such an expansion in coverage remains somewhat inadequate at this stage.

Populist spending towards welfare schemes that have seen a cutback in allocations in recent months could actually resurface in H2FY14 closer to the general elections due in May, 2014.

Q.5. What will the budget mean for financial markets ?

Bond market: The 10-yr G-sec has rallied by 38 bps since November, 2012 being supported by efforts by the government to trim the fisc and monetary easing. It is likely that Budget FY14 will reinforce these positives and extend the rally in gilts that is currently underway. The govt may also reduce its reliance on dated securities choosing instead to increase the proportion of funding from other sources such as a larger T‐bill issuance, cash balances and mobilization through small savings.

USD/INR: The Finance Minister could tick all the right boxes for global investors in the annual budget who will respond favorably to a further commitment towards fiscal consolidation that might reduce the prospect of a rating downgrade in the immediate future. Hence, USD/INR pair could move lower but remain within 53.5-55.00.

Data compiled by Treasury economics research team at  HDFC Bank