New Delhi: With the Indian economy picking up steam, winding down the fiscal stimulus may be the central theme in the Union Budget scheduled to be presented on 26 February.
The government has provided fiscal stimulus worth about Rs1.86 trillion ($40 billion) in tax concessions and a further $4 billion in new spending since 2008, but this has strained the deficit and borrowing.
Here are some possible scenarios for the budget and its policy and market impact:
Partial withdrawl of fiscal stimulus
A partial rollback would help the government bring down the fiscal deficit to it forecast of 5.5% of gross domestic product in 2010-11 from a projected 6.8% in the current fiscal year.
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But the gross market borrowing figure for 2010-11 could still touch Rs4.61 trillion ($100 billion) because of higher redemptions, according to a Reuters poll of 28 economists.
That would be broadly in line with what the central bank seems to have factored in. It has said it expected gross borrowing to be “slightly higher” than this year’s record Rs4.51 trillion.
Such an outcome would cement expectations that the central bank continue to unwind its loose policy and raise interest rates by 25 to 50 basis points at its April review following last month’s rise in banks’ required reserves.
The government may start unwinding its stimulus by hiking factory gate duties — effectively a tax on manufactured goods — by about 2 percentage points for sectors such as automobiles, consumer durables, and metals, which are now growing at 20-45% in annualised terms.
The government may also raise service tax by 2 percentage points or bring more services under the tax net.
This would yield the government around $9 billion in revenue and would go some way in bringing the deficit down just below 5.5% of the GDP.
Lower duties may remain in slow sectors like textiles, food products, beverages, paper, non-mineral metals and other export-oriented sectors, where growth is still below 5%.
Market Impact: Very limited, given that both a partial unwinding of tax breaks and a moderate policy rate tightening are priced in.
Complete rollback of fiscal stimulus
Record industrial growth of 16.8% in December has increased speculation a rollback could be more extensive than markets expect, though policymakers believe the recovery is still uneven and driven largely by the stimulus.
A complete reversal would mean factory gate rates going up by 6 percentage points and service tax rate by 2 percentage points to pre-crisis levels. This would fetch the government over $21 billion in revenue, pushing down the fiscal deficit to below 5.2% of GDP and gross borrowing even below the Rs4 trillion mark.
But such radical action may endanger the recovery in the sectors, which are showing only tentative signs of revival. It also runs the risk of fanning inflation, as companies may choose to pass on the higher tax burden on to consumers.
Such a risk might prompt the central bank to act to anchor inflationary expectations, but it may opt for not more than a 25 basis point rate rise, wary of possible slowing in demand due to a higher tax burden.
Market Impact: Analysts say the stock markets may slide if the government decides to completely roll back the stimulus measures but bond traders say bond yields may not be much affected by the move.
No rollback of stimulus
Theoretically, with the advance estimates suggesting an annual economic growth of 7.2% in the current fiscal year, the government could bet on higher tax revenues to beat the loss of revenue through fiscal concessions.
Another revenue stream could be stake sales where the government hopes to raise nearly $7 billion.
But the decision to keep all of the crisis schemes in place would still leave a huge fiscal and funding holes driving both the fiscal deficit and borrowing well above current levels.
Analysts say under such scenario the deficit could stay above 6% and gross borrowing could climb above Rs4.8 trillion ($104 billion), pushing up bond yields.
Much higher government borrowing could crowd out corporate borrowers and might prompt the central bank to delay rate increases until later in the year to help the government raise funds in the markets.
Indian federal bond yields hit 16-month highs of 7.97% on Monday on concerns about heavy government debt supply.
Probability: Very unlikely
Market Impact: Analysts who track the bond markets closely say yields will spike but may be capped at 8% on expectation that the central bank might delay a rate rise.