India's Budget has no room to delight investors

ANALYST'S VIEW

The Finance Minister Palaniappan Chidambaram will be a genius if his budgetary proposals, to be announced in Parliament tomorrow, do not damage the economy.

The minister is in a tight corner.

The ideal budget at this juncture would be one that gives top priority to fiscal prudence even as it seeks to increase government investments in infrastructure "� such as roads, ports and power stations "� while lowering the burden of indirect taxes on manufacturers.

This is what is required to persuade the monetary authority to gradually lower interest rates without losing its grip on inflation. However, politically, this isn't an option that Chidambaram could even consider.

This will be the fifth and final budget for Prime Minister Manmohan Singh's government before general elections this year or next. That, in itself, presents a big challenge for the finance minister, who will be expected by the ruling Congress Party-led coalition to announce a populist spending plan.

If that wasn't enough, there's the spectre of a generous pay increase for 5.5 million government employees.

The Pay Commission, which recalibrates civil-servant wages every 10 years, will formally submit its report to the government in April.

The state-owned Indian Railways, the country's largest employer, has already given an indication of the large financial allocations that Chidambaram may be forced to make in his budget to fulfill the pay panel's recommendations. It has set aside Rs 50 billion ($1.3 billion) to meet the additional wage bill.

Pay increases
The increase in salaries and pensions of government workers in 1997 cost the federal and state exchequers 1 per cent of gross domestic product annually for more than three years. If that experience is repeated this time around, it would essentially mean surrendering the tax buoyancy that India has recently witnessed. That would be a shame.

There are good reasons to be skeptical that tax collections will continue to be as strong as they have been recently.

With deceleration in external demand and some pullback in domestic consumption, the Indian economy may struggle to maintain the 8.7 per cent pace of expansion expected in the current fiscal year ending March 31; that, in turn, is slower than 9.6 per cent growth in GDP a year earlier.

Fiscal slippage
If the pace of increase in tax collection moderates, the Pay Commission's generosity may degenerate into fiscal slippage.

A weekly reading of price gains has shown inflation accelerating since early January. The so-called wholesale price index rose 4.35 per cent in the week ended February 9 from a year earlier, a six-month high.

With the government forcing refineries to sell petroleum products in the local market at lower-than-international prices, inflationary expectations in India are still not firmly anchored even though there is tremendous political pressure on the central bank to lower its policy interest rate of 7.75 per cent.

The combination of fiscal adventurism and monetary easing may, in this environment, become a lethal concoction, sparking capital outflows.

Chidambaram will have some room to make a direct attack on inflation if he cuts indirect taxes, especially the excise duties that manufacturers have to pay.

He is unable, however, to seek matching cuts in expenditure.

Limited choices
With elections near, the government has already committed itself to extending a rural job-guarantee programme nationwide, even though audits have shown the project to be a disastrous failure, riddled with inefficiencies and corruption.

There are also media speculations about a big debt waiver to farmers in tomorrow's budget.

If Chidambaram tries to satisfy demands for both lower taxes and higher spending, he may end up missing the government's legal obligation to eliminate the revenue deficit in the year ended March 31, 2009.

The choices before Chidambaram are so limited that if he tries to offer immediate gratification to investors by announcing deep and bold tax cuts, he might end up putting India's longer-term prospects at risk.

The equity market's response to the budget, considered the litmus test of how a finance minister has measured up against expectations, may be quite misleading this year.

With inflation as the No 1 concern, it might be more prudent for investors to watch the yield on 10-year bond.

(The author is a Bloomberg News columnist)