Budget’s Central Message Is Inflation Control, Morgan Stanley’s Ridham Desai Says

Ridham Desai expects rise in food inflation by the end of the year.

A vendor counts money in a vegetable stall in Gangtok, Sikkim, India (Photographer: Prashanth Vishwanathan/Bloomberg)  
A vendor counts money in a vegetable stall in Gangtok, Sikkim, India (Photographer: Prashanth Vishwanathan/Bloomberg)  

The Union Budget 2018 was neither growth-focused nor populist. It was more aimed at controlling inflation this year. That’s the view from Ridham Desai, head of India equity research at Morgan Stanley.

I sense that this budget is to protect inflation in 2018. We were expecting that since this is a pre-election year and therefore the expenditure growth will be budgeted at a much higher level. However, they went for 10 percent. Therefore, they are protecting inflation.
Ridham Desai, Head (India Equity Research), Morgan Stanley

Finance Minister Arun Jaitley proposed higher support prices for kharif crops and an increased farm credit target of Rs 11 lakh crore in the Budget for 2018-19 to ease the stress in the rural economy. The move is expected to stoke consumer inflation, which may prompt some in the six-member monetary policy committee to turn more hawkish.

“It is not that they [government] have raised prices. They have just given them the ammunition to lift kharif prices because rabi is already done.” Desai said the call to raise prices may be taken at the end of the year if there is a spike in food inflation.

Watch the full interview here:

Edited excerpts from the interview:

How did you view the Budget?

We have started expecting over the years that something will happen in the fine print which will be bad. But there was not much in the fine print. Even the foreign portfolio investor thing is a drafting error. So, it will get rectified and there’s no need to panic about it. Finance Minister Arun Jaitley is very clear that there is no intention of taxing retrospectively. Till Jan. 31, there will be grandfathering on equity investment gains, and it will be applicable to all classes.

It is all the equity gains starting after the budget. So, why should it be on purchases of gains? The gains which we make from Feb. 1 will be charged to the new tax...

This budget is to protect inflation in 2018. We were expecting the expenditure growth to be at a much higher level, as this is a pre-election year. But they have gone for only 10 percent, an indication they are protecting inflation.

Certainly, there is the provision on minimum support prices but it’s not that they have raised prices. They have just given the ammunition to lift Kharif prices because Rabi season is already over and wheat was done at about 6.7 percent, which was same as last year. So, no change in inflation for wheat. But for rice, there is possibility that in October-November, the price increase would be higher than the average of 5 percent of last two years.

If you go for 1.5 times the cost of production, then that allows you to increase prices but only 10-12 percent. Unlike wheat, rice is marked much lower in terms of price-to- cost ratio. It is at about 1.38. In fact, a host of Kharif crops are below 1.5 times. There is some food inflation which can come towards the end of the year. There may be some merit in this because farm income has been very sluggish. So, in some form it is transfer of income. But it will be contingent on how inflation behaves.

The Finance Minister has completely rejigged oil, which means that petrol and diesel are getting into the ambit of Goods and Services Tax. When it comes to GST, the central government controls the taxes. In the last few years, when oil prices were falling, the government increased taxes. The retail price in India has not fallen, whereas global prices went from $110 to $40/bbl. We didn’t experience that fall because the government raised those taxes and put them in infrastructure, which is why infrastructure spending is at an all-time high....Once oil becomes part of GST, then largely the control is with the central government and they can cut taxes. ,They can make sure that consumers do not pay the higher oil prices. So, again it’s an inflation-oriented move.

There is no overpowering growth message in this budget, no populist message...I think they went to protect inflation. To that extent, the rise in bond yields may have been reaction to markets disbelief of the numbers but the numbers are conservative.

For revenue growth, the GST revenue collection next year will be 12 months versus 11 months. So, if you make that adjustment, they are budgeting for 11 percent GST growth which embeds a lot of tax cuts in it. If the nominal growth in budget is estimated at 11.5 percent, I think that the GST would have a multiplier of 1.2-1.3 percent. Therefore, GST revenue growth should have been 14 percent and not 11 percent, which means that you are already embedding some rate cuts. So, again, it is fighting inflation. “I will compromise revenues, but I will not let prices go up” is the thought process in the budget

This is good for equity markets because inflation is their biggest worry this year. Government has done whatever they could in order to protect the oil prices. It’s beyond there control if oil goes to $100. If they control it to a certain extent, then growth gets effected. But they are trying.

For the expenditure number, is it optimistic to assume that you have to curtail the expenditure so much?

I agree that there could be some slippage which is what the bond market is currently expecting. There will be some slippage... the government could have started with 15 percent expenditure growth assumption and then slipped from there. But they have chosen to start from 10 percent and slip later in the year, if it happens. I think there is upside risk on revenues. The government has estimated corporate tax collections at 10 percent. Earnings growth this year will be in double digit. The first quarter of this year is showing 15 percent broad market earnings growth and there is a multiplier effect to it.

What was the need to announce the world’s largest health care plan and then funding it to only Rs 2,000 crore?

I had written in 2006 that India’s biggest risk going into next two decades is health and education. This budget has got extreme focus on both these items. Not necessarily from the contribution from the budget because it takes time to scale this market up. The National Health Insurance scheme is very promising. If it can be scaled up, then for the first time, it will provide health protection to poor people. So, it will take time.

But why they backed it with only Rs 2,000 crore?

But they have backed up education with Rs 30,000 crore, up from Rs 300 crore—a 124-fold increase. That’s where they have put the money. So, you can’t do both as you have budget constraints. They have announced the health plan to seed the idea and they will scale this up. So, meanwhile get all out on education. So, education has received more from this budget. Finally, health and education has got attention. The expenditure of health and education for the last 20 years has been falling. So, it is very bad but at least we now have inclining which may turn. Education is certainly turning this year. But this is not this year’s agenda. They did that even to direct benefit transfer which took two years to scale it up. So, it takes time to scale these things.

So, it is just a promise unlikely to get delivered this year, if this is the funding which they could back it with?

The real optics aspect of the budget is in the rural segment. Everybody is saying that it is a rural budget. But in reality, the rural expenditure as a percent of GDP will drop from 0.65 percent to 0.6 percent. But health, I think, is real plan and it will scale up. You cannot put $30 million to work in a single year on a new program. This is how the new programs like highways are built. You had to make announcement that this is the vision and let’s start.

If you look at history of the government and their successive programs, they always started small with the big vision and then they scaled up. I would be worried if they would have thought to scale this in the first year itself. It could be an execution disaster.I wouldn’t criticise them on health plan.

Do you think that the government thinks that growth will come in an organic way and we don’t need to do anything additionally to support return of growth?

It is the choice of spending. They continue to focus on infrastructure which will get 20 percent support this year, on top of 20 percent support for the past two years. There is no let up of that and it is a good quality spending. Urban development spending is budgeted 57 percent higher. The only weakness is in electricity generation because they don’t need to attend that right now.

Otherwise, it is robust plan of continuing what they have been doing. So, it is good quality spending rather than roll out subsidies. This government’s spending is of this nature since it took office. It is to cut back consumption spending and boost investment spending. The social spending, which the government has attempted in the budget, is likely increase in MSPs in October-November. Again, they have not guaranteed it, but have left room to do it. Otherwise, this budget continues to be hawkish on social spending and be bullish on asset building.

Last year, capital expenditure ended up being down...

For the first time, they have explained that this classification is not really worth it. So, we have stopped looking at it that way. What we think is revenue, is actually not it. A lot of railway expenditure is classified as revenue, but it is actually capital expenditure.

From the government expenditure perspective, we should look at the aggregate spending. Instead of capital revenue, look at what is subsidy, interest and infrastructure. Because infrastructure is capital and we mix elements of other types of spends. Like defense, it can be a mix thing of revenue and capex and it is very hard to judge.

They haven’t increased defense.

But what’s the need? I don’t think there is need.

When asked about securities transaction tax, the Finance Minister said that rolling it back is on the table and they will go with both of it and then take a call. Are your clientele disappointed that all three are on the table right now?

I think so. I was not expecting long-term capital gains tax this year. There was a lot of debate. In the Economic Survey, there was a three-page note on equity risk premium which argued the introduction of LTCG as the government needed to temper share prices. But on the other hand, the government had very big divestment targets. So, it is counter intuitive. But they have gone for it. I thought they will increase the holding period from one year to two years and spare the tax this year, and make it the next year’s agenda.

If the tax came, then there was large expectation in market that STT would be rolled back. They have chosen not to do it. In fact, the government revealed that they see a big jump in STT collections. It is a disappointment for market participants. But having said that, those who pay STT are very different from those who pay capital gains tax. The investors who pay capital gains tax are holding these shares for a much longer duration, whereas the bulk of the STT comes from day traders, around 90 percent. So they are not subjected to LTCG tax.

For investors who are generating long-term capital gains, the portion of STT is a very small number. So, they are not fungible items. While we may have expectation that we can roll it back, by rolling back STT you are supporting day trading. By bringing in capital gains tax, you are dampening returns for long-term investors. If you are taxing dividends, you have to tax capital gains because capital gains is nothing but future dividends.

It is an anomaly that you tax dividends. So, you are incentivising firms to delay all dividends. Don’t pay dividends because dividends are taxed, arbitrage them because capital gains are not. That behaviour did not come through from corporate India. Corporate India, on an aggregate basis, does not get this point but that’s what the tax law was doing. So, it is fair to bring capital gains under taxation. There should not be any independent income stream which is not subject to tax. So, eventually even farm income should become taxable.

Would India stand out as the sore thumb across large Asian countries which do not have tax from foreign institutional investors’ perspective? Do you think that the growth will be strong enough and people will find merit in investing?

The tax issue around FPIs is not a new thing. It is being persistent from past 25 years since they came to this country in 1993. It has not prevented them from buying stocks. Ultimately, you buy if the markets are going up and you take care of the tax. If you are making money, you are happy to pay tax.

There are some accounting and admin issues around it which people will have to sort out and that’s the headache. It is extra headache for people which will irritate them. But if somebody told that markets are going up 25 percent in next one year then I will worry about the tax later and first buy the market. I don’t think India losses out on account of it. But we have more transparent tax regime and it will help bring some peripheral investors who stay away as they want to deal with India’s tax issues.

Over the last year, we have seen domestic money support lot more than FII money. To some extent, the government is expecting that it will not sour the mood.

FPI flows are not a function of just India. So, there is an emerging market angle to it. If the SGX is down this morning, then it is nothing to do with budget. So, we should not fall in this trap. In fact, 80-85 percent of what Nifty does in next three months is nothing to do with India. So, we can keep printing our growth numbers, capex, the market will do its thing because the Dow Jones will do its thing. If Dow goes down, Nifty it about to fall. It doesn’t matter. In this earning season, three out of four companies have surprised the analyst yet only one out of three stocks has gone up after the earnings. The market doesn’t want to go up. There is pressure on the SPX and nervousness in global equity markets. So, there is no bid left here.

You came out with India’s digital leap report which was pro urban consumption, pro non-corporate lenders. Is it in line with the Budget?

That was a 10-year view, and this is 12-month view. Next 12 months is a big environment for corporate lenders. Do you want them as compounders for next 5-7 years? Probably, not. But the stocks can go up 30-40 percent this year. The economy and growth are picking up, and infrastructure industrials will grow this year. For corporate lenders, the insolvency and bankruptcy process is gathering momentum. It is further tailwind from the budget which reconfirms the government’s intention not to tax or provide tax protection to cumulative losses.

That will help the corporate lenders. So, it is cyclical or one-year call versus a 5-10-year view on India. We continue to stay constructive on consumption. So, there is not let up on it. I just found that my focus list is loaded with rural names. It is also the case of next 12-18 months that rural-oriented consumer companies should do well because the rural economy is picking up after a few years of pain. When the Narendra Modi government assumed office in 2014, the first thing they did was to crash rural wages. So, MNREGA spending went through re-structuring. It became a public works department from being a wage distribution program. That’s what helped stem inflation. That was there contribution to inflation. Wage growth running in low 20s came down almost at zero. Imagine the pain the rural India had to go through. So, that pain is also behind us.

What will push up the rural cycle now?

There has been enough infrastructure spending in rural India which is creating jobs. The challenge is different in my view and it is long term. A lot of landless labour is leaving rural India seeking jobs. That’s why there is a feeling of not enough job creation, but when we look at indicators, then job creation is very strong. But we have job losses in rural India. So, that will stem for a while. Inflation has come down now on a sustainable basis, inflation expectations have come down and wage growth has gone up from zero to five percent.

Wages have turned positive on a real basis. There has been some pick up in farm growth and agriculture commodity prices, thus, nominal farm incomes will do better. The government has spent on infrastructure in rural areas. Road construction have been strong and electricity distribution network have been built. We should see some recovery this year. It is evident from the way that tractor sales are picking up which could sustain over the next few months.

The important thing going in 2019 is that rural economy is looking better, unlike 2003 (of ‘Shining India’ period). In the next six months, there will be broader benefits which will be visible to people, So, right now the benefits are not percolated to masses which will happen in the next 6-8 months. Of course, that’s keeping in mind the caveat that we should not get unusual surge in oil prices or some other global factor.

Do you think that the interest story will turn this year?

Rates go up when the growth outlook is improved, or inflation outlook is deteriorating. Inflation was 4-5 percent for a while...Headline has gone up from unusually low levels. If you take trending numbers, then it is around 4.5-5 percent and maybe it is up 50 basis points, and in the next six months it could be down by 50 bps. Inflation targeting is a great achievement of this administration, as it is great for bond yields, and also growth in the long run. If there is volatility, then it is welcomed. Markets have become too quiet. We were certain that there will be volatility in market...It is not fixed deposit that it will accrue every single day.

Are you suggesting that they have planned the economy to be this way over the last four years? Is this a benign backdrop for 2019 elections?

I don’t think you can plan for these things. But there are some policy choices which this government has made versus previous administration with respect to inflation. The outcomes are not entirely controlled. The Prime Minister said that he underestimated the pain in the economy. It has taken a longer than he had thought. So, it clearly has not gone as per plan. Export growth had collapsed in 2015. That couldn’t have been in the plan. Private capex took a lot longer. It took a lot of time to fix the banking sector. If the plan had been in place, then they would have fixed the banking sector in 2014. But the waited for market forces to fix it. Then ultimately, they have to come with recapitalisation. I don’t think there was grand plan to workout for 2018. You can make your choices; some choices are good and bad. And things happen according to desire.

Do you think economy is on a solid uptick?

The economy is on a solid footing but the markets will be a little less assured due to global factors...if the SPX will do yoyo every morning, then Nifty will also do yoyo. Tomorrow, if SPX goes down 10 percent, then you can’t save Nifty going back to four digits.