India Economy: Fiscal policy: Between Scylla and Charybdis - Kotak

Fiscal policy: Between Scylla and Charybdis. Over the next couple of months, the government will have to choose between (1) overshooting the fiscal deficit target, and (2) reducing expenditure if tax revenues disappoint. We remain cautious on FY2018 growth prospects even with a likely "targeted" expenditure increase even as the government faces risks of revenue slippage. We expect 10-year yield to range within 6.5-6.8% for rest of FY2018 and maintain our FY2018 USD-INR average at 65.25.

Two primary concerns: slow growth and low tax revenues

We have been cautious on growth since demonetization and we have maintained our forecast for FY2018 GVA growth at 6.8% since start CY2017. In fact, growth (excluding agriculture and government expenditure) has consistently slowed down since March 2016 - the impact of which is getting manifested in weak government accounts. GST tax revenues have come under some doubt with regards to tax credits, tax filing, and technological issues clouding the tax collections scenario over the next 6-12 months. Lower surplus transfer by the RBI to the tune of around Rs300 bn has increased the risks of fiscal slippages.

Avoiding a knee-jerk reaction is of paramount importance

India's macroeconomic stability has been hard-earned and on the back of a series of structural reforms. We believe that (1) the current economic slowdown which has been a confluence of structural (investment cycle slowdown) and cyclical (GST, demonetization) does not necessarily require pump-priming the economy, and (2) pertinent issues of employment generation and private sector capex cycle are unlikely to be addressed simply by any broad-based "stimulus" and has to be through long-term focused "targeted" expenditure spends. The fiscal arithmetic will anyway be at risk from likely revenue slippage. In that scenario, any additional spending needs to be calibrated and targeted. The government should use the current slowdown to further its spending pattern towards employment generating soft and physical infrastructure.

Scylla (more likely): Overshooting the fiscal deficit target; 30-70 bps of fiscal slippage possible

We note the government's commitment to fiscal consolidation even as it has gradually increased the expenditure mix towards capital expenditure. Overshooting the deficit target may be looked upon negatively by ratings agencies, but well-targeted capital expenditure will be a positive. Apart from the focus on roads, railways, urban development, bank recapitalization, etc. the government could likely focus on the MSME sector which has faced some difficulties from demonetization and GST implementation. Further, some focus on the housing sector which can have a high multiplier effect will also be a positive.

Charybdis (less likely): Reducing expenditure and low economic growth

With tax revenues (possibly in GST revenues) likely to be lower than budgeted, unless non-tax receipts (divestments and dividends) are higher than budgeted, expenditure will need to be pruned to maintain fiscal deficit. If the government chooses to weather the ongoing cyclical slowdown and remain fiscally prudent, the hit on growth numbers will be visible given that government expenditure was one of the primary drivers for GVA growth.

Strong rupee and growth slowdown will put pressure on RBI's hawkish stance

The RBI in its next policy will have four issues to contend with: (1) 50-80 bps downward revision in its GVA growth estimate to 6.5-6.8%, (2) medium-term inflation estimate of around 4.5%, (3) overvalued INR (on REER basis) and its effect on exports, and (4) adverse global conditions. We expect the RBI to pause, but there will be a compelling case to ease to support growth. With most firms operating at low capacity utilization levels, interest cut alone may not move the needle much unless the magnitude is large. Given the RBI's expected inflation path a large cut is unlikely.

FX and rates: Higher yields and INR depreciation

The combination of higher policy rate and balance sheet adjustment by the Fed along with domestic monetary policy had predicated our somewhat negative outlook on rates and INR in 2HFY18. The Fed has indicated that a December rate hike remains strongly on the cards along with start of the balance sheet reduction from October. The Fed is on course to reduce the balance sheet (and hence withdraw liquidity) by Rs300 bn in the first year and Rs600 bn in each successive years.

Factoring in the global and domestic factors, we expect the 10-year benchmark yield in the range of 6.5-6.8% for the rest of FY2018. We hold on to our average USD-INR of 65.25 in FY2018 on the back of global monetary policy dynamics, geo-political risks, and India's CAD-BOP dynamics. We had factored in a narrowing of the real interest differentials and Fed's likely monetary/QE withdrawal policy. The heightened geo-political risks strengthen our case for a depreciating bias for the INR against the USD for rest of FY2018.

Source : Equity Bulls

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