Corporate Tax Cuts The ‘Start’ Of Meaningful Reforms, Says Credit Suisse’s Neelkanth Mishra
The bigger picture, according to Mishra, is the creation of risk capital and hence spending capacity in the hands of corporations.
The decision to cut corporate tax rates — a move that the Government estimates will cost it Rs 1.45 lakh crore — is the start of meaningful reforms but may not help revive the economy immediately, said Neelkanth Mishra, managing director and India strategist at Credit Suisse.
The decision will help in three key ways, Mishra told BloombergQuint in an interview.
It will help generate more equity capital by lowering the effective tax payouts for corporations. It will make the tax rate in India more competitive vis-a-vis other competing economies. At the same time, the reduced rate for new manufacturing facilities will give a boost to the idea of ‘Make In India’, Mishra said.
The bigger picture, according to Mishra, is the creation of risk capital and hence spending capacity in the hands of corporations.
The government, in terms of capital formation, I think has run out of ideas. So how many more highways can you plan and build? They are starting to see that at the current growth rate some of the roads are not viable. In the railways there is potential to invest, but the ability to spend faster than Rs 1.6 lakh crore a year is still not big enough. So what will the government do? Therefore it is much better to leave it with the corporates.Neelkanth Mishra, India Strategist, Credit Suisse
What it won’t do is help revive growth in the near term.
A number of corporations will choose to use the tax savings to speed up the process of deleveraging, which will strengthen their ability to invest eventually. Those investments, however, are unlikely to pick-up in the near term, Mishra said. At the same time, the Government’s decision to use fiscal space to cut corporate taxes means that hopes of any consumption stimulus are now dim.
In fact, as the center and states try to balance out the impact of tax cuts announced on Friday, there could be some spending cuts. This, too, would have a bearing on growth.
The corporate tax cuts, however, will help sentiment, Mishra said.
What it does do, at the margin, is that it changes sentiment. There was this belief among people that this government was anti-rich or anti-corporate. This changes that view. But this is consistent with the government’s stance so far that we need to prioritise investment over consumption.Neelkanth Mishra, India Strategist, Credit Suisse
Mishra expects the impact on central government fiscal deficit to be close 0.2 percent of GDP and believes that concerns about high public sector borrowings are overstated.
Concerns over a higher fiscal deficit pushed up the benchmark 10-year bond yield to 6.8 percent on Friday and widened the term premium, or the spread between short term and long term rates. A high term premia, together with wider credit spreads, would mean that interest rates for end-borrowers will remain high despite steep interest rate cuts of 110 basis points announced this year.
Mishra reiterated that rates, particularly real interest rates after adjusting for inflation, need to come down further. He expects India’s Monetary Policy Committee to continue paring rates but calls for better signalling to help bring down term premiums in the market.
Watch the full interview here
Edited excerpts of the interview below:
Do you see this as a start of meaningful reform?
So far we’ve just been waiting for the government to feel that there was something meaningful and large necessary. This reflects that the government sees this as a serious problem in need of large and structural changes. I suspect this is only the first one. Any economic framework needs many changes, not just one. Therefore I think this is just the start of a process.
I view it from three different approaches.
The first one is that India lacks risk capital. At this stage of per capita GDP, the nature of savings is mostly in deposits or very fragmented equity.There is not too much of aggregated equity available. So if you need, for example, 50 million tonne of steel capacity and 200 gigawatt of power capacity you need at least $100 billion equity. Where will that come from? Aggregating it through stock markets is not sufficient.
This shortage of risk capital, other emerging markets have done exactly what we decided not to do, which is socialise the losses and privatise the gains. So in China, for example, banks give a lot of loans, the loans that work create billionaires and the loans that don’t, these losses are spread out over the depositors getting 2 percent interest rate. This is something we decided not to do.
So where will the equity come from? If you reduce the tax rate you are leaving 10 percent extra with the corporates and this is very important for equity generation.
The second thing is that it attracts significant FDI. In the last 20 years, every country has cut corporate rates.In the last 20 years, everyone moved towards the 20-25 percent bracket. India was an outlier at 35 percent. This is a very meaningful change. The intent is to attract foreign capital which is important for the risk capital generation. Most people don’t know that almost 40 percent of the Chinese exports are from foreign companies. And its very important to attract that kind of capital and this tax rate does that.
The 15 percent tax rate on new manufacturing companies is a reaction to what’s been happening in South East Asia.As companies look to move out of China, countries are competing to attract them. This is a welcome reaction to that. The government means business.
The third aspect is that you have Rs 1.45 lakh crore, either the government spends it or the companies spends it. It’s just a transfer, and now, a lack of it. The government, in terms of capital formation, I think has run out of ideas. So how many more highways can you plan and build? They are starting to see that at the current growth some of the roads are not viable. In the railways there is potential to invest, but the ability to spend faster than Rs 1.6 lakh crore a year is still not big enough.So what will the government do? Therefore it is much better to leave it with the corporates.
I don’t think this will get re-invested so quickly. The companies that are deleveraging will deleverage faster. The companies that are sitting on surplus anyway had no avenue to invest so they were not investing.
But in the medium term, this allows for the equity capital to accumulate on which the companies can build their investment case, even if it is 2-3 years down the line. This will help prevent the pyramid cases that we had in the last cycle, where people borrowed at the parent level and made that equity at a subsidiary level so even at the whiff of a downfall, the house of cards collapsed. That kind of situation can be prevented if you allow equity to accumulate in the companies. The most obvious impact is in the banks. Fast growing banks, every few years, need external capital. The necessity of that goes down because of this.
Does this announcement do much for the current economic situation?
What it does do, at the margin, is that it changes sentiment. There was this belief among people that this government was anti-rich or anti-corporate. This changes that view. But this is consistent with the government’s stance so far that we need to prioritise investment over consumption.
The objective is to bring down interest rate. We all assume that this Rs 1.45 lakh crore is going to add up to the central and state government bond issuances. If you think about the arithmetic, Rs 84,000 crore or 58 percent will be borne by the centre and remaining 42 percent or about Rs 60,000 crore from the states. Given that the states can’t breach their 3 percent fiscal deficit target, they will have to cut expenditure to that extent.
Similarly, at the Centre, for PM Kisan the budgeted number is Rs 80-85,000 crore. But since they are struggling to identify farmers. Of the 14 crore farmers they were able to find only 7 crore. So that’s running at half the pace it should. Hence about Rs 40,000 crore saving. And the remaining Rs 40,000 crore can come from curtailing expenditure. And if it doesn’t, that’s a small cost to pay.
So again, what the government is prioritising is investment over consumption.
I don’t think the government is as worried as markets and companies are about the next six months of growth. I think they are looking at the long haul. They’ve realised that the fiscal discipline observed and the vigil on inflation should result in much lower interest rates and therefore this is very good for the economy three to five years out.
This clearly shows no consumption stimulus is coming. The government is willing to ride through this downcycle and it could get worse.
So to answer the question on interest rates, before you even ask it, if this had been a consumption stimulus, it would’ve been even more of a risk to interest rates. Because if it is just pure consumption stimulus, it would be inflationary. Especially if funded by RBI’s open market purchases. Whereas something that adds to capacity, potentially, and the cuts are funded by curtailment of expenditure, is actually negative for inflation.
And therefore, the immediate reaction in the bond market notwithstanding, this should mean lower interest rates a year out.
What do you think the dominant corporate behavior after this will be?
See it is very hard to talk about all the Rs 1.45 lakh crore. So let’s look at the microcosm of that--the BSE 500. So the BSE 500 in FY19 paid about Rs 2.3 lakh crore. That’s about 34 percent of the Rs 6.7 lakh crore of the total tax paid by corporate India. Two-thirds of this was energy, financials and materials.
The consumption companies, the durables and staples, which are about 10 percent of this number, they could respond because of competitive dynamics by passing it through and use this as a stimulus to generate demand by advertising or cut prices.
In some cases,there are some companies which are on MAT, some paying 35 percent tax. So those companies paying 35 percent now has ammunition to fight those on MAT. By and large, two thirds of this BSE 500 numbers is from the three sectors.
In materials and energy I don’t expect any fresh catalyst. Cement is in oversupply, there’s no need to build fresh capacity. For steel companies, given the global environment, it would be prudent to deleverage.
Therefore I do not expect this to be invested immediately.
On the financial side this helps. What it does is that it allows for better accretion of tier-1 capital and therefore slightly better lending intentions.
Contrary to fears that a corporate stimulus will become a consumption stimulus, it may show up with a lag, but it is not a consumption stimulus.
On to the bond markets. You saw the reaction in the bond markets. The issue of term premia and credit risk that you’ve spoken about for very long, that isn’t going away any time soon.
Absolutely right. So if you see the OIS market, it is effectively already pricing in a 50 basis point cut, so that brings the repo rate to 4.9 percent. On that a 6.8 percent 10-year bond yield means a 190 basis point term premia. That’s astounding. In an environment where the RBI is buying Rs 2-3 lakh crore in bonds and the government is not yet talked about a fiscal slippage.
So after this stimulus, given that we can guess how this will be funded, and how in the medium term this is positive for ratings, for weird reasons bond market decides to sell off. My sense is that this term premium is less about the fiscal slippage and the crowding out. India’s capital economy is closed to a large extent but it is not like we are dipping into domestic savings. There is large capital coming from outside as well. So its wrong to think about crowding out and public sector borrowing requirement.
My sense is that it is a signaling problem, that the MPC has erred in saying that ‘okay we are cutting by 25 basis points and this is it’. About 45 percent of the bond ownership is with the PSU banks where the treasury department, sad to say, is not really driven by profit motive and is quite lethargic.
It is not to criticise the market. The market is the market. We have to learn to navigate through it. And also, if you are a policymaker, guide it.
Interest rates that a borrower sees consists of four parts: inflation, real repo rate, term premium and the credit spread. This is the bond market equivalent. Now inflation has come down, and this I’ve long believed is the crux of the problem. Our inflation is half of what it averaged for the past six decades. And neither the government, nor corporates adjusted to it. The corporates thought the inflation will take away their debt burden. It’s not doing so. The government though nominal GDP growth will stay at 12 percent. It is not doing that. And therefore the tax assumption needs to be adjusted.
But interest rates needs to fall. What has happened is that while inflation has come down the real repo rate has averaged 2.5 percent over the last two years. There is a significant reduction that can happen in the repo rate. The term premium is worth questioning that even with a 20 basis point potential slippage in the central deficit, do you want to be talking about a 190 basis point premium.
I think it is a matter of signaling and it will come down.
The last segment is credit spread which is about the capacity of the banking system and their intention to lend. So what has happened in the last three four months is that the credit spreads have widened. I am told that in the auto market where 3-4 percent of the potential borrowers were being rejected, now 20 percent of the applicants are being rejected. Even if the loan is available. Banks have tightened. This shows that spreads have widened. The same has happened for banks lending to the corporate sector. This is a financial system capacity problem which will take some time to adjust.
But the repo rate and term premium will fall and need to fall for us to see lower rates. I think the bit about PSBR is being blown out of proportion. Given the quantum of purchases RBI is doing, it is not about demand and supply. It is about anchoring, medium term fiscal outlook, the resolve of the government to stick to its fiscal path.
Are we running out of bullets to address the current problem? With this tax cut, there is no scope for consumption stimulus. At the same time we have already done 110 basis points in rate cuts and maybe have room for another 40-50 basis points more.
I think rate cuts will continue to happen. The RBI governor is talking about it and that’s the right signal for the bond markets.
I also think that yhe problem with economic cycles is that they build on themselves. So banks become more circumspect, they reduce credit, that slows down demand. As companies become circumspect, they slow down investment and that slows down the economy. The government, look at the Telangana budget, the new budget has a 20 percent lower fiscal spending target than the interim budget. Primarily due to lower taxes.
Look at GST compensation, the June-July compensation was Rs 28,000 crore means it annualises to Rs 1.68 lakh crore and the total compensation cess is Rs 1.7 lakh crore. So you will see fiscal spending cuts, I fear.
The economy will continue to slow.
At some point, the government will have to, in the coming months and quarters, use their political capital. Equity markets have gone ballistic after this. Maybe they need to do disinvestment to show their resolve for reform, which hurts them politically, but still is better for the economy, it is better use of funds and getting large profit making PSUs in private hands. So that in 2-3 years theystart generating more value. These are things that are necessary.
The moment you see a large profit making PSU being sold, see where the term premium goes. This will also reduce stress on the fact that the government cannot spend. They are really fiscally constrained. If they get the disinvestment funds, the ability to spend will be there and that will perhaps allow the trough to be visible earlier.
So I do think more steps are needed, but eventually we need to privatise PSU banks or create incentives to them to start lending. In the current architecture there is a systemic problem with financial sector capacity. Those things may happen in the next 9-12 months. That is when the economy should start taking off.