Conclusion: Finance Minister Mukherjee’s budget failed to adequately address the #1 issue facing the Indian economy – inflation. As a result, our bearish stance on Indian equities continues unabated. Further, we don't see India meeting its FY12 deficit reduction target as a likely outcome.
Position: Short Emerging Market Equities via the etf EEM.
Though we tactically covered our short position in Indian equities on 2/24 (for a gain), we still remain quite bearish on them at current prices. India’s SENSEX has rallied +1.1% off its lows on 2/24, driven by a confluence of declining crude oil prices (India imports ~70% of its crude oil needs) and hopeful expectations surrounding the unveiling of the government’s FY12 budget, which took place today.
Regarding the budget specifically, it delivered where quite a few investors were hoping it would – on promoting investment in India’s woeful infrastructure. Highlights include:
- An additional +23% more spending on roads, ports, and power generation capacity;
- The limit for foreign institutional investment in debt issued to finance infrastructure projects quintupled to $25B vs. $5B prior;
- The limit for foreign investment for Indian corporate bonds doubled to $40B vs. $20B prior, with the entire delta reserved for bonds issued by infrastructure companies;
- Domestic individual investors could purchase up to $450 worth of infrastructure bonds and receive tax-free status on the returns for an additional year;
- $330M for investing in clusters of farmland with the intent on increasing lentil, palm oil, and vegetable production;
- Keeping the excise tax at 10%, rather than returning it to its pre-crisis level of 12%;
- $450M in rural infrastructure spending designed to created 4M tons of warehouse capacity used to store food grain (by March 31, 2012);
- To further encourage investment in cold-storage capacity, the budget exempts air-conditioning units and refrigeration equipment from the excise duty; and
- Mukherjee plans to incentivize commercial banks to increase lending to India’s farmers by +27%.
For perma-bull BRIC-lovers, this bullish-on-infrastructure budget is full of long-term investment opportunities. For those of us that prefer to manage the risk associated with playing the game that’s in front of us, this budget is a flat-out failure, missing where it matters most – reigning in inflation. This budget does very little in combating India’s massive inflation problem, which now shifts the bulk of the onus of suppressing inflation back towards the central bank (think: policy “hot potato”).
To Mukherjee’s credit, his proposed budget “only” calls for a +3.4% YoY increase in spending, which is down substantially from the +20% YoY increases of India’s more recent budgets. On the flip side, however, these recent budgets reflect heavy countercyclical gov’t spending during and in the wake of the global financial crisis.
The fact that India is unable to retract from such elevated levels of gov’t spending shows that India’s ruling elite may be increasingly unconcerned about the strife of its impoverished populous. The reactions by India’s competing politicians (which certainly need to be taken with a grain of salt) underscore this assertion:
- “This is an anti-people budget. The budget is targeted at a section of the country who are considered to be the cream of the society. No relief measures have been unveiled to provide relief to the common man.” – Left Front Chairman and Communist Party of India-Marxist (CPI-M) politburo member Biman Bose
- “The most important issue that is taking a toll on common man is price [increases]. No measures have been taken to tackle it. Rather they have given attention to indirect taxes. And another thing, no measures have been taken for the minority community of India.” – Forward Bloc leader Hafiz Alam Sairani
- “This budget is for the rich section of the society, not for the poor people.” – Communist Party of India (CPI) leader and state Water Resource Minister Nandogopal Bhattacharjee
Less anecdotally, our analysis of the budget leads us to side with the gentlemen above. The budget is rife with tax hikes and income tax deductions that appear more symbolic than impactful in nature:
- A new service tax will be levied on air-conditioned restaurants that serve alcohol – in addition to the VAT, which is typically 12.5% for food and 20% for alcohol;
- Hotels will levy an additional 5% service tax and all room rates will increase by a minimum of +1,000 ($22) rupees per night;
- A +50 rupees ($1.10) service tax will be levied on domestic airfare and a +250 rupees ($5.50) service tax will be levied on international airfare, with an additional tax for flying business class;
- A 5% tax will be levied against all services provided by air-conditioned hospitals with greater than 25 beds (essentially all major hospitals in every urban area);
- The income tax exemption for individual male taxpayers increased +20,000 rupees ($445) to 180,000 rupees ($4,000). For women, the increase brings their exemption level to 190,000 rupees ($4,220). Calculations by consulting firm Deloitte Haskins & Sells suggests these increases amount to a tax saving of ~$45 per year, which is likely to be consumed by the increases in the effective tax rates on many services broadly; and
- The retirement age drops to 60 from 65 previously and those individuals will maintain tax-exempt status on income less than 250,000 rupees ($5,555). Individuals older than 80 will maintain tax exempt status on incomes up to 500,000 rupees ($11,111). It remains to be seen how many individuals will benefit from this change in tax code.
All told, taxes are going up, which directly equate to higher consumer prices. $112 Brent crude oil and a currency that is down (-1.3%) YTD indirectly contribute to accelerating inflation as well. As we have seen with the RBI’s decision to engage in Quantitative Easing throughout 4Q10 and early 2011, Indian monetary and fiscal policy continue to be managed in a way that disenfranchises the bulk of India’s population (the World Bank estimates that over 75% of Indians live on less than $2 per day).
Perhaps that is why thousands of protesters continue organizing rallies on the nation’s capital – a trend we expect to accelerate as growth decelerates over the next 6-9 months and inflation remains sticky due to corporate COGS increases being passed through to Indian consumers. Perhaps the worst part of the Finance Minister’s budget proposal is that it forecasts growth to accelerate to +9.25% YoY next year, which implies that corporations are likely to be increasingly comfortable passing through price increases to Indian consumers in an environment of robust growth expectations.
Decelerating global growth, heightened interest rates, and accelerating inflation – particularly elevated crude oil prices – all remain headwinds to Indian GDP growth over the intermediate-term TREND. Perhaps that’s why the SENSEX has diverged from both the government’s and sell-side consensus’ lofty growth projections (down -13.1% YTD).