Union budget of India 2019: taking the prudent path

In an earlier note, we argued that the strong foundation of reforms the government had laid down in the past five years presents a unique opportunity to lift India’s growth rate if it made the right policy pivot. We suggested this policy pivot could take the form of three Rs—recycle, rebuild, and reinvest; indeed, the latest budget introduced several measures that pursue these objectives, which, in our view, should be supportive of economic growth in the medium to long term.

This refers to measures targeted at freeing up state resources through disinvestments that should underpin the government’s social spending agenda without raising the country’s fiscal deficit.

• Relaxing SOE disinvestment norms: The government is considering paring its stake in state-owned enterprises (SOE) to 51.0%. This could include effective stakes (indirect shareholdings through other state-owned entities), which should liberate additional sources of revenue. However, it could create a supply overhang in SOE securities if this disinvestment is done through the stock market.
  
• Higher spending, but not at the cost of the fiscal deficit: As a result of higher tax collection and disinvestment targets, the government has been able to maintain the country’s projected fiscal deficit at 3.3%. This is despite a projected expenditure growth of 21.0% from the previous budget, which is better than the market expected. In particular, spending in rural areas is projected to increase by around 70 basis points (bps) of GDP, a 55.0% jump from a year ago.³ We expect to see ongoing public investment in areas such as rural housing, roads, power, gas, and water connections, which should bring about broad-based economic gains. 

The budget also included measures aimed at easing domestic credit conditions and attracting foreign savings—developments that could help to rebuild savings:

• SOE banks recap: An increase in the recapitalization budget to Rs$700 billion (US$10 billion) should offer support for SOE banks.
• Partial credit guarantee for NBFC assets and better supervision: The budget also includes plans to provide a one-time six-month partial-credit guarantee to public sector banks for the purchase of higher-rated pools of financially sound nonbanking financial companies (NBFCs). Moreover, the government gave the Reserve Bank of India (RBI) more power to regulate NBFCs, including the right to appoint and remove directors. In our view, these measures should ease liquidity conditions for NBFCs and reduce risk aversion.
• Measures aimed at attracting foreign savings:
  • Relaxed foreign direct investment restrictions on single-brand retail,⁴ airline, insurance, and media firms.
  • Issuing government securities in international markets. If we bear in mind that external holding of India’s sovereign debt only represents around 5% of GDP,⁵ this could open a significant new source of funding.
  • A potential increase in minimum public shareholding requirements to 35% from 25% for listed entities, with a view to raising India’s weighting in global equity indices. This could deepen India’s equity markets over the longer term, and generate a substantial supply of new shares in select companies. 

Proposals to boost the investment rate should help domestic capital formation:

• Focus on housing: Tax relief for interest paid on mortgages⁶ has been raised from Rs$200,000 (around US$2,900) per year to Rs$350,000 (around US$5,000) for first-time homebuyers purchasing properties priced below Rs$4.5 million, or US$65,000 (if the purchase took place before March 2020).⁷ This is a positive development because it translates into savings of around Rs$50,000 (US$725) per household for every year that a first-time homebuyer is financing the said mortgage. For a 10-year loan, this could represent gross savings of up to 10%.⁸
  
• Focus on infrastructure: The government reiterated its plan to invest US$1.4 trillion in infrastructure over the next five years. 

Proposals to boost the investment rate should help domestic capital formation:

• Increase in stock issuance: The government is considering capping promoter stakeholding⁹ in listed companies at 65%, down from 75%, in consultation with the Indian capital markets regulator, the Securities and Exchange Board of India. While this is aimed at raising India’s free float and weighting in global indexes, we believe it could also potentially result in US$50 billion of new stock issuance.¹⁰ However, we think that the regulator will likely implement this in a phased manner to give the market enough time to absorb the additional shares.
• Increase in the top tax rates: The government has increased the tax rate on high-income earners—those earning more than Rs$20 million (around US$300,000) per year will see their marginal tax rates go up by between 300bps and 700bps due to a surcharge. This could hurt discretionary and premium consumption. We believe such a surcharge will be levied on capital gains as well; if these gains push an individual’s overall income above the aforementioned threshold, this could weigh on near-term sentiment. 

We’re happy to see that the government has, at least in principle, adopted the three Rs framework that we referred to in our previous note. In our view, the government has shown fiscal restraint and chosen a prudent path that will fulfill longer-term growth aspirations. That said, we’d like to have seen the government target more strategic asset sales instead of relying on the stock market to recycle its capital. We’d have also preferred a larger and more strategic program of asset sales to raise revenue and stabilize tax rates.

India needs higher investment rates to achieve its growth target. However, part of the credit delivery system (almost half of SOE banks and NBFCs) is broken because of nonperforming loans and low capitalization levels. While this problem is being fixed through market mechanisms, we believe the government’s budgetary steps—SOE bank recapitalization, partial credit guarantees, and better supervision—should help. It’s also very important to attract foreign savings at a time when global liquidity is abundant, and the government’s decision to open up the capital account by tapping overseas bond markets for sovereign issues is a bold step in this direction. This will likely free up domestic savings, which will be assisted by the transmission of lower rates, which could in turn help to revive private investments.

We remain constructive about India. While the government hasn’t opted for an overall fiscal expansion, rural areas and small enterprises could still experience a positive effect. On the other hand, the benefits of lower interest rates have started filter through into the real economy as liquidity conditions improve. Prudent fiscal management should also help to deliver lower rates. This should benefit interest-rate-sensitive sectors such as financials, commercial real estate, and utilities. We also believe that sectors that are sensitive to rate demand will also recover after a time lag—these include autos and building materials. However, the Indian rupee may remain well bid as a result of rising foreign inflows. This could be an issue for Indian exporters, particularly in mature industries like infotech and healthcare.

1 India’s coalition government is widely known the National Democratic Alliance, or NDA, government, led by the Bharatiya Janata Party. The coalition won a second term in an election earlier this year, which concluded in May. 2 “Union Budget 2019-2020—Budget Highlights: Key Features,” Ministry of Finance, Government of India, July 5, 2019. 3 Compared with financial year 2019, which began in April 2018 and concluded in March 2019. 4  Single-brand retail refers to companies that market products under a single brand. 5 Bloomberg, June 2019. 6 Interest paid by borrowers on mortgages is tax deductible (i.e., it can be reduced from the taxable income). 7 “Budget 2019 hikes tax break on interest paid on loan for affordable housing by Rs 1.5 lakh,” Economic Times, July 8, 2019. 8 Manulife Investment Management estimates, July 2019. 9 In India, the main shareholders of a company (individuals or families) who control the management are called promoters. This refers to the maximum stake that they can hold in a listed entity. Introducing a lower threshold will increase free float of the shares of listed companies. 10 Manulife Investment Management estimates, based on market capitalization, as of July 5, 2019.