The Markets Will Tell Us if the Magic Works or Not

‘Modinomics’ is still a work in progress. It is not bold, it is incremental, and works within the Indian statist structure and will thus find it tough to break free and unleash structural reforms.

Finance Minister Arun Jaitley. Credit: Flickr, CC-BY-NC-SA 2.0

Finance Minister Arun Jaitley. Credit: Flickr, CC-BY-NC-SA 2.0

The Union Budget 2016 delivered a steady message of incremental progress on a wide range of long term deliverables. What is commendable is the steadfast delivery of the fiscal deficit target, which needed immense discipline and an ability to say no to political populism and expediency in a tough global environment. What disappointed is the lack of bold reform measures to address the key issues confronting the economy and the Indian people.

The NDA II government has been steadily losing the “expectations halo” since it came to power in May 2014. Expectations ran ahead of reality with the election of the first single-party majority government in decades. The mandate was for rapid development and far reaching reforms, to catapult India and Indians on the path of prosperity. The task of transforming the Indian polity and economy has proved enormous with the focus on the long term rather than on superficial populist diversions the previous governments had found expedient to take.

The expectations from the budget were low, with the Economic Survey laying out the issues to consider – difficult global scenario, two failed monsoons, lack of pickup in the manufacturing sector, poor tax participation, stalled private capital investments and pervasive rural distress. Finance Minister Arun Jaitley was bound by his fiscal consolidation promise and a central bank that was refusing to oblige with monetary easing unless fiscal rectitude was assured by the government.

Fiscal consolidation

Jaitley unequivocally delivered on the fiscal consolidation front. The 3.5% fiscal deficit target was adhered to, government borrowings were kept at acceptable levels of six lakh crore rupees, and a framework was laid out to replace the confusing plan/non-plan expenditure nomenclature with a clearer capital/revenue expenditure classification from the next year.

Jaitley deserves praise for this, as a slippage of 0.01% or 0.02% in the fiscal deficit would not have moved the needle on the economy, but would have closed the monetary easing window. Now the Reserve Bank of India has a strong reason to cut rates quickly. Given the 60 lakh crore rupees debt burden of the Indian state, the gains from a 25 bps to 50 bps cut in rates will generate a much larger impact than a small fiscal deficit increase would have. The ball is now in the RBI’s court to deliver on its accommodative pledge given in the February credit policy statement.

The twin challenges of finding money for the Seventh Pay Commission and OROP have ostensibly been addressed with Rs 65,000 crore and Rs 5,400 crore provisioned respectively.

On the rural front, there was a comprehensive package to address rural distress and provide a safety net to the rural economy. Crop insurance, enhanced irrigation spends, increased spends on NREGA, rural infrastructure creation, electrification and road linkages, and an ambitious target to double rural incomes in the next five years are all laudable objectives. With two failed monsoons, rural distress is a huge challenge and these measures are most welcome.

Banks were the cause of stock market weakness once more. The stock markets sold off when the finance minister read the PSU bank capitalisation figure of Rs 25,000 crore for FY2017. The reason was heightened expectations on an increased allocation for PSU banks in the light of the deteriorating non-performing assets situation. A net 2,000 crore rupees plus of FPI selling happened on the day. But the markets recovered when Jaitley made two statements – one on bank consolidation and the second that the government was open to reducing its holding to below 52% in PSU banks.

Meanwhile, the bond markets celebrated the fiscal consolidation commitment and gave a big thumbs up to Jaitley.

Taxes and subsidy

The big relief was no change in equity assets’ long term capital gains tax treatment. Unlisted companies benefited with the long term tenure being reduced to two years. The tax measures had the usual winners and losers, with lower income individuals, small firms, start-ups and new manufacturing firms favoured. The auto sector, tobacco, jewellery and many more were disappointed with fresh levies. High income earners were hit with higher surcharges and a tax on dividend incomes above 10 lakh rupees. The removal of accelerated depreciation and enhanced R&D deductions were on expected lines, though unwelcome by the affected corporates and sectors.

The surprise was the commitment to no new retrospective tax cases, the promise of waiving penalties on existing cases for settlement under a dispute resolution mechanism and the reintroduction of a tax amnesty scheme for undeclared income.

The market did not fully take into account the reaffirmation that the General Anti-Avoidance Rules (GAAR) will be applied from April 1, 2017. Many thought the GAAR had been done away with for good, like the error ridden Direct Tax Code. Thus it is likely that its re-emergence will spook the markets in the days to come.

The infrastructure thrust was underlined with a focus on roads and railways spending. Similarly, the subsidy safety nets were maintained for food, fuel and fertilizers with intentions for better targeting, direct benefit transfers and rationalisation.

How the markets viewed the budget

On record, all industrialists and bankers sang praises of the government, as is customary every year. But the markets speak the truth. As against the usual 500 crore rupees net sell off by FPIs that we have been seeing for the last few months, we had a massive 2,000 crore rupees plus net sell off. That was unnerving and led to a nearly 2% fall in the markets. But there was an equally sharp recovery with DII’s stepping in with 1,400 crore rupees of net purchases that gave a floor to the markets and allowed them to bounce back.

What lies ahead

There is now certainty that earnings recovery in corporate India will have to follow a global cyclical recovery. There is little domestic stimulus to kick-start the dormant domestic capex cycle. With huge idle capacities, highly leveraged balancesheets and debilitated lenders nursing large balancesheet holes caused by historically high stressed assets, the domestic investment recovery is postponed. If this is a replay of the 1996 to 2004 era, then we may have to wait another two years for the demand to catch up and ignite fresh investments.

The government has shown great resolve in sticking to the fiscal roadmap and deserves kudos for that. The long term impact of its actions will be superlative for the Indian people and economy. And hopefully, the rural focus will reduce rural distress and provide succour to the poor in the short term.

For the middle class and industry owners, however, the situation will be grim with low private investment and scarcity of new jobs creation. Despite its best intentions and a real change in eradicating corruption at the top, the government is not able to change the rent seeking behaviour of the pervasive petty bureaucracy of the Indian state. This is holding back enterprise in the country and only bold structural reforms, such as the creation of a common market, GST and the removal of the Inspector Raj, can transform the situation.

Our advice to industrialists: cut down debt, sell assets to reduce leverage, focus on cost cutting and productivity enhancement and don’t expect crony capitalist policies that led to superordinate profits of yore. It’s a tough new world where the old order has been shown the door and the new order is still struggling to find its feet. This is the time to hunker down and survive, not to be foolhardy and extravagant.

With foreign portfolio investors owning around 23% of the Indian market and continuing to sell around a net 500 crore rupees of stocks per day, the easiest and most profitable trade on the Indian markets has been to short the FPI-owned stocks and wait for the selling to take its toll on the prices. Crown jewels with great business models and no deterioration in outlook have fallen over 20% in this mode over the last three months. As a result, the oversold levels in the Indian markets are at a huge level.


The writing on the wall is clear. This is not going to be a liberalising right-of-centre regime. This will be a policy regime that will emphasise stronger state units, tolerated corporate sector that needs to behave and know its place, and a rapidly expanding welfare state with its attendant bills. We have leapfrogged a developmental phase and we need a 21st century WW Rostow to name this phase in Indian history, which is much like Abenomics in terms of appeal to nationalism and self-assertion but one only hopes the economic consequences are not similar.

‘Modinomics’ is still a work in progress. It is not bold, it is incremental, and works within the Indian statist structure and will thus find it tough to break free and unleash structural reforms. Whether it will deliver for the Indian masses, the Indian classes, or both, will only be known years down the line. British Prime Minister David Cameron is a good example of how a Conservative politician won a majority and a re-election by portraying his policies as the only reasonable alternative in a very tough global and domestic environment. Modi needs to fashion himself as a decent man doing his best and offering the only reasonable alternative in ‘Modinomics’.

In the meantime, the stock markets, which are always forward looking, will give us a good indication of whether it is working or not. For our future, it must work.