Pranab Mukherjee doesn’t do folksy, he doesn’t do big bangs or dream Budgets either. Mercifully, he seems to do prudence, a virtue that warrants a premium these days when governments around the world grapple with the aftermath of the fiscal excesses of stimulus. Thus, despite the obvious negatives in the Budget (higher excise duties and MAT rates), industry and the stock-market seem to have reacted positively to the Budget’s plans for fiscal consolidation.
However, one has to look at the bond market’s reaction to figure what the Budget perhaps failed to address and what could well emerge as the biggest economic problem this year. In one of the briefest rallies in its history, government bond prices went up (yields went down) in response to the net borrowing figure in the Budget — that at about Rs 345,000 crore was a bit lower than the consensus expectation — but as the petrol price hike was announced in the afternoon, prices went down again on concerns of rising inflation.
I would argue that the bond market did not react merely to the isolated event of petrol price increase. There is a sense in the fixed-income markets that fiscal policy is a tad too soft on inflation in its quest to ensure growth momentum. Thus, the onus falls almost entirely on monetary policy to tame inflation and this could mean very sharp increases in interest rates in the medium term. That’s bad for the bond markets in particular and for borrowers in general.
Whether the Budget can or should address the inflation issue remains an open question. There are some who believe that the finance ministry should stick to its knitting and focus solely on fiscal matters. But surely the country’s key fiscal document cannot ignore an important variable like the price level. If its analytical apparatus appears to be completely unrealistic about its take on inflation prospects, then there’s a problem. Take the basic macroeconomic assumption of the Budget, that of 12.5 per cent growth in nominal GDP. That works out to roughly 4 per cent inflation over 2010-11, a number that even the most dovish forecaster would claim is extremely optimistic. The finance ministry’s optimism is perhaps underpinned by the fact that it still sees inflation as what the Economic Survey terms “skewflation”, sharp increases in just about four commodities due to gross mismanagement of supply. The assumption seems to be that once these supply problems are sorted, inflation will abate.
That, in a trivial sense, might well be true. If supply conditions do improve, inflation might just climb down from the double-digit level it threatens to touch in March 2010. But supply-driven inflation is only part of the problem. A trickier, more stubborn form of inflation associated with a rising business cycle threatens to be the main problem this year. Rising growth rates have sowed the seeds of rising “core” inflation, driven by growing demand rather than supply bottlenecks. Core inflation perked up in December (RBI chose to comment on this in its monetary policy review) and hardened further in January.
Anecdotal evidence suggests companies in a number of sectors (FMCG for one) are on the verge of hiking prices sharply. Almost all industry surveys show a massive increase in capacity utilisation over the past few quarters. Add to this the increase in excise duties that companies will invariably pass on to their consumers and this could drive a spurt in core inflation in March. In an environment where better demand conditions, rather than supply bottlenecks, are likely to drive prices up, the wisdom of increasing disposable income by cutting income-tax rates for the lower tiers of the tax-paying segment seems a little suspect. There is no free lunch in economics — efforts to try and soften the blow of fiscal consolidation are likely to manifest as other costs.
The Economic Survey advises close vigil on private investment spending that still remains relatively weak. I would argue that macroeconomic conditions in 2010 would create a bias against private investment. The tax cuts might well prop consumption demand further but the heft of government borrowings, rising inflation expectations and tighter monetary policy are bound to mean higher borrowing costs for firms and that could impinge on investments. Global risk appetite is and could remain weak as long as risks like sovereign default continue to loom — thus the recourse to external borrowings might be limited.
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Stock-markets tend to fret less about inflation. In fact, they like a little increase in inflation since it means better pricing power for companies and better bottom lines. Thus the Sensex and the Nifty might just break out of the doldrums that they’ve been stuck in. But it is unlikely to be long before someone begins fretting about the overhang of Rs 40,000 crore of fresh supply of government paper. A fiscal strategy that is so dependent on divestments is taking a massive bet on international fund flows. If they fail to materialise, the steady flow of stocks from government companies will hurt both the secondary market and public offers by private companies through a kind of “crowding out” in equity markets. Since PSU stocks are in general considered to be of better quality, the worst-hit could be small and medium companies (whose equity typically has a worse risk profile) looking to raise capital. As I said earlier, 2010 is unlikely to be a great year for private capex.
What happens if global risk appetite does improve? To cut a long story short, investors will sell dollars and buy riskier assets and that includes crude oil. Finance Minister Pranab Mukherjee has budgeted just Rs 3,108 crore as petroleum subsidies for 2010-11 compared to Rs 14,954 crore last year. If oil prices breach the $75-80 range and keep moving up, petrol subsidies will have to increase even with a couple of hikes in product prices. So, either he will have to bite the bullet and follow Dr Parikh’s prescription to a tee, or take on a larger subsidy bill and let his deficit targets slip. Catch 22, Mr Mukherjee?
The author is Chief Economist, HDFC Bank. The views expressed are personal