Musings on a new financial year
A crystal ball gazing looking at rear view mirror!!
(Long read alert)
We, in India, follow many New Year’s Day celebrations based on our colourful religio-socio-linguistic-cultural traditions but the most mundane & commercial one in ‘industrial – commercial age’ goes eventless. None celebrates our accounting financial year though traditionally the new year celebrations were aligned to agricultural production cycle when people together celebrate the benefits of harvests toiled for in the preceding year and prayed to for luck and prosperity for the coming year!
The ‘commercial age’ financial new year is just a book keeping concept but beyond that we can always use this opportunity to see what we achieved financially and where all we need to focus to improve our financial health. It is needed in a country where a new middle class is emerging with very poor financial literacy. It’s irony of our education system that compound interest principles are taught in high school level but the practical implications is not properly understood by even very educated non-finance persons.
In last few years interest surged of financial education especially among younger generations and with wide penetration of Internet, there are mushrooming of financial educators and trainers of different shades with wide disparity in basic quality. However, it’s a good development and surely more people will be benefitted than misled.
However, the main focus of this writing is not financial education but to make a crystal ball gazing for coming 365 days. Now among younger generation, both knowledge and interest in economy and finance is growing. I feel it may worth an effort to share our views of what went by and what lies ahead. If at times it seems like a boring or complex read for you, just leave it there. As a writer, I would consider that as failure to convey our ideas in simple language and will try harder to make it simpler in future without being simplistic.
Let’s start with the central govt budget. Best part of Govt of India budget is: It’s a media friendly event but people forget it after 48 hours of high decibel debates. It’s quite funny that Budget becomes a distant past event even before it is functionally operationalized on the upcoming 1st April!
Let’s take few minutes to look back at it.
The GOI budget showed encouraging surge in tax revenue due to formalization of the economy and uptrend in business cycle resulted from high corporate profitability after almost 12 years. Gross Tax collection increased from Rs. 20 L crore in FY ’20 (pre – Covid year) to Rs. 25 L crore in FY ’22 (Revised Estimate) and projected to be Rs. 27.50 L crore in FY ’23. It is 37% jump in 3 years. Corporate Tax component expected to increase by Rs. 3 L crore, Personal Income Tax by Rs. 2 L crore, GST by Rs. 2 L crore and Customs Duty by Rs. 50 K crores. Removing states share of gross tax revenue, net total tax revenue increase from Rs. 16 L crore to 22 L crores. The corporate tax buoyancy is seen in spite of cut in corporate tax rate to 25% done in FY 21. We also believe the FY 23 estimate of tax receipt has a chance of overshooting in case we can plug loopholes of fraudulent claims of input tax credits still rampant in many sectors.
Second good part of budget is significant increase in grant-in-aid to states and moderate increase in capital expenditure. It increased from Rs. 5.2 L crores in 2019 -20 (pre-Covid) to Rs. 10.67 L crores. The effective increase between FY 22 and FY 23 is not significant though on headline basis the increase is whopping 26% (Rs. 5.5 L cr to Rs. 7.5 L cr). The reason is, it accounted for Rs. 52 K cr to be paid back to banks for the loan due from Air India which govt absorbed while selling the airline.
Rs. 1.25 L cr additional amount budgeted for transport sector. It increased from 1.53 L cr in 2019-20 to 3.51 L cr in FY ’23. Here again, the revised Estimate of FY ’22 shows almost Rs. 1L cr additional expenditure made in transport sector (BE FY’22 Rs. 2.33 L cr to RE FY ’22 Rs. 3.25 L cr). So not much additional allocation made to road sector but the off-balance sheet funding to NHAI has been done away with which brings credibility to budget numbers in this area.
Effective increase in Capital Expenditure is not more than Rs. 65 K cr as per estimate. Grant in Aid to states for capital expenditure may not be fully utilised by states for the intended purpose (it may be used to repay high-cost debts) and also, we don't have any clarity whether the distribution of the money will be made in equitable manner or not. Nonetheless, giving more money in hands of states is a right approach as their expenditures have higher multiplier effect in overall economy.
Now let’s focus on big numbers to get a perspective. As per RE FY ’22, Govt net income is Rs. 21 L cr and by selling assets and from miscellaneous income it gets another Rs. 1 L cr. Against this income of Rs. 22 L cr, its expenditure is Rs. 38 L crores. So almost Rs. 16 L crore is to be borrowed either from small savings account or from market by selling bonds. More than Rs. 8 L cr (50%+) of the amount borrowed would be paid as interest for outstanding loans.
For next year (FY ’23), it plans to raise Rs. 23 L cr as total income and Rs. 39.5 L cr as total expenditure. Borrowing would be Rs. 16.5 L cr and total interest payment for outstanding loan would be Rs. 9.5 L cr. (57% of loan raised). The interest burden has gone up significantly from Rs. 6 L cr in FY ’20 (pre-Covid) to Rs. 9.5 L cr in BE FY ’23. As long as economy can grow at 9% + rate, these interest payments and loan can be handled in due course, if tax buoyancy can be sustained.
But here comes the tricky parts of the budget. Budget estimates nominal GDP to be Rs. 258 L cr (hence fiscal deficit of 6.4% of GDP as borrowing estimated and as explained above is Rs. 16.5 L cr). It is estimated to grow at 11.1% in nominal terms with GDP deflator projected to be 3% to 3.5%. In strictest term GDP deflator is not same as rate of inflation but can be taken as proxy in very crude way (check the difference searching internet, if interested). So, Govt expects real GDP to grow by 7.5% to 8%. We feel this projection is optimistic because inflation is already hovering around 6% and credit growth is around 9% in spite of very low interest rate. Credit growth in emerging economics generally hovers around 1.5X to 2X of GDP growth. Considering tax shield available on interest payment, India’s real interest rate is almost 0% now. In spite of this there is tepid credit demand. Secondly, India’s gross domestic savings rate is coming down consistently from a high of 36% in 2010 to 29% in 2021. It shows people’s ability to save is being consistently eroded. India’s ICOR (Incremental Capital Output Ratio) is inching up. ICOR is roughly defined as the amount of capital required to produce one unit of output. The higher the ICOR, the less efficient is the use of capital. India’s ICOR is consistently increasing from 3.8 in FY ’17 to 4.9 in FY 19 to 6.9 in FY 20. Even assuming an ICOR of 6, domestic savings can’t generate growth of more than 5% if both domestic savings fall and ICOR rises.
We need huge amount of domestic private and foreign capital to plug the gap to achieve desired rate of economic growth. Private corporate capex will gradually pick up when the capacity utilization level crosses 75%. It’s below at present but on many sectors, it will cross the threshold level soon. Large corporates deleveraged their balance sheet significantly and banks have come out of the very long and one of the harshest NPA cycle in their lifetime. So, even though savings rate is down, banking sector have enough liquidity to meet the credit demand as and when it picks up. We can roughly assign maximum of 1.5% of additional GDP growth coming from the strength of large private and PSU corporate balance sheets.
But to meet our desired level of 8% plus growth rate and to plug the huge loan and interest burden of sovereign Govt, it is almost imperative for us to attract long term foreign direct investment, without which we may get trapped in a vicious circle of lower growth, higher debt, lower employment and nagging inflation. We need major land, labour, bureaucratic and legal reform to get serious money into India. We may feel elated at start up valuing at US$ 1 bn + coming out of India and funded by foreign funds at regular intervals but those start-ups won’t move the needle as far as our major structural problems are concerned. These reforms are beyond the purview of the budget and needs serious political will, ability, statesmanship and leadership, which, so far, has not been seen in Indian governance. After repealing of farm laws, which we believe were a good legislation for long term health of agri sector, we think the appetite for major reform will be low during next two years before election.
Possibly government understands it limitations to raise India’s growth rate and hence refrained from increasing spend on health, education and public service in spite of Covid created mayhem in health and education sectors. Health budget hardly budged and education expenditure increased from Rs. 88 K cr to Rs. 1 L cr which we feel is very nominal especially considering the fact that we had huge learning loss for 70% of the population due to lock down. It created digital divide, threw learners out of the education system and created a vast pool of unemployable youth for future. This erosion of social capital may haunt us 4 – 10 years down the line when these youngsters expect to join the labor force. Unless govt chips in, there is no way this damage can be reversed. Unfortunately, both center and state govts are oblivious to this future tragedy. Private sector can’t fill this gap as there is no immediate or objectively measurable return on investment in these types of ventures.
One important point to note here is, Govt predicts oil price to be US$ 75 per barrel in its budget estimate for FY ’23. It’s currently hovering around US$ 100/- ++ due to tension in Russia. If the tension doesn’t subside quickly and oil comes back to US$ 60 – 70 range, all calculations of both Govt and RBI would face temporary setback. But it would not dent the major macroeconomic indicators for long time. Oil import is now 4% of GDP compared to 8% about 9 years ago. And presently software services exports are more than oil import bill. Also, we have a strong foreign currency reserve which can withstand pressure on currency.
Now coming to RBI policy declarations, it seems RBI would allow inflation to run ahead of interest rate hike. In our advisory newsletters we mentioned this to our clients months back. This way Govt can inflate away a portion of its debt. So, in spite of high inflation, RBI will slowly raise reverse repo rate (and then repo rate). Also, as on date RBI is focussed more on sucking liquidity out of the system, which will help taming inflation going ahead. However, market has priced in an increase in reverse repo rate as latest VRRR (Variable Reverse Repo Rate) auction was done at 3.99%. Also, India’s 6 months bond yield jumped to 4.2% from 3.7% in Oct ’21. So, money can’t be priced by a declared rate but it finds its own price in market. One interesting data point to note that liquidity surplus is narrowing now and banks are comfortable with excess liquidity.
Other critical issues are global benchmark cost of money which is universally presumed to be 10-year treasury bond yield of US Sovereign bonds (US$ 23 trillion of total bonds are in circulation of different maturities). All sorts of asset class has been richly valued as cost of money was near 0% for almost 10 long years. It’s gradually inching up with 40-year high US inflation which seems will be stickier than Indian inflation. US 10Y yield is up from 0.45% in Feb 2020 to 2.33% now but still negative adjusting for inflation. Also, the 2Y bond yield in US gone up significantly from 0.22% in Sept ’21 to 2.33% as on date. This jump is unprecedented in scale but in recent history, between 2017 and 2018, US 02Y yield went up from 1.3% to 2.9% which coincided with fall in Indian market with a lag effect. If the pattern recurs then it doesn’t bode well for Indian market from FII flow perspective. And generally, the narrowing of yield between 10Y and 2Y bonds are termed technically as “flattening of yield curve” which professional economists term as an early sign of recession in US market. But flattening of yield curve happens more frequently than actual recession so more data points are needed before reaching a firm conclusion.
In India in last 6 months FIIs sold about US$ 15 billion worth of securities in secondary market but fall in Indian market is not significant because domestic investors have structurally shifted to equity investments and it’s a very good sign for long term health of the market. Our dependence on FII investments are gradually decreasing and unless they increase their pace of selling, we don’t feel Indian market would be greatly affected. Also, it needs to be remembered that foreign investors lost almost US$ 1 trillion year in Chinese market due to abrupt and severe government diktat on different industry sectors. Currently, these investors also lost almost US$ 100 – 200 billion in Russian market due to sanction, fall in stock price and collapse of Russian currency. All these events bode well for Indian market as it has proved over the years as more predictable, more strongly regulated and with better quality companies with high standard of disclosures and governance. Even though these types of companies are small in numbers but it’s growing at a rapid pace every year. Also, the investment through Venture Capital and Private Equity funds have really picked up in our market obviating the need for banks to get into this risky area with public money. It bodes well for budding entrepreneurs with idea and ability but no family connection to high places or family wealth to bankroll their ideas. We may not have got a Zomato or Flipkart or Swiggy or MapMyIndia or Zoho or Byjus without foreign and local risk capital flowing in to fund these in early days.
We elaborately laid down the backdrop --- the big picture which we as investors need to keep in mind. So, to summarize, our crystal ball gazing, we believe, India can grow at a 6% to 7% rate for many years to come. For additional growth we need many reforms. From market perspective, both interest in equity as investment vehicle and profitability of corporates are growing and may continue for coming few years. NIFTY went up by 17% in last one year but entire gain came during first 6 months and since then its moving sideways. We don’t foresee trigger for significant upmove in NIFTY unless FIIs quickly return in a big way. We estimate, 17% type of return is tough at index level next year. Our bet will be more from mid and small cap space where one needs to be extremely selective and, both sector and stock specific.
Founder & CEO
Aveksat Financial Advisory