Fitch: India's Budget Misses the Boat on Fiscal Consolidation.

NEW YORK -- Fitch Ratings, the international rating agency, today said that India's proposed budget falls short of expectations in terms of fiscal consolidation. This, in part, reflects the realities of India's coalition politics whereby the reformists in the government need to balance fiscal consolidation against the need to boost spending on social and physical infrastructure and continue with large subsidies. However, Fitch notes that the reform agenda has been carried forward somewhat, as the long-delayed state level VAT is expected to be introduced in 2005/2006. Fitch currently assigns foreign and local currency ratings of 'BB+' to the Republic of India. The Rating Outlook is Stable.

'We are disappointed that the government has largely ignored the opportunity for faster fiscal consolidation at a time of higher growth,' said Shelly Shetty, Fitch analyst on India. Surpassing the targets set by the Fiscal Responsibility and Budgetary Management Act (FRBM) would have boosted investor confidence significantly, as it would have reflected the government's ability to pursue a more aggressive front-loaded fiscal consolidation process. Instead, the authorities have used the excuse of greater transfer of resources to states (as recommended by the Twelfth Finance Commission) to put on hold the deficit-reducing provisions of the FRBM in 2005/2006, which does little to improve the credibility of this act. The fiscal deficit target of 4.3% of GDP for 2005/2006 is quite unambitious, especially when growth is expected to remain close to 7%. This, in turn, raises concerns about India's fiscal situation when growth falters, especially as the Indian economy is unlikely to sustain 7%-8% growth in the absence of significant fiscal correction. In addition, in the absence of significant fiscal consolidation in 2005/2006, it will be more challenging for the government to eliminate the revenue deficit by 2008/2009 as set by the FRBM.

On the positive side, Fitch is encouraged that the government is set to undertake an important rationalization of the indirect tax system by announcing the implementation of the statewide VAT system from April 1, 2005.

'The long-awaited implementation of VAT will help to simplify the tax system, cut tax evasion, and boost efficiency and revenue potential over the medium term,' said Shetty. Moreover, the agency welcomes the steps taken to rationalize the personal income tax structure and streamline the deductions allowed for various personal saving schemes. Furthermore, the cut in the maximum corporate tax rate for domestic firms should promote investment and growth in the medium term. However, the revenue impact of these measures will critically depend on tax administration efforts, which are critical to fighting tax evasion. Consequently, Fitch will closely monitor tax performance (targeted to grow at 21%) during 2005/2006, which will largely determine the ability of the government to meet its revenue and fiscal deficit targets.

The government has broadened the services tax net, although the scope for further widening is still considerable, as many of the lucrative and fast-growing services remain outside the tax net. Even though services represent over 50% of GDP, their contribution to the total tax intake will continue to amount to 5% in 2005/2006. Further trade liberalization through the cut in peak custom duty (from 20% to 15%) for non-agricultural products is desirable, as it will improve the efficiency of the Indian industry in the medium term. The government continued to build on the concept of education by increasing taxes on tobacco products to fund the heath care sector. Finally, the government has continued to support the textiles sector through various tax measures to foster growth in textile exports to take advantage of the increased demand following the abolishment of the quotas under the Multi-Fiber Agreement in 2005.

Fitch is disappointed that the authorities did not set any explicit target for disinvestment receipts. This reflects the less aggressive approach of the Congress-led coalition to privatize state-owned enterprises, even when a number of them incur chronic losses. Moreover, the budget made only a passing comment on liberalizing the foreign direct investment (FDI) regime in sectors like mining, trade, and pensions after a careful review and consultation process. This is unsatisfactory owing to the low foreign direct investment flows of 1% of GDP in India.

'Liberalizing the FDI regime will not be an easy task for the government, as it will need the support from the left parties, which in the past year have been quite skeptical in backing initiatives designed for attracting foreign direct investment flows into India,' said Shetty. India's trade integration and export potential could be boosted tremendously with higher foreign direct investment, such as witnessed in China and Mexico.

In line with its Common Minimum Program and continuing on the theme of last July's budget, the government has focused its spending to develop physical and social infrastructure in the areas of education, health, housing, and rural development. Addressing the need of the agricultural sector is good, as it can have a multiplier effect on the economy, given that two-thirds of the population is employed in this sector. Investment in irrigation facilities, development of rural infrastructure, crop diversification, and increasing credit to the sector were the main elements of the government's agricultural strategy. However, Fitch was disappointed that the authorities refrained from cutting subsidies drastically, which impose a significant burden on public finances. Selective phasing out of subsidies is critical to releasing resources for increasing capital and infrastructure outlays. Moreover, unlike the budgets of the previous government, no interest rate cuts were made in the small saving instruments, which continue to burden the public finances and reduce the effectiveness of monetary policy.

Overall, Fitch is disappointed that the government did not seize the opportunity of higher growth to reduce the fiscal deficit further. India's general government debt burden, at over 80% of GDP, is among the highest in the 'BB' rating category, and its revenue-based fiscal indicators are far worse than the 'BB' median.

'Despite the country's external strengths, such as solid external liquidity and moderate and fast declining external debt burden, the high fiscal deficit stands in the way of India achieving an investment-grade rating in the near term. As this budget was neither a very reformist nor an extremely tight one, it will do little for India to move up the rating scale,' said Shetty. Fitch will continue to monitor the government's fiscal consolidation efforts to decide on any potential upward movement in India's sovereign ratings. Conversely, repeated delays in fiscal consolidation will increasingly weigh on sovereign risk perceptions over time.