F2008 Budget: An Effort to Address Social Challenges
March 01, 2007
By Chetan Ahya | Mumbai
Summary
The Minister of Finance presented the annual central government budget, which is watched closely by the markets as it sets the tone for the direction of policy reforms over the coming year. Apart from addressing fiscal management as a broader issue, the government has traditionally used the budget as a platform for relaying the measures it aims to take to address the pressing macro issues. F2008 (financial year ended March 2008) budget measures focused on three key macro themes: (a) increasing agriculture spend; (b) enhancing social objectives; and (c) pushing infrastructure spending (albeit this was half-hearted, in our view). Overall, we believe the budget took a few more steps in the right direction. However, we believe that many of the critical macro challenges for the country need to be addressed outside the budget. In this context, the budget per se did not give us much encouragement that the pace of structural reforms will accelerate. Macro themes that influenced budget measures We believe that the budget largely focused on addressing the political challenges of rising inequality, redistribution of wealth and meeting the needs of the lower and middle-income population, which has not experienced the full benefits from the last three years’ strong economic growth. In this context, we believe that the F2008 budget measures focused on following three macro objectives: Increasing agriculture spend: Growth in India’s agriculture sector (which employs 220 million people) steadily decelerated to an annual average of 2.5% over the F1996-F2006 period, from 3.5% during the five years ending F1995 and 4.6% during the 1980s. This deceleration has been a concern among policymakers for quite some time and was a focus area in the budget announcement. Budget F2008 announced some measures targeted at improving conditions in the sector. To help improve public sector capex in the agriculture sector, the government plans to increase spending on irrigation by 54% and on the Bharat Nirman programme (which covers power, roads, telecom and housing in the rural areas) by 38%. Both these measures will cumulatively result in additional capex of US$2.2 billion (0.14% of GDP) in F2008. In addition, the government is targeting a net disbursement of US$7.8 billion (or 0.4% of GDP) in farm credit by the end of next year. The government added that it would take action on the recommendations of the Committee on Agricultural Indebtedness as soon as they are received. The government announced additional measures to train farmers and also launched a subsidized insurance scheme for rural landless households. Enhancing social objectives: Social development has remained among the most important issues and gained the attention of policymakers over the past three years (since the UPA government assumed power). The central government continued with its push for spending on social development, particularly in the areas of education and health. The government plans to further accelerate spending on education by 34% in F2008 from an average of 29% in the preceding three years. This would take the central government’s annual spend on education to US$7 billion (0.7% of GDP). The F2008 budget targeted an increase in spending on secondary and higher education. The increased spending will be funded by education cess (levied on tax collections for the purposes of funding education), which has been increased to 3% from 2% previously. The government also launched an innovative programme that will incentivize (via scholarships) students to continue their education up to the secondary level and potentially help reduce dropout rates. Government spending on the health and social welfare is expected to grow by 30% to US$4.4 billion (0.4% of GDP). Half-hearted push to infrastructure spending:The government moved in the right direction, in our view, by announcing measures to promote infrastructure investment. It announced two key measures to augment spending on rural infrastructure that included a 38% increase in allocation for the Bharat Nirman program and a 20% increase in allocation for the rural infrastructure development fund. This would cumulatively result in an increase in spending to the tune of US$1.8 billion (0.1% of GDP). However, we note that despite the increased spending allocation, overall capital expenditure by the government is estimated to remain close to a 15-year low, implying that the government is opting for a shift in mix rather than increasing overall capital spending. The most important announcement in this year’s budget with regards infrastructure was the government’s plan to use a ‘small’ part of foreign exchange reserves to fund infrastructure. Although there was no indication of the exact amount, we believe is it unlikely to be larger than US$5 billion in the first stage. More important, we believe this is still just a recommendation from the Ministry of Finance; to crystallize the plans for actual spending would take a long time as the government would require the support of the Reserve Bank of India (RBI), and it would also have to enact the necessary legislation to back such a measure. In the past, the RBI has not been warm to such ideas. Fiscal management improving, but still more cyclical than structural In line with the trend in the last three years, the central government announced that the headline deficit is estimated to have fallen a bit further to 3.7% of GDP during the 12 months ended March 2007 (compared with the budgeted forecast of 3.8% of GDP), well within the target implied by the Fiscal Responsibility and Budget Management Act. The central government has been able to cut its fiscal deficit from a peak of 6.2% in F2002, primarily on account of a higher ratio of tax to GDP. We believe that a significant part of the improvement in tax to GDP is cyclical, reflecting a leveraged growth cycle supported by global liquidity and low real interest rates. Indeed, most of the increase in tax to GDP is due to higher corporate taxes because of higher profits. Moreover, if we add the off-balance sheet oil subsidy of 1.1% of GDP, the fiscal deficit would be 4.8%. We believe that a sustainable reduction in the fiscal deficit requires a reduction in non-interest revenue expenditure, which has cumulatively increased by 0.3 percentage points of GDP since F2002. F2008: Forecasting a slowdown in expenditures and receipts For F2008, the Finance Minister is budgeting for an improvement in the central government fiscal deficit to 3.3% from 3.7% in F2007. The key driver behind the improvement would be a slowdown in total expenditure growth to 10% in F2008 from 15% in F2007. In our view, however, the budgeted slowdown in expenditure growth is optimistic, given that the government has failed to implement any significant expenditure reforms. For instance, total expenditure growth was budgeted to grow at 10.9% in F2007, but the figure was higher at 14.9%. On the revenue side, we believe that the government is fairly realistic in its tax collection target. It forecasts a slowdown in tax collection growth to 17% in F2008 from 28% recorded in the previous year — with corporate tax collection growth expected to decelerate to 15% from 45% in F2007. This is also in line with our view that economic growth is expected to slow over the coming year. Conclusion Overall, the budget took a few more steps in the right direction. As expected, the government initiated measures to increase social development expenditures, e.g., education and health. Not surprisingly, the budget avoided the push for privatization and foreign direct investment (particularly multi-product retail business and insurance sector). More important, in our view, is that while the government will likely initiate some reforms, the pace of implementation is unlikely to be strong enough to sustain the current 9% GDP growth without concurrent emergence of overheating signs. We believe that the government needs to anchor a stronger supply response (growth in productive capacity) in order to transition to higher and sustainable growth. The government needs to implement measures to accelerate the supply-side response by investing much larger sums in infrastructure, augmenting resources through privatization, implementing labor reforms, and strengthening the regulatory and administrative framework.
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Bigger Budget Surplus, More Concessions than Expected
March 01, 2007
By Denise Yam | Hong Kong
Financial Secretary (FS) Mr. Henry Tang presented his fourth budget speech on February 28, 2007, and his final one in his current term as FS. Favorable results in the 2006/07 fiscal year, with a revised estimated budget surplus of HK$55.1 billion (3.6% of GDP), put the government under immense pressure to “share the surplus with the people”. The FS unveiled significant one-off concessions as well as tax cuts for the next fiscal year. Strong economic growth (+6.8% YoY in 2006) and favorable asset market conditions boosted tax revenues and gave Hong Kong a surplus in its operating fiscal account for the second straight year, of an estimated HK$38.6 billion (versus HK$0.6 billion originally budgeted). Operating revenue excluding investment income is estimated at HK$211.6 billion (14% of GDP), HK$16.3 billion higher than budgeted originally. The operating balance before investment income also enjoyed a surplus of HK$15.9 billion, larger than F05/06’s HK$4 billion. For F07/08, the government projects for a consolidated surplus of HK$25.4 billion. Nevertheless, the surplus budget remains driven by a surplus in the capital account (HK$18.2 billion) and investment income on fiscal reserves (HK$19.9 billion). The operating budget balance before investment income is expected to remain in deficit (HK$13 billion) for three more fiscal years before turning to a surplus in F10/11. Concessions that “share the surplus with the people” To “share the surplus with the people”, the FS proposed one-off concessions and tax cuts totaling more than HK$20 billion (37% of the estimated surplus in F06/07, or 1.3% of GDP) in the latest budget speech. One-off waivers and concessions totaling HK$14.8 billion include: 1) Waiver of 50% of salaries tax and tax under personal assessment for F06/07 with a cap of $15,000 — HK$8.1 billion;
2) Waiver of two quarters of property rates in F07/08 with a ceiling of $5,000 per property per quarter — HK$5.2 billion;
3) Additional one month of CSSA allowance to be paid to CSSA recipients — HK$1.5 billion Tax cuts totaling HK$5.5 billion in F07/08 include: 1) Salaries tax — HK$4.9 billion;
2) Alcohol duty — HK$350 million. Beer tax lowered from 40% to 20%, and wine to from 80% to 40%;
3) Stamp duty on property transactions — HK$250 million. Transactions between HK$1-2 million will only be subject to a flat amount of stamp duty of HK$100, from 0.75% of the transaction value previously. The largest concessions in the F07/08 budget were made in salaries tax. Marginal salaries tax bands and marginal tax rates have been proposed to return to their F02/03 levels, although the basic allowance (HK$100,000) and the standard tax rate (16%) remain unchanged. Marginal tax bands expand from HK$30,000 to HK$35,000, while the top two marginal tax rates are cut from 19% and 13% to 17% and 12%, respectively. To encourage childbirth, child allowances are raised from HK$40,000 per child to HK$50,000, with an extra HK$50,000 in the year of birth. Meanwhile, maximum deduction for self-education expenses is raised from HK$40,000 to HK$60,000 to encourage employees to seek continual self-education and training. Because of the cut in the top marginal tax rate to 17%, which is close to the standard rate, the annual income level at which the standard rate kicks in jumps significantly from HK$983,350 to HK$2.75 million (we have assumed, for simplicity, that an individual is not eligible for any deductions apart from the basic personal allowance). It follows that the largest drop in the effective tax rate (from 16% standard rate to 14.2%) as well as the largest absolute decrease in the tax bill (HK$17,667) will be seen by the HK$983,350 gross annual income group. The highest income group (less than 1% of the total number of taxpayers in F2004/05) — i.e., those earning more than the HK$2.75 million threshold — do not benefit from the latest tax cuts and continue to pay a 16% standard rate. Who do the concessions benefit? How are the latest announced benefits distributed within the economy? While the most disadvantaged groups receive extra social security assistance (HK$1.5 billion), the one-off salaries tax waiver (HK$8.1 billion) only benefits 38% of the employed population, and not the ‘poor’. Around 75% of the salaried taxpayers (28% of the employed population) will get the full 50% waiver on F06/07 taxes. The remaining 25% (10% of the employed), because they paid more than HK$30,000 in taxes, will not get a full 50% waiver as the rebate is capped at HK$15,000. With regards to the tax cuts in the next fiscal year, the biggest tax savings (>HK$10,000), as described in the previous section, go to the middle-class earning HK$600,000 to HK$1.75 million a year (around 10% of the salaried taxpayers). The waiver on rates and the cut in indirect taxes (such as alcohol duty) reach a larger population, nevertheless. The generous cap of HK$5,000 per property per quarter means that 99% of the domestic properties will have their rates completely waived in the next two quarters. Government shows complacency and optimism Although the F06/07 budget surplus is turning out to be larger than expected, the concessions offered in the latest budget have far exceeded our expectations. While the rationale was to “share the surplus with the people”, it ironically makes the budget a pro-cyclical one: fiscal stimulus when the economy is growing above-trend. Given that Hong Kong has already given up independent monetary policy due to its fixed exchange rate system, we cannot help but be slightly critical of a government showing limited appreciation that it may be constructive to let fiscal policy serve a counter-cyclical function in managing the economic cycle. On the other hand, once again, we feel that the hasty move to cut taxes suggests that the government could be getting too complacent with its finances. The better-than-expected results in the last two fiscal years have been realized with the economy growing above trend. Moreover, the exceptionally strong fiscal revenues resulted partly from buoyant asset markets in terms of both price gains and heavy turnover. Over-dependence on direct taxes and asset-related sources has made Hong Kong's government revenue excessively volatile. Actual surpluses/deficits have deviated dramatically from original budgets by a wide margin. The budget documents again reveal rather optimistic medium-range forecasts. Investment income is projected to sustain a contribution to operating revenue averaging 10% of the total in the next five fiscal years. With the less-than-impressive record in budgeting over the past decade, we maintain our skepticism towards the latest set of projections. An accounting measure to “stabilize revenues” With limited prospects to revamp the tax system any time soon, given the latest decision to shelve the GST (for the foreseeable future), Hong Kong will likely continue to bear with volatility in government revenue. Nevertheless, the government has instead looked at another way to “stabilize” its revenues. The FS has proposed revising the income-sharing arrangement between the fiscal reserves and the Exchange Fund (EF). From F07/08, the investment return on reserves will be calculated based on a 6-year average rate of return of the EF. The FS also proposed the inclusion of a guaranteed minimum rate of return equivalent to the average yield of 3Y EF notes for the previous year. We do not yet have further details on this arrangement, and believe more information will be available later from the government as well as the EF. Tasks left for the next administration The latest budget speech dedicated less (than usual) attention to longer-term policies, which could have been expected for the last speech for the current administration. Needless to say, strategic positioning for the Hong Kong economy had been comprehensively detailed in the recently released Report on Economic Summit on China’s 11th Five-Year Plan and the Development of Hong Kong. We believe that economic policy will be formulated consistent with the report’s recommendations, in strengthening Hong Kong’s competitiveness in financial services, trade, logistics and tourism industries. There was only one paragraph on “tax reform”, regarding the ongoing consultation on broadening the tax base that will conclude at the end of March. The government appears aware of Hong Kong’s need to rebalance the sources of fiscal revenues, although this has been discussed for many years and the progress has been limited. The government has continued to project ambitious targets (again upwardly revised except for asset sales) for land premium, asset sales and investment income for the next five fiscal years. In the next five fiscal years, the government now targets HK$217.1 billion in land, HK$26.6 billion in other assets, and HK$132 billion from investment income on fiscal reserves. It remains to be seen whether the ongoing tax consultation will lead Hong Kong towards the global trend or shifting from direct to indirect taxes. Meanwhile, Chief Executive Donald Tsang has already made a promise to lower the standard personal tax rate and corporate profits tax rate to 15% in his next term if he gets re-elected. We shall await with interest how fiscal management may evolve in the next administration. Maintaining economic forecasts The Hong Kong economy grew by 6.8% in real terms in 2006, just above our 6.6% forecast as resilient trade growth and bullish asset markets buoyed domestic consumer spending in the last quarter. We are maintaining our 5% growth forecast for 2007, factoring in a slowdown in trade growth (to around 7%) in line with a softening in global demand. We forecast 2.5% CPI inflation in 2007, picking up further from 2% in 2006.
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Slowing, but Nothing Fundamentally Wrong
March 01, 2007
By Sharon Lam | Hong Kong
Still waiting to bottom out: January’s economic data is often distorted by the Chinese New Year (CNY) timing effect but we can still infer from last month’s data that the Korean economy remains in a slowdown stage. This slowdown is caused by external factors (slowing global demand and exchange rate) rather than any deterioration in domestic economic fundamentals, in my view. The bad news is we believe that the external conditions, especially China, will remain under the clouds in the near term. The good news is since the domestic economy is solid, and so we do not see any forces that can hold back Korea from recovering once the external uncertainties gets cleared out. Slower production but not crash: News headlines paint a rather positive picture for January’s industrial production data as it focuses on saying last month’s production accelerated. It has accelerated, but this was already anticipated due to a low base CNY effect from last year and also due to the squeezed production schedule between Christmas and the CNY holidays. What is disappointing is that the acceleration in January production growth came in weaker than market expectations (actual +1.3% MoM versus consensus +1.9% MoM). Despite a boost from a low base effect, the YoY growth came at +7.4% in January, still lower than the average 2006 growth of +10.1%, implying that the economy is still in a slowdown phrase, but not a severe one. Taking hints from inventory and export expectations, we should already know that industrial production will slow. Should the market set expectations correctly, this mild slowdown should not be a source of big disappointment. High inventory needs to be cleared first: Despite already slowing production, Korea’s inventory level continues to pile up. Inventory growth in January saw the sharpest increase in 20 months by surging +10.7% compared to an average +5.3% growth in 2006. The rapid accumulation in inventory implies that the slowdown in final demand is faster than the manufacturers can adjust to. The largest increase in inventory came from IT, machinery, telecom equipment and automobiles, namely the major export sectors. High inventory coupled with a dim export outlook means more cyclical downturn as manufacturers will have to continue to cut production ahead until final demand improves in 2H07, we believe. Domestic demand appears stable: Consumption growth is not seeing any upside either yet, but it has remained relatively stable. In fact, despite a high base CNY effect when consumption rose during the festival in January last year, sales growth in January this year has not plunged. Growth of consumer goods sales rose +3.1% in January compared to +3.3% in December. Growth of automobile sales was particularly high in January but that could be due to a low base effect from last year when the end of special excise tax cut led to weakened sales. We do not expect any real recovery in durable goods sales, including automobiles, until overall consumer sentiment improves. On the other hand, sales of semi-durables (including clothing, footwear and cosmetics) has stayed quite resilient, meaning that the core of consumption in Korea remains intact, which is in line with our view that there is nothing fundamentally wrong with the economy, or else consumers would have cut spending on all items. The plunge in non-durable goods sales (mainly food & beverage) in January is understandable as it compared to a high base festival effect from CNY last year. We believe that overall consumption will remain stable as the current slowdown is caused only by soft sentiment, not by any adjustment in income growth. Current account likely to stay in deficit in 1H07: Korea’s current account turned red in January (-US$0.5 billion in January versus US$0.1 billion in December) due to weaker export sales than imports. At the same time, the services account remained in large deficit due to a continual increase in outbound travel, driven by a strong won and overseas business expansion. I also speculate that the sluggish consumer sentiment at home could prompt the high income group to feel more comfortable spending abroad. Indeed, this again illustrates our view that the fundamentals in Korea are solid, otherwise the people will not be able to spend either at home or abroad. Nevertheless, it means that Korea’s current account is likely to stay in red until export growth picks up. March/April will see even deeper current account deficit due to dividend payments to foreigners. Portfolio investment balance also remained in the red in January as the investment outflows by Koreans continued to be larger than the investment inflows by foreigners. The latest market sell-off in China may slow down the equity investment outflow in the near term, but the increase in investment outflow is likely to be a structural trend as the aging Koreans seek higher-return assets as well as investment diversification. More equity outflows do not mean less equity investment at home if the total liquidity for equity investment increases. Higher household savings, pension market development and the urge for higher return are all bull factors to keep expanding Korea’s total liquidity for investment in the long run, in my view. As a result, the equity outflow should not be of any fundamental concern. Despite current account and portfolio account deficits, there will not be depreciative pressure on the won as the overall balance of payment surplus stayed strong in January. The overall balance came in at $2.4 billion in January, lower than the $4.9 billion in December but still higher than the average $1.8/month in 2006. The surplus came from the continual borrowings in foreign currency (mainly in yen) to capture the benefits of a low cost of borrowing and won appreciation. With a strong balance of payment surplus, the won is likely to stay strong in the near term. In particular, I believe that the recent won/yen reversal will turn out to be temporary as the pressure on yen appreciation will die down for a while after the G7 meeting and Bank of Japan (BoJ) raised interest rate this month. Our Japan economist expects more market speculation on BoJ rate hikes to start only in the summer. Until then, I believe that there will not be any meaningful won/yen reversal. Hopes of recovery: The Korean economy is likely to remain at a crossroads in 1H07. Macro tightening in China has not loosened its grip, but rather speeded up with five increases in reserve requirement ratios in nine months (with the latest one announced on February 16). Loan growth in China is set to slow in the next few months, which will affect demand for equipment and machinery from Korea. Meanwhile, the exchange rate situation is not improving much for the exporters either. We do not see upside on export growth yet and there is likely to be more disappointing export and production data to come in the next 2-3 months, in my view. Nevertheless, the Korean economy is still intact in terms of healthy credit profile, lack of inflation risks and stable labor market. There is no smell of a macro crisis in Korea, in my view. If the economy is fragile, we should have seen a broad-based slowdown already but consumption is stable, outbound spending keeps rising and even the property market continues to hold up relatively well (bubble or no bubble), despite tough policies from the government. Once the external uncertainties get cleared out and when the global economy picks up in 2H07 as our team predicts, the Korean economy will rebound immediately, in my view.
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February Inflation Was Surprisingly Subdued
March 01, 2007
By Deyi Tan | Singapore
February inflation came in at 6.3% YoY – lower than our and market expectations of 7.0% and 6.8%, respectively. Prices rose 6.3% YoY, unchanged from the January reading. On a sequential basis, prices rose a mere 0.6% MoM, lower than the 1.2% MoM we saw in February 2002 when severe floods caused prices to surge. Where was the surprise? Inflation in key segments surprised on the downside. In particular, food prices rose a slower 10.8% YoY (versus +11.2% YoY in January) despite the El Niño impact on rice as well as disruptions caused by floods. Meanwhile, transport prices also rose at a slightly slower pace, at 1.0% YoY versus 1.2% YoY in January. What does this mean for the monetary policy outlook? Following the February floods, central bank officials pointed to limited room for a rate reduction at the March 6 meeting. This is likely due to inflationary concerns, especially since the central bank can now afford to take a breather following the 350bp of cuts that have taken place in the past ten months. While we have continually reiterated our view that the central bank need not pause rate cuts in response to supply-side inflation shocks (from floods and El Niño), especially when core inflation remains stable, it appears that the central bank is in favour of a conservative stance with respect to the timing of future rate moves. However, our central case of a further two 25bp cuts remains intact. We still expect the BI rate to come down to 8.75% by year-end.
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February Inflation Decelerates Sharply
March 01, 2007
By Deyi Tan | Singapore
February inflation lowest since March 2004: February inflation rose 2.3% YoY, following an increase of 3.0% YoY in January. This was below our and market expectations. Even on a sequential basis, prices declined by 0.4% MoM (versus -0.3% YoY in January). Core inflation also eased to 1.4% YoY, having rebounded to 1.6% YoY last month. Food inflation contributed towards the bulk of the downside: Food prices decelerated to 5.2% compared with 6.3% YoY in January, thus contributing 1.9ppt to headline inflation (versus 2.3ppt last month). Prices of fruit & veg (+23.2% YoY versus +27.8% YoY in January), seasonings & condiments (+4.2% YoY versus +4.4% YoY in January) and meat, poultry & fish (-3.4% YoY versus -1.4% YoY in January) decelerated/contracted. However, prices accelerated in the eggs & milk (+1.5% YoY versus 0.1% YoY) and non-alcoholic beverages (+6% YoY versus +5.8% YoY) segments. Non-food inflation decelerated across all categories: Inflation in the non-food category eased further to 0.5% YoY and 0.3ppt (versus 1.1% YoY and 0.7ppt in January). Specifically, prices in the transportation and housing segments (with weights of 22% and 24% in the overall index, respectively) decelerated to 0.4% YoY and 0.5% (versus 0.8% YoY and 1.4% YoY in January). In addition, the other components — personal & medical care and recreation & education — moderated to 1.2% YoY and 1.3% YoY, respectively (versus 1.3% YoY and 1.4% YoY in January).
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4Q GDP Rose 5.7% YoY
March 01, 2007
By Chetan Ahya | Mumbai
4Q GDP growth at 5.7% YoY: GDP expanded at 5.7% YoY in 4Q06 (versus 5.8% YoY in 3Q06), higher than our and market expectations. GDP growth for 2006 stands at 5.9% YoY compared with 5.2% YoY in 2005. Fixed investment accelerated, government expenditure decelerated: Domestic demand expanded 5% YoY in 4Q06 (versus 1.8% YoY in 3Q06), thus contributing 4.6%-pt to the headline number (versus 1.7%-pt in previous quarter). Particularly, gross fixed investment accelerated sharply to 9.8% YoY and 2.5%-pt (versus 3.5% YoY and 1%-pt in 3Q06). Private consumption expenditure moderated to 6.6% YoY (versus 6.8% YoY in 3Q06) amid the deceleration in credit growth. However, government expenditure decelerated sharply to 6.9% YoY (versus 13% YoY in 3Q06). Exports and imports growth also eased (4.1% YoY and 3.5% YoY in 4Q06 versus 10.5% and 7.4% in 3Q06), in line with the slowdown seen in other Asian countries. Growth picked up in agriculture and services sectors but slowed in manufacturing: On the supply side, growth in the agriculture sector accelerated to 6.5% YoY in 4Q06 (versus 6.2% YoY in 3Q06), underscored by higher production of palm oil and rubber products. The services sector also registered buoyant growth, rising by 7% YoY in 4Q06 (versus 6.4% YoY in 3Q06) on the back of strong growth in the finance, insurance and real estate sub sector. The production in the mining sector rose 1.9% YoY following a decline of 0.4% YoY in 3Q06. However, the manufacturing sector growth remained lackluster in 4Q06 at 4.3% YoY (versus 7.2% in 3Q06).
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