Modi, Don't Fix What You Broke in This Indian Budget

(Bloomberg Gadfly) -- You break it, you fix it. That’s the sentiment ahead of India’s annual budget this week. Amid signs that New Delhi’s Nov. 8 ban on 86 percent of the country’s currency has disrupted demand, snapped supply chains and cratered credit growth, investors expect a fiscal lollipop from Prime Minister Narendra Modi and Finance Minister Arun Jaitley.

Bigger tax rebates for the mere 3 percent of the population that files returns would not be amiss. Without some feel-good sops for the middle class, the V-shaped recovery in consumption could become painfully U-shaped.

At the same time, a cut in the 30 percent corporate tax rate to lift sagging investments could be tricky. If fiscal largess ends up deflating hopes of a 100 to 200 basis point reduction in domestic interest rates, India Inc. will be in a worse place a year from now.

India’s fiscal house, always a little shaky, is precariously perched right now atop the crude oil market. Federal and state governments opportunistically increased their take as international prices fell, to a point where taxes account for more half the price of gasoline in New Delhi. Energy consumers never got much of a boost to disposable incomes. Now, as imported crude oil gets costlier, there’s no room to raise taxes further.

With important state elections around the corner, the petroleum levies may even have to be cut to spare voters the angst of higher pump prices on top of everything else they’ve suffered since the demonetization drive.

Morgan Stanley estimates that a $10 per barrel increase in global oil prices would require New Delhi to forgo 0.25 percent of GDP in excise duties. That may not sound like much, but bond investors have already accepted that the coming year’s budget deficit will skip a targeted pruning of 0.5 percent of GDP. A further 0.25 percent slippage could raise risk-free rates, which have headed sharply lower in the past couple of months because of a surge in bank deposits.

Who’ll be hurt? From New Delhi airport operator GMR Infrastructure Ltd. to project construction company Larsen & Toubro Ltd. as well as Tata Steel Ltd. and Tata Power Ltd., there are nine large Indian firms with leverage -- or the ratio of assets to equity -- of more than 4 times. Put another way, they have at least 3 times as much debt as equity.

When Modi came to power in 2014, there were 13 such companies on the BSE 100 Index. If the likes of Adani Power Ltd. and Jaiprakash Associates Ltd. hadn't been dropped from the gauge, it would become clear that India’s crisis of extreme leverage is raging just as intensely as ever. If anything, the malaise has spread to companies like truckmaker Ashok Leyland Ltd.

A lower cost of capital would help far more than a smaller tax bill. Markets, though, might cheer a bold corporate tax cut for the simple reason that the last time they saw one was 20 years ago, although if the government tries to pay for it by taxing long-term capital gains, investors will be less than impressed.

More importantly, if the net result of the budget is higher interest rates and a weaker rupee later this year, stock markets may be ecstatic at first -- but get cranky later. So while they’ve indeed broken a fragile economy by banning currency notes, Modi and Jaitley should eschew a quick fix. That could just make things worse.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Andy Mukherjee is a Bloomberg Gadfly columnist covering industrial companies and financial services. He previously was a columnist for Reuters Breakingviews. He has also worked for the Straits Times, ET NOW and Bloomberg News.

To contact the author of this story: Andy Mukherjee in Singapore at amukherjee@bloomberg.net.

To contact the editor responsible for this story: Matthew Brooker at mbrooker1@bloomberg.net.