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Tone of Mr. Mukherjee’s speech was primarily buoyant, and he’s quite confident about the consolidated growth of the economy. However, India is still getting short on social welfare spending and spending on education. Overall, VMW sees the Budget 2011 as an introduction to reforms apart from a speech of the government accounts.

  
Union Budget In Brief – “What The FM Has Unfolded For A Common Denizen”

If we compare the budget speech for India in the given fiscal year, over the past two years, government framed the union budget to confront the challenges from the global economic downturn, which lacked the economic reforms but contained relief package for several sectors to stimulate the economy. Last year’s budget has primarily addressed to put the Indian economy back on track to the pre-crisis growth rate (i.e. 9%), sustainable economic expansion with moderate inflation and fiscal deficit.

While, this time around, announcing the budget for fiscal year 2011-12, India’s Finance Minister Pranab Mukherjee, most interestingly, has addressed all the sectors and laid down the policies to support the industries by making user-friendly policies for foreign direct investments (apparently trying to attract FDI in certain sectors). Apart from focussing on the economy and businesses, Mr. Mukherjee has also addressed the social welfare spending by revising  the priority housing mortgage from Rs20 lakhs ($44,000) to Rs25 lakhs ($55,000) and strong focus on the rural side with the commitment of giving out cash subsidy on kerosene, LPG and fertilizers via Aadhaar.

Going back to the previous year budgets is important since the solid material growth of the Indian economy is largely supported by the expansion of service sector, which contributes over 57 percent. Since FY2009, Mr. Mukherjee has announced the budget to inoculate the economy from the external shocks and he wanted to maintain the 

economic growth of over and above 7 percent. It is quite interesting to know that the Indian economy is expected to expand further by 8.6 percent in FY2011 amid concerns of high inflation rate, uncomfortable interest rates, current account deficit and shocking oil prices. Furthermore, the implementation of the budget’s proposal over the past couple of years could be palpable and the government is  trying to reinforce the rural participation in the economic growth. Although, the government’s focus on the agriculture sector is blemishing, and the one time credit waived-off to the farmers could not support in the long run. Now, VMW is going into details of the agriculture sector of the country and will give you an important perspective.

Budget 2011 in Detail

Discussion Topic I : Agriculture Sector

Let’s discuss the Union Budget for the fiscal year 2011. Starting with the agriculture sector and rural side of the country. Although, India’s agriculture sector accounts for over 15 percent to the economy, however its importance is much beyond from this contribution. Over the past few years, the agriculture growth has been in decline phase. Over the past decade, VMW analyzed India’s agricultural growth at 3 per cent, which is almost half of the manufacturing growth rate and one-third of the service sector growth. The another nerve-racking point is, India’s agriculture sector’s contribution to the Indian economy is consistently declining.

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In the above figure, we can observe the level of prompt attention, the agriculture sector needs at this point. From the budget speech, we found nothing attractive which can lift this sector up. Mr. Mukherjee gave attention to the credit facility by revising the credit flow to farmers from Rs375,000 Crores ($82 billion) to 475,000 Crores ($105 billion). India has a good rural financial institution network, or generally known as Regional Rural Banks (RRBs) set-up by nationalized banks, in the rural part of the country. However, poor farmers are still away from the credit facility due to inefficiency of banks or financial institutions since they are having high level of non-performing assets (average NPA of 3 percent on their books) amid extremely low margins, threatening the rural banks to sustain in the business to extend credit facility, high cost of credit and high risk associated with lending to agriculture sector. Thus, extension of credit flow alone could not prop-up sector’s growth. Stringent land regulation, non-access to markets due to poor key infrastructure such as road, (even absence of road connectivity in several villages) electricity -  leading to poor supply chain management, storage management, which ultimately reduces the food security.

It is more important to make India’s agriculture sector internationally competitive and increase productivity by focusing on research by investing in agricultural biotechnology to meet the sector’s challenges and proliferating demand in the 21st century, promoting the non-farm sector by investing in horticulture and cattle . Furthermore to this, severe land regulations discouraging the private investments in rural parts of the country. Currently, several states in India are still lacking the access to the modern-day agricultural technology, which includes part of Uttar Pradesh, Madhya Pradesh, Bihar, Jharkhand and Orissa, ultimately losing the productivity and since there is no water management or slow execution of water management projects are causing the severe floods.

Agricultural reforms are the cornerstone of the country’s economic expansion and for a country like India, where the resources are ample, India should strongly focus on the land regulations to encourage private investments by enhancing the land access policy to the landless farmers.

Discussion Topic II : Infrastructure Sector

Infrastructure development is the key to the economic growth and to make India a competitive global marketplace in today’s globalized world. According to the latest data, available with VMW, more than 28 per cent of India’s population living in urban areas and out of this, housing crisis along with other key social infrastructure is a problem, when people from smaller towns and villages are shifting towards the urbanized parts of the country in search of an economic opportunity. To alleviate the urban poverty, government is improving the key infrastructure by setting up ”Jawaharlal Nehru National Urban Renewal Mission” (JNNURM) in which the government is signing up the agreement with the states to fund in their projects and to facilitate the state governments to improve their housing situation (since 1/4th of the urban population living in slums), transportation system. Over the next seven years (from 2005-06), government has projected over Rs120,536 Crores ($26.5 billion) of investments in urban sector. As proposed, largest investments will be done in 35 cities with over 1-4 million population, focusing on social housing and special attention to slum dwellers.

JNNURM has great scope of mission to facilitate the states with funds to invest in the existing urban cities in their key social infrastructure such as water supply, sewerage, telecom, health, roads, public transportation. However, it could not be able to urbanized the rural parts of India, since its aim is limited to existing urban areas.

Many infrastructure projects are stuck in mid-way and taking a longer time to execute the project due to insufficient access to credit. Moreover, cost of capital has also risen significantly in the past few months, stalling the execution of projects. For an infrastructure development across India and to serene the flow of credit, Finance Minister has proposed to enhance the flow of funds to the infrastructure sector by increasing the investment limit of FIIs in corporate bonds from $20 billion to $25 billion. By enhancing the investments by foreign investors, it will attract the foreign participation in the infrastructural development and credit flow to the sector. However, the annual capital investments by the central government in this union budget is 4.6 per cent of total GDP, which is still very low in compare to what exactly proposed to invest up to 9 per cent of the country’s GDP, which is a discouraging sign. To achieve a double digit economic growth or at least to consistently achieve a 9 per cent growth rate, India should need to meet the target of 11th five year plan and to reduce the infrastructure deficit. In its 11th plan, India made an investment target of $498 billion in the infrastructure sector alone.

Further to our analysis on the infrastructure sector, there is a wall-to-wall financing gap of $40 billion, which could deter the government’s target to meet it. On the other side, plentiful of challenges are making to achieve target more strenuous such as lack of creditworthiness of  the local municipal bodies to support the government’s desire of infrastructure development and to renew the existing one.

Discussion Topic III : Taxes

The main source of revenue to the government is Tax. Better and simplified tax reforms has a greater importance to simplify the laws and compliance.  To improve the tax governance and to simplify the process, Mr. Mukherjee has introduced Direct Taxes Code or DTC in Aug last year and it will bring a greater compliance in terms of several heads of income. Most importantly in DTC, surcharge on income tax and the education cess on tax has been abolished. Not only this, the DTC has also brought men and women taxpayers under the same tax net (or same exemption limit for all). But the disappointment is, the application of DTC has further been extended to fiscal year 2012.

On account of tax evasion, the Indian government has signed an agreement of Tax Information Exchange Agreements (TIEAs) with two countries named as The Bahamas (signed on 11th Feb 2011) and Bermuda (signed on 7th Oct 2010). This will equip India and allows both countries to exchange the information on individuals, companies, publicly traded companies and many other entities. The harmful tax practices was adopted backed by lack of effective exchange of information and the TIEA with several other island nations, which are considered as a tax heaven, will improve the poor practices of evading tax. Until now, India has a long way to go to further improve the taxation system in the country and to get most revenue out of the direct taxes, which is the main source of income to the government. Moreover, India should strongly focus on the money laundering issue by empowering the independent investigative organization such as Enforcement Directorate (ED) to give complete autonomy to make them stronger to contain the issue.

Discussion Topic IV: Price, National Income & Liquidity

The current nasty problem this year is inflation. India’s central bank, Reserve Bank of India has revised its policy rate several time this fiscal year to bring the inflation levels back to its comfortable zone. However, so far, RBI has been unable to contain inflation and now the tight liquidity situation is threatening the robust economic growth. Even the 9 per cent of economic growth is looking unachievable under this kind of policy environment and hawkish tone of the central bank. RBI, itself is in dilemma to contain inflation (surging due to demand side) alongside a task of maintaining the current pace of economic growth. VMW believes, the persisting tightness in liquidity and further increase in interest rates will eventually lead India to lose the ground of  modest economic growth.

Source: VMW Analytic Services. © 2011 VMW. All Rights Reserved. Read Copyright Policy.

As discussed in our research on the Indian Economy 2011, VMW seeing the current account deficit as a major cause of concern. Inflation is expected to come down in the next few months, however the political uncertainty in the country would make the foreign inflows a challenge to finance the trade deficit, since the inflows via portfolio investments or investments by the Foreign Institutional Investors (FIIs) are the major source of capital account and Indian equity markets are expected to remain range bound due to several economic and political challenges. So far this year, Foreign Direct Investments (FDI) remains robust and expected to outpace the previous year’s record. Further to our discussion on foreign investments, Finance Minister has proposed to make a favorable FDI policy and to review the investment guidelines every six months.

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Over the past few months, inflation is projected as the most crucial thing to look out for the year 2011. Economists believe, that inflation would remain high and will be a roadblock for the economic expansion, however VMW Intelligence expects inflation will come down to 6 per cent and it was largely risen by huge public debt. What is the fountainhead of this high inflationary pressure in the Indian Economy? Let’s discuss it now!

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Theme For 2011: Inflation

The new decade starts with the bang of inflation, and everyone believes it is going to impede the faster expansion of global economy. Predominantly, inflation is playing a bigger role for the policy makers to factor in while cogitating the policy for the sustainable economic expansion and without affecting the current economic growth rate and this trend in real is followed across the globe as the apprehension of discernible impact of inflation on the economy is high. India has a high inflation rate of around 8 per cent and core consumer prices is currently reading at more than 15 per cent, giving policy makers a food for thought for a stricter policy to contain the rise in prices, since VMW believes, high inflation could come down to 6 per cent in the next few months owing to expectations of good crop output resulted by good monsoon rains last year. For now, inflation is rising because there are some reason, which does exist. fundamentally, inflation is rising due to supply side constraint and inflation is not only making a new monthly highs alike gold prices in India, but other largest emerging economies such as China, Brazil and Russia too has high inflation rate at 5.1 per cent, 5.63 per cent and 8.1 per cent respectively and developed economies are also seeing the risk of high inflation. The reason is simple, one: food prices and two: economic recovery around the world pushing commodity prices upward. For every country, abnormal inflation is a problem (deflation too!). What does abnormal inflation means here? VMW have used this term in the context of micro economy for the middle-class population of the country. India’s annual food price inflation rate is more than 15 per cent and making it rowdy for the people to survive with high inflation rate (that’s why, VMW is maintaining negative Political Outlook for the country). At the bottom of the production pyramid of an organization, the price of an article is rising significantly and directly impacting the consumers and inflating the price of the basket of goods. Moreover, consistent rise in government borrowings and expansion of money supply in the United States or so-called Quantitative Easing has also propelled the higher growth in inflation as the expansion of money supply means, more dollars or rupees in hand to spend.

What The Year 2011 Stores For India?

People’s perception about the global economy has still not changed even after robust recovery in economy from the bottom. People’s concern is sustainable job environment, which is still not there and would take more time to repair. Domestic consumption is on high in the emerging economies and those economies are now leading the global economic expansion. Year 2012 could emerge as the revival of the next business cycle (i.e. expansion).

VMW has given inflation as the year 2011′s theme and it’s evident that food prices, expansion of money supply in the United States, stimulus packages announced during the economic crisis and economic recovery sending the commodity prices higher are the tangible factors for the higher inflation figure across the emerging economies as well as the industrialized economies. If we make a focus on the Indian economy, India, so far, has maintained a good resilience in terms of economic expansion but, nevertheless, the recent boutade of scams, fresh highs of corruption level and lack of policy reforms from the UPA government for faster economic growth has made a significant impact on India as an investment destination. Here, VMW has the another concern, which is Current Account (CA) Deficit. Current account deficit is expected to expand further backed by depreciation of Indian Rupee (due to high inflation and real interest rates) will make imports dearer and India’s largest import product is crude, higher crude oil prices as projected and lower expectations of foreign capital inflows.

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For FY2009-10, and FY2010-11 (Apr-Sep), India’s current account deficit was $38.38 billion and $27.9 billion respectively and India largely depends on the portfolio investments as well as foreign direct investments to finance the minus CA. The oxidized image of India followed by the intransigence mismanagement in the allotment of 2nd generation of wireless technology spectrum would make an impact on the foreign investors’ sentiment (the main source of the capital account) and it becomes hard for India to finance the CA deficit through short-term financing (which is a typical FII investments in India). Although FDI is better than the portfolio investments due to the longer time horizon and stable source of financing the negative current account. However, that too has seen a reduction due to the tough entry barrier because of lack of economic policy reforms, which was supposed to be introduced during the last fiscal year.

India has a wide range of corruption. Accentuating the subject, private sector is always accountable for fostering the corruption in a country and India has a long way to go to ameliorate its regulatory framework to counter it. Every country has corruption, however it should not become a norm.

As per local media, year 2010 declared as the year of scam. Apparently, India is a capitalist economy and almost every country in this world has a certain level of corruption. It is not startling, that India has seen multiple scams in a wide range of issues (of course the extent of corruption matters, too)  but here the question is, how the country deal with those issues and the ability of its judicial system to resolve it. Although, certain system can stand some corruption. However, India has the systematic corruption in the certain system, and it should be checked with priority. But VMW does not believes that these reasons will play a significant role in the economic growth for a longer period, since the country’s justice department is accountable to fix those issues and India is efficient enough in this regard.

Public Debt & Political Outlook: Our main focus has shifted from inflation to recent political instability in India. Political developments is enough to equate the real interest rate either high or low. If we discuss the economic outlook for the year 2011, inflation, interest rates, current account deficit and depreciation of local currency could be the reason for slowing the down the economic growth. RBI is worry about the only thing, which is inflation and to control that thing, it would virtually hamper the dream level of economic growth (10 per cent). We still believes that the country’s economic progress to continue to persist but certain macro issues will cut the economic outlook to certain extent and will keep foreign investments away from the economy i.e. scorching level of public debt. Rise in government spending and widening of fiscal deficit would jeopardize the economic growth. Since, we already projected that the inflation will come down to 6 per cent in the next few months however, the public debt and loose in fiscal policy will almost lead to rise in real interest rates, and downside in real economic growth. 

Source: VMW Analytic Services (©2011. VMW. See Copyright Notice)

As per VMW Analytic, India’s public debt swollen to 76 per cent of the total GDP. Inflation is rising, real economic growth is at risk, interest rates are on the growth track leaving all worries to central bank. Government has total control to its control panel to monitor all the situation. A tight fiscal policy will increase confidence over the debt sustainability and virtually increases real economic growth, reduces pressure on the interest rates. If we go through our analysis, over the past few years, specifically since fiscal year 2007-08, borrowings of central government has seen a significant rise. Since fiscal year FY-2007 through FY-2010, public debt grew at 10.45 per cent annually (compounded annual growth rate) in comparison to 6.48 per cent from FY-2003 through FY-2006. For a sustainable economic growth, India needs to maintain it fiscal policy to curb risk premium. Moreover, the political uncertainity could jeopardize the fiscal balance of a country and it is extremely important, that government should work with the opposition parties to avoid any circumstances, which is not healthy for a capitalist economy.

Endnote: Nevertheless, west is rebounding and demand for east’s exports are increasing gradually. In our previous economic research, VMW has projected the higher supply side inflation, now which can easily be seen, but it will come down soon. India’s public debt zoomed to more 76 per cent of the total GDP, which is much higher than our previous economic outlook research (55 per cent was then) and the further fiscal imbalances and rise in government cash balances will keep inflation on the higher side for the next few months but the we have projected the cut in inflation rate backed by lower food price inflation. Since, the central bank’s responsibility is to keep the moderate inflation rate, liquidity in the system is expected to remain narrow with high interest throughout the year. Even though, RBI has raised its policy rates by more than 100 bps in the past fiscal year, however we does not rule out the further revision. RBI is ready to revise interest rates further and even ready to hamper the economic growth to certain extent to control inflation up to its comfortable level or at least somewhere around its comfort zone levels (which is 5 per cent). It’s obvious that high interest rate would make an impact on the Indian companies’ finances, since much of the companies are having debt in their books of accounts, resulted higher interest cost hitting the company’s bottom-line and halting the investments plans.

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Inflation rate in double-digit and much higher than the comfort level gives RBI  food for thought, resulted in hike in policy rates by 150 bps, which put the liquidity situation under high stress. Although, further rate hike is not imminent, but inflation would drive the monetary policy further and interest rate expected to remain high.

Headline inflation is always considered as a major vexation for the India’s central bank. Since, inflation was reading in a double-digit figure, it was a challenge for the Reserve Bank of India to fix the inflation problem under the condition of fragile global economic recovery without denting the recovery process. In response to that, RBI revised its policy rates by over 100 bps and now it does seem that the policy action is working (see the figure) but the money supply is still at 20.34 per cent. Both trend line are now acting inversely, and inflation is falling down to 8 per cent. According to VMW Research, inflation is projected at 7.48 per cent for the month of Nov, 2010. It is also evident that in the past three months, schedule commercial banks and non-banking financial companies have started borrowing from the RBI’s window of Liquidity Adjustment Facility (LAF) at the rate of 6.25 per cent. Since, banks are now left with the limited amount of liquidity, they’re again focusing on deposits from customers. Several banks have revised their deposit rates between 50 bps and 150 bps to attract funds, however, going forward, banks will see a narrow interest rate spread, resulted in lower earnings.

Prospect of Liquidity and Interest Rate

By going through the given above graph, should RBI tight its monetary policy further to keep inflation under control, since the 150 bps already become nasty to the banks and consumers? It is good to know that the RBI’s policy is working to quell higher inflation. However further revision in interest rates in the near term (although RBI indicated temporary pause in interest rate hikes) would be inimical for the economy, since India’s core economic strength is its domestic consumption, and the same is already started fading or set to fall. Perhaps, inflation would remain above the comfortable zone of 5 per cent given the fact that the money supply is above 20 per cent, higher commodity prices such as oil, base metals, although food price component of the inflation index is expected to ease-off owing to strong crop output backed by good monsoon rains.

Discomfort levels of inflation and money supply will keep interest rates higher for the next few months. Moreover, to reduce the impact of tight liquidity, RBI has already started the Open Market Operation (OMO) to infuse liquidity by way of purchasing government bonds in exchange of money.