Has the party begun?

Debt servicing, dollar appreciation, and liquidity will determine the sustainability of global recovery

What would be the reaction if a fund manager promised investors to double their money in exactly a year’s time? The offer would be dismissed as a ponzi scam, or one of those dubious chit funds based in Uttar Pradesh and West Bengal. There was also a possibility of Sebi cracking down if the scheme was sponsored by a mutual fund or the Reserve Bank of India hauling the promoters if it was run by a non-banking financial company. Yet, this is what investors would have earned if they were to invest in an index fund on 9 March 2009. From a low of 8,160.40, the Sensex has risen over 100% since then. It is a moot point how many would have ventured into the market at that point of time, when seemingly sturdy financial institutions in the developed world had crumbled under the weight of non-performing assets, credit had dried up, and the backlash of debt default by even tiny nations such as Iceland could be felt around the globe. Though governments were announcing stimulus packages and central banks were pumping liquidity, only the brave could bet that the market had bottomed out at that juncture. There could not be a more stark contrast today to the bleak outlook a year ago. Despite the problems of excessive spending persisting in some pockets of the European Union, major economies except perhaps Japan are on the path to recovery. From Wall Street to Dalal Street, the markets have bounced back. Many governments are debating when stimulus should be rolled back rather than if it should be. Some like India have already begun the process. Central banks from Australia to China and India are tightening money supply.

Is the worst behind us? As Dubai and Greece have shown, it is foolish to become complacent. This is one of the important lessons of the global financial market meltdown, which had its roots in the belief of mortgage lenders and borrowers that home prices will always go up, commodity investors that oil could stay above $100 a barrel as China and India rack up above 7% growth rate, and hedge funds and private equity investors that P/E of 20 and above would be the norm as markets scaled new peaks. The markets appear have factored in these concerns as is evident from the recurring volatility. The cycle of market spurts followed by profit-booking is getting shorter as investors seem reconciled that another Lehman Brothers is waiting to implode. That even small countries have the potency to disrupt economic activity has increased the uncertainty. Last year’s financial crisis has exploded a myth that countries like China and India, with large domestic markets, were decoupled. The health of the US economy though is going to be keenly watched, particularly employment data and fiscal deficit. Apart from being the largest consumer market for the world’s exports, it is an important financial market to raise capital. Most countries’ reserves are also held in dollars.

A moderately strong dollar aids China’s exports and India’s requirement of capital. It is, hence, important for the consolidation of global recovery that the US bounce-back is quick and sustainable. This will happen if China allows its currency to appreciate. Yet, the liquidity flow to emerging countries could pose as much a hurdle for recovery as anemic manufacturing in the US. Just as the turning off of the credit tap squeezes companies implementing expansion and derails the infrastructure roadmap of countries like India, too much liquidity leads to the creation of asset bubbles and inflation could puncture not only domestic growth but also slow down global expansion as these regions flirt with capital controls. Foreign capital took a flight and markets suffered a setback on Brazil’s tax on foreign portfolio investment. Poised to follow suit, the eruption of the debt-default crisis in Greece and slowing of foreign inflows as a result buffeted India. Despite foreign capital being a function of global recovery, it also hinges on the recipient country’s fiscal health. Large deficits require the government to borrow from the market, pushing up interest rates and pushing off companies in need of credit. The current round off PSU disinvestments is crucial for the government to mop up resources to fund social welfare programs without enlarging deficit. So far, the track record has been mixed. The good response to share sell-off at the end of calendar year 2009 did not spill over to the FPOs of NTPC, REC and NMDC in 2010. Hopefully, good southwest monsoon will keep the market mood bullish to realise the government’s PSU divestment target for 2010-11 and consolidate India’s growth.

Divestment to the rescue

Budget 2010-11 rolls out the roadmap to implement GST and DTC from next fiscal

But for the raising of excise duty on petrol and diesel, Union Budget 2010-11 proposals appear to be non-controversial. The almost across-the-board increase in excise duty to 10% and expanding the slabs attracting lower tax rates are baby steps towards implementing the 12% Goods and Services Tax and the Direct Tax Code with a peak personal tax rate of 20% without exemptions from 1 April 2011 and also to demystifying the budget as a routine balance-sheet presentation. After the havoc caused to the nation’s finances by election-eve yojnas and farm loan write-offs in the 2008-09 budget and the fiscal stimuli to insulate the economy from global recession, Pranab Mukherjee was expected to roll back the excise duty cuts to repair the fiscal imbalance as the economy was expected to close the current fiscal with a higher growth, of 7.2%, than anticipated. The automobile, IT, real estate, and several infrastructure related sectors including cement and steel had bounced back from their 2008-09 lows. On the flip side were concerns about the fragile nature of global recovery and straining inflation. Worries of a blowout from some debt-ridden European countries and rising food grain prices due to deficient southwest monsoon narrowed the scope for taking one-time action to restore financial health. Yet doing nothing would have bogged down the efforts for inclusive growth, implying increased spending on rural economy, education and infrastructure. Not surprisingly, the finance minister has cautiously raised the excise duty by 2% on most non-petroleum products, while maintaining the focus on farmers and the urban poor.

Helping the finance minister was PSU divestment, raising Rs 25000 crore in the current fiscal, which, this column had predicted (see CM, Jan 25-Feb 07, 2010), would lead to a moderate tax regime and a buoyant market. As a result, the market focused on the lower fiscal deficit estimate of 5.5% of GDP in 2010-11 as against the revised fiscal deficit of 6.9% for the current year did not seem bothered about the impact of the increase in excise duty on the fast-growing automobile sector, which has been one of the drivers of the revival. Nor did investors give much thought to the fallout of the increase in Central excise duty by Re one per litre on petrol and diesel as the ground was prepared before hand with buzz on hike in petrol and diesel prices by Rs 3 to Rs 5 per litre to reflect the rising crude oil. As such the restoration of basic import duty on petroleum products could be meaningless. Even without the duty, imports would have been expensive compared with the local subsidised products unless the government is set to quickly implement the Kirit Parikh Committee report on deregulating the petroleum industry. Club the rise in refined product prices with the government’s intention of providing cash subsidy to PSU fertiliser and oil marketing companies to show these liabilities in fiscal accounting, bringing eight more services in the tax net, and more disposable income in the hands of nearly 60% of the tax payers.

The mixture could be a recipe for triggering inflationary pressure or fuelling growth. Increased consumption, so necessary to spur economic expansion, could lead to asset bubbles as seen during the heady growth days of 2006-09. The government, however, seems confident that Budget 2010-11 would boost growth rather than inflation. The finance minister’s balancing act hinges on better tax compliance striking out lower direct tax rates. Non-plan expenditure is only 6% more than that of 2009-10. Moreover, the net market borrowing of the government, the budget claims, would not crowd out private borrowings. This implies divestment in 2010-11 as a source separate from budgetary allocation to undertake the social programs so essential for all-round growth. Nonetheless, in a globalised economy, it is not only management of internal factors such food security and a safety net for the poor that determine GDP expansion and cost of living. Flow of foreign capital, for instance, decides if a country will see a slowdown or high interest rates. A healthy balance sheet is a crucial but not the only criterion to make a country an attractive investment destination. If this was so, China would not have to pump up its economy with massive liquidity. As seen during the last couple of years, even events outside the government’s control can spoil the party. India’s growth decelerated on global risk aversion. For the finance minister’s gamble to pay off, India needs not only good monsoons but also consolidation of US economic recovery.