What the markets want

PRE-BUDGET SPECIAL

'Sexy' is not an adjective that you would normally use to describe a Union Budget, but that is what Finance Minister P Chidambaram has promised the public come July 8th.

While the connotations of the word are apparently not causing much titillation for markets - till now at least - the finance minister's aim surely was to lift the sagging spirits of the markets, post the government change and the Common Minimum Programme (CMP), which has been viewed with apprehension regarding its intentions.

But realistically the markets are more worried about what the FM can achieve, keeping in mind the myriad equations of coalition politics, that will determine the Manmohan Singh-led government's future policy. Will Chidambaram be able to conjure up another 'dream budget' like he managed to do in 1997? While a section of the markets does feel that the economic reform process will continue, come what may, there are others who have reservations that the finance minister will be forced to come up with populist measures, which in turn could mean the tough reforms agenda taking a back seat.

While there is no doubt that the FM will be under enormous pressure to present a budget that will please both sides, how much he can achieve is anybody's guess.

There is always the risk that whatever he does will inevitably be compared to the 'dream budget' of 1997. Though much has changed since then, the fact that Chidambaram did given an enormous stimuli to the supply side economics is how he will be judged this time around.

Sure enough the markets gave a thumbs up to many of the path-breaking measures announced that year. This time though, things might just turn about to be a little bit more humdrum. "The low expectations are actually a good thing," says leading Mumbai-based investor Rakesh Jhunjhunwala.

That being the case, there is a fair chance that any positive surprises by way of introduction of innovative measures may work as an antidote to the current somber mood in the markets.

There is another angle to this. The fact that stock markets gave a thumbs down to the new government and has not responded positively to any of their pep talks puts additional burden on the government to announce measure to gain back the confidence of investors, especially foreign institutions.

That gives rise to hopes that there could be specific capital market-related measures. "If measures are not announced that will make a case for foreign investors to stay put in India, they are bound to look at other emerging markets with better valuaitons," warns Nilesh Shah, chief investment officer of Prudential ICICI mutual fund.

At the very least, the finance minister would make the right noises to make the investing community cheer this Budget. How the markets react to these noises is quite another matter though.

CMP sets the tone

Needless to say CMP is going to set the tone of the Budget. Several of its proposed measures points to populist steps, like the changes in labour laws which will protect only workers' interests, subsidies for the "poor and truly needy," and easing burden of high interest on farm loans.

The CMP's call to do away with the privatisation ministry and the review of electricity bill has also been viewed by many as taking a backward step. But an inspection of CMP makes it clear that it is not all darkness.

It plans to boost GDP growth by 7-8 per cent annually over this decade, keep tax rates stable, eliminate federal revenue deficit by 2009, introduce value added tax (VAT) at the earliest and launch special schemes to unearth black money.

It also plans to allow state firms and banks to tap capital markets and importantly, encourage higher FDI in core sectors. Specific to capital markets, the CMP signals include, encouragement to FIIs, stopping misuse of double taxation agreements, reducing the flow of speculative capital, and further strengthening Sebi. There are also indications that the finance minister may review capital gains tax laws concerning foreign institutional investors.

Going green

So much by way of public speak. But realistically what do the markets expect out of the Budget? Not much, it would seem. "Even though the markets are awaiting the Budget for future direction, I don't think people are expecting too much out of the Budget," says Nimish Shah, director and CEO of Mumbai-based investment advisory firm, Parag Parikh Financial Advisory Services.

According to Shah, the lack of enthusiasm stems mainly from the broad policy agenda signals sent out by the government. "The focus this time will be more on the rural sector," says he. "This time the focus of the Budget will be on rural and farm sector development over other sectors," Shah adds.

The finance minister had underlined the importance of agriculture, manufacturing sector and employment shortly after taking office, noting that these three sectors require massive investment. Chidambaram has also assured of promoting both private and public investment in these sectors.

Market watchers note that with the Congress and its allies having rode to electoral success on the back of promised welfare for farmers and weaker sections of society, it is only natural that higher investment allocation is planned for the agriculture sector besides continuation of subsidies for farmers.

A taxing problem

But the so-called populist measures brings us to another vexing question: where does the money come from to finance rural growth? Soaring deficits and decreasing avenues of revenues mean that it will be a tight rope walk for the finance minister.

Experts note that the current fiscal imbalance has more to do with higher interest payments, unsustainable subsidy levels and an increase in pension payments over the last few years. India's combined fiscal deficit (central plus state governments' deficit) is estimated to be 9.6 per cent of GDP in 2004 compared with 6.4 per cent in 1997.

A recent report by JP Morgan, says that poor management of state finances has been the key reason for the recent sharp rise in combined deficit, although the central government has been less profligate in this period.

The report states that the combined deficit at above 9.5 per cent of GDP is close to the levels in the years prior to the 1991 crisis and is one of the highest in the emerging markets. The decline in tax collection rates has also contributed in no small measure to higher revenue deficit.

The increasing deficit has meant that the funds available for public finances is starting to dry up, thus affecting investments in education, health care and infrastructure, etc.

According to analysts, since disinvestment is ruled out, revenue must be raised through more conventional means - read tax rationalisation and the recent hike in fuel prices. "The government can think of making provision for higher revenues by way of volume inducements by lowering taxes and widening the tax base," notes Rajesh Jain, head of research at Mumbai-based Pranav Securities.

According to Nikhil Vora, vice president - research of domestic securities firm, SSKI Securities, the finance minister has an unenviable task of balancing the stated objectives of the CMP with financial prudence. "The total bill of CMP, comprising subsidies and increased social expenditure on education and health, is likely to cross Rs 25,000 crore whereas the options for raising revenues are limited. We believe it would ultimately be a combination of widening of the service tax net, cess on indirect/ direct taxes and higher dividends from PSUs."

There is a feeling that the focus of the Budget has to be on getting the fiscal imbalance right, because it is one number foreign investors take very seriously. That will require taking tough measures to raise more money, like raising taxes and cutting down on subsidies and government expenditure.

However, the need to please the government's allies like the Left means that there is little maneuverability in such matters. Markets will, thus, be watching out for innovative schemes/measures that can achieve social objectives without putting additional burden on corporates and individuals. 

What Chidamaram did in 1997	What markets would like in 2004	CMP speak
Corporate tax rate for domestic companies was cut to 35 per cent (down from 40 per cent) and for foreign companies to 48 per cent	Removal of dividend  distribution tax	Profit-making PSU companies not to be sold
Share buyback allowed, inter-corporate investment eased	Reduction of corporate tax rate from the existing 35 per cent to 30 per cent	Approach privatisation on a case-by-case basis - selling off  loss-making companies after obtaining workers' assent
An across-the-board cut in income tax left the new rates at 10, 20 and 30 per cent (above Rs 1.5 lakh), compared with the previous levels of 15, 30 and 40 per cent.	Reducing taxes for both corporates and individuals	Raise expenditure on education to 6 per cent of GDP
Abolition of dividend tax in the hands of shareholders	Abolition of minimum alternative tax (MAT) for companies	On interest rate policy, to provide incentives to investors, senior citizens and pensioners
Average level of tariffs was cut to nearly 25 per cent	Introduction of turnover tax instead of capital gains tax for FIIs	Keep tax rates stable and conducive to growth and investment
Allowed foreign institutional investors and non-resident Indians to invest up to 30 per cent in Indian companies	Doing away with the distinction between long-term and short-term capital gains taxes	Eliminate federal revenue deficit by 2009
		Introduce value added tax at the earliest
		Encourage foreign direct investment

What will make the markets swoon?

Markets are hoping that the minister would announce some market friendly measures. One such measure could be the removal dividend distribution tax. "The removal of dividend distribution tax will also give the markets a boost," says Jain. In its pre-Budget memorandum, the Confederation of Indian Industry (CII) has called for the withdrawal of dividend distribution tax.

However, economic realities do not favour this. Government earns around Rs 6,000 crore from dividend tax from corporates. And that is a significant amount to give up. "Removing dividend tax seems difficult," opines Ambareesh Baliga, vice president of domestic brokerage Karvy Securities.

Service tax is also expected to go up. Significantly, many more services could be brought under the tax ambit and the tax rate could be hiked to 12 per cent. "Total tax collection was just Rs 8,300 crore in 2003-04. I think an 8 per cent service tax might be levied on road transporters. This alone could fetch the government Rs 10,000 crore" says Baliga.

The CII has also urged the government not only to reduce corporate tax rate from the existing 35 per cent to 30 per cent but also remove the surcharge of 2.5 per cent. The memorandum has also made a case for the abolishment of minimum alternative tax (MAT) for all companies. Analysts say this may not come through.

There are hopes that the finance minister will review the long-term capital gains tax laws concerning FIIs. "From a capital markets point of view, removal or reduction of capital gains tax for FIIs will be welcome," notes Jain.

Another key measure the markets are awaiting is the removal of distinction between long-term and short-term capital gains taxes. Shah feels that the FM might do away with the differentiation between the two. There is a hope in the industry that the introduction of turnover tax or transaction tax instead of capital gains tax will do a lot of good for FII confidence in the Indian markets.

One significant measure could be related to pension funds. There could be measures to facilitate more inflows into the markets by allowing pension funds to invest in markets. "Greater sops to FIIs will also facilitate a higher participation from them in Indian markets," says Jain.

Markets will most certainly give a thumbs down to measures seen as being major give-aways to satisfy political allies. The deficit that has been hovering around the 5-6 per cent of GDP in each of the past five years is said to one of the biggest worries of FIIs.

Unless the finance minister comes up with tighter expenditure control norms, there is a fair chance that they must just decide to stay away till things improve, say analysts.

The future of interest rate movements also seem to be a concern with the markets. While the finance minister has said interest rates will benefit savers, analysts feel that interest rates will remain untouched for a while yet.

While Chidambaram's predecessor, Jaswant Singh, had cut the rate on small savings by 50 basis points last fiscal to an average of 8 per cent across all instruments to make small-savings rate closer to market-determined interest rate, pointers are that the finance minister may decide to leave small savings rates unchanged than to hike it.

"Reaffirmation of infrastructure spending and reiteration of reforms in key sectors (especially oil & gas) would soothe frayed nerves from the 'excessive focus o farmer'," says Vora.

Be prepared for a fall

So is it going to be a market-friendly Budget? Well, there could be measures to appease capital markets, and there could be radical reform measure too.

The consensus is that Chidambaram's Budget may throw in sops to attract investors to the markets, but the positive effects may be undone by other measures that are perceived to be playing to the rural gallery. If that happens, the markets are going to slump in the short-while at least.

In case the markets go down by a small margin, there is a good argument for investors to get in, considering the strong long-term fundamentals, note market watchers. The bullish outlook on the economy, in terms of growth at 6-7 per cent, inflation and balance of payments makes it a compelling argument.

Also, in view of the low expectations currently, markets could surge on positive surprises. However, the big worry is, if the markets are not convinced by the budget measures, we could be in for a long haul. "If the markets go down, the recovery as and when it happens will be weak," warns Jain.

As such the market reaction to the new government has been pretty lukewarm, to say the least. Over the past 3 months, market has fallen 17 per cent, thus making it the worst pre-budget market performance since the economy opened up in 1991.

What should add to the gloomy mood is the fact that traditionally, the Indian markets have not performed well post-budget, having reported positive returns only twice in the last 10 years in the month after the budget. But investment bank Merrill Lynch sees hope yet.

In a pre-budget report that firm has said that it expects markets to rally 8-10 per cent to 5200 levels, post-budget. According to the report, the positive vibes come from the fact that market is already discounting the bad news. "Contrary to market fears, we believe the budget will be pro-reform while keeping fiscal deficit under check at 4.5 per cent. We believe market fears of budget being too populist, are overdone. The budget is likely to continue the reform process and spur focus on investments as well as the agriculture sector," adds the report.

Rakesh Jhunjhunwala also expresses the opinion that markets should do well over the longer term considerign the current valuations. And if you are worried about the dreaded budget impact, then here's a comforting thought. "More than the any budget impact, it will be the monsoons and the interest rates that will determine market behaviour going forward," says Jhunjhunwala.

Merrill also notes that "the prime minister, Dr. Manmohan Singh and the finance minister, P C Chidambaram constitute the best economic team that we could have." With the pressures mounting, team Manmohan will have its hands full to come up with the goods to satisfy the markets needs.

While 'sexy' innovations may lead to a short-term bullishness at the bourses, the basis for a credible bull run in the long-term can be set only by attending to the urgent need of pruning the country's burgeoning deficits, say experts.

 

Sectoral expectations
Auto Thrust on agriculture to help tractors. Service tax extension seen extended to transporters; could hurt truck makers. No further reduction seen in excise duty and custom duty. Basic customs duty on HR/CR steel sheets likely to be cut. Customs duty on used CVs to be hiked from 20 per cent to 40 per cent.	Power Likely extension of Electricity Act implementation deadline to July 2005. May extend zero per cent import duty benefit to generation projects of upto 250 MW from current thermal projects over 1000 MW and hydel project over 500 MW. May accelerate allocation to upgrade T&D networks of state electricity boards to cut T&D losses. Power capex to hydro power projects to continue.
Cement Excise duty to be lowered. Focus seen on infrastructure and irrigation projects, which will drive demand. No tariff changes expected in the sector. Income tax incentives for housing finance to continue - interest up to 1,50,000 rupees on housing loans is currently exempted from tax. Customs duty of 5 per cent on non-coking coal expected to be scrapped.	Metals Accelerated infrastructure spending on road and irrigation projects to see pick up  in steel demand. Export benefits for steel companies like DEPB scheme to be restored. Cut in existing custom duty for coke.
Consumer goods Increase in cigarette excise duty Increase in excise duty on packaged food products like biscuits, sugar confectionery, ketchup, sauces etc. Broad thrust on a rural-friendly budget to have a positive impact on consumption. Reduction in customs duty on raw materials for durable goods.	Oil & Gas Duty cut in key petroleum products like gasoline and diesel Government may choose to cut duties on LPG and kerosene Government may take a stance on the interim Budget's notification on irrecoverable taxes (central sales tax, octroi and entry tax).
Infotech Service tax on software education may be raised BPO services whether run by captives or otherwise may continue to enjoy tax exemption No change in taxation of software companies expected Peak excise duty of computer products (basic inputs) could be reduced to 8 per cent from16 per cent Tax computation methods, ESOP treatments would be rationalised, made clearer and simple Measures to boost domestic consumption of technology services could be announced For ITES business, some relief could be provided on the capital equipment importing end	Media Reduction in import duty on set-top box Increase in service tax on print as well as broadcasting media to 12 per cent
	Pharmaceuticals No change expected in excise and import duty on bulk drugs, drug intermediates and formulations. Implementation of MRP based excise duty. Concessional import duty rate of 5 per cent may be extended to some more life-saving drugs and medical equipment Likelihood of further structural direction for the health insurance sector.
Banking Government may lower corporate tax rate. Easy access to credit for farmers may be at banks' expense. May provide clarity on the new government's stance on some of the financial sector reforms like cap on voting rights and hike in 20 per cent foreign ownership limit for PSU banks. Limit for tax exemption on housing loan repayments may be lowered from the current levels. Minimum priority sector lending requirement could be raised beyond 40 percent. Small savings rate cut likely.	Textiles Expected reduction in import duty rates for textile machinery Central VAT (CENVAT) will be removed, hurting large producers. Fiscal incentives for loom modernisation In principle implementation of NK Singh Committee recommendations
	Telecom No further duty cuts on handsets expected. Increase in FDI limit to 74 percent from 49 percent. Infrastructure benefit (80IA tax benefit) to continue Increase in service tax