Union Budget -Impact On The Economy and.......

The Union Budget 2010-11 presented on last Friday has several important implications for the economy as well as equity and debt markets for the year ahead. Broadly speaking, the government aims to improve its finances by reducing subsidies and normalizing indirect taxes even as it has reduced income taxes on individuals. Over the last couple of years, because of the macro-economic crisis and rise in subsidies due to high commodity prices, the government’s finances weakened considerably and the government has announced a multi-year road map to improve its finances. Specifically this budget aims to reduce the gap between the government’s overall revenue and expenditure, called fiscal deficit, from 6.7% in FY2010 to an estimated 5.5% in FY2011.

The most important driver of improving long-term finances, and indeed generating surpluses necessary for investment, is growth in economic activity. The budget has either maintained the momentum, or increased it, as far as demand drivers of the economy are concerned with more allocations to various development and infrastructure segments. Experts believe that reduction in income taxes on individuals, will put more money into the hands of consumers who in turn will provide a boost to private sector demand. This will also partly neutralize the impact of the rise in prices that will happen in various segments, such as petrol and diesel prices, on account of reduction in subsidies. GDP which is on an improving trend overall, notwithstanding the impact of weak monsoon, will maintain the momentum in FY2011 and will show a higher GDP growth rate than FY2010. As such the budget for the overall economy is growth enabling even though it is likely to be mildly inflationary.

Impact on Equity Markets

What is good for economy is usually good for equity markets. Equity Market experts believe the budget will provide an additional boost to the already strong domestic demand, particularly in the consumption-oriented segments. From corporate revenue and earnings perspective, the budget has positives for consumer sectors such as Auto, negatives for cement and realty sectors and is neutral for banking sector. Also this budget is likely to enable a positive environment for infrastructure and capital goods sectors, given the increased outlays and additional tax break on infrastructure bonds. Overall the budget 2010 will be a year of economic revival, and also a year of strong growth in corporate earnings which is a significant improvement from the flattish trend observed over last two years.

While growth in earnings will remain robust, however the market valuation multiple is likely to remain capped, closer to the long-term trend line levels of 14-15 times one-year forward earnings, given the government’s planned disinvestment target of Rs 40,000 Cr for next year. Experts believe that there is a case for range bound markets in the short-term driven by factors like current valuations and likely supply of paper on account of fresh issuances in the backdrop of resurgent economic growth and capital flows.

Impact on Fixed Income markets

The government has taken the first step towards fiscal consolidation by reducing the deficit to more sustainable levels in the Union budget for FY2011. The government announced a fiscal deficit target of 5.5% of GDP for FY2011 compared to a deficit of 6.7% of GDP registered in FY2010. The government aims to achieve this through Improvement in tax to GDP ratio by increasing excise duty rates, Minimum Alternative Tax paid by corporates and increasing the scope of service tax Less than expected increase in overall expenditure Higher receipts through disinvestment and auction of 3G telecom licenses

As a result the net market borrowing program for the FY 2010-11 has been reduced to Rs. 345,010 cr compared to Rs. 398,411 cr for the FY 2009-10. The commitment by government to further reduce its fiscal deficit to 4.1% of GDP by in FY 2012-13 is likely to lead to lower interest rates in medium term.

However there may be some pressure on government security yields in the near term as the government hits the market with next year’s borrowing program in an environment characterized by rising inflation, possible interest rate hikes by RBI and possibly no support from RBI in the form of Open Market Operation (OMO) purchases of government securities. As a result yields may gradually drift higher from current levels and peak out some time in the first half of next fiscal.