4 April, 2016
Now that the dust has settled, and the din has died down, and the sound-bytes have shot into the ether, and the op-eds have swung between utter condemnation and relentless fawning, one can actually sit down and assess the budgetary proposals free of distraction. The best starting point for this is the speech of Dr. Raghuram Rajan, the current governor of the Reserve Bank of India (RBI) at the inaugural Ramnath Goenka Memorial Lecture at New Delhi on March 12, 2016, which amongst others noted that "the monetary reforms of this Government will stand out as one of its signal achievements".
The speech very correctly and succinctly notes that:
(1) achieving pre-2008 growth rates in the immediate term is difficult with the debt overhang caused by, governments, households and banks racking up huge amounts of debt prior to the 2008 crisis;
(2) in an environment where the "international investor is manic depressive", India should ensure that the domestic environment "promotes strong, sustainable, and stable growth. This requires a firm platform of macroeconomic stability"; and (3) India is not alone in suffering reductions in trade levels. Importantly, the speech notes the importance of attracting stable cash flows, and highlights two key developments on this count. Firstly, the new external commercial borrowing (ECB) guidelines encourages infrastructure and other projects with limited foreign exchange earning capacity to either issue rupee denominated bonds or borrow really long tenor ECBs, thereby limiting foreign exchange risk. Secondly, the government's "Make in India" initiative has resulted in a sizeable rise in foreign direct investment (FDI), which is the most stable type of capital inflow.
The current FDI inflows are the second highest recorded, and are comfortably "higher than the current account deficit".
Lastly, to quote from the governor's speech, "Structural reforms, typically ones that increase competition, foster innovation, and drive institutional change, are the way to raise potential growth. But these hurt protected constituencies that have become accustomed to the rents they get from the status quo.Moreover, the gains to constituencies that are benefited are typically later and uncertain."
The governor's speech arrives at a crucial juncture. By virtue of its position and its independence, the RBI governor is looked at by both domestic retail and institutional investors, as well as foreign institutional investors, as a reliable barometer of the state of the economy, and as an earnest oracle for the times ahead. Thus,the measured tones of the governor set the stage for a dispassionate assessment of the Finance Minister's speech of February 29, 2016 presenting the union budget 2016-17.
Budget Proposals
The budget speech notes that the theme of the budget is "Transform India", and proposes to accomplish this through "nine pillars" that include: Social sector including healthcare (to cover all under welfare and health services);education, skills and job creation (to make India a knowledge based and productive society); infrastructure and investment (to enhance efficiency and quality of life); financial sector reforms (to bring transparency and stability); governance and ease of doing business; fiscal discipline; and tax reforms. While some of these proposals are reflected on below, the budget contains many more proposals that aid the citizen or have the effect of incrementally rectifying the economy.
One of the first proposals of the budget was the announcement of a health insurance scheme to protect one-third of Indians from hospitalization expenditure. While further details are awaited, this is a sensible start to providing some sort of public health cover, given that India is one of those countries that is inordinately dependent on the private healthcare sector. While this can be criticized as a populist measure, it is necessary and has the added benefit of adding scale to the health insurance sector, thus driving down the costs of insurance policies.
On skilling and job creation, the budget notes that the retail trade sector is the largest service sector employer in India, and that this sector has the capability of creating many more jobs as long as "regulations are simplified". To this end, the government proposes to circulate a 'Model Shops and Establishments Bill' which can be adopted by state governments on a voluntary basis.
Recognizing the importance of the Public Private Partnership (PPP) in development of infrastructure, the budget proposed 3 initiatives to re-invigorate this sector: (a) the introduction of a Public Utility (Resolution of Disputes) Bill to streamline arrangements for resolution of disputes in infrastructure related construction contracts, PPP and public utility contracts; (b) the issuance of guidelines for renegotiation of PPP concession agreements which shall consider the long term nature of such contracts and potential uncertainties of the real economy; (c) the development of a new credit rating system for infrastructure projects which emphasizes 'in-built credit enhancement structures' to enable lenders to discontinue their reliance on a standard perception of risk which often results in mispriced loans.
With the following proposals, the budget also proposes to ease FDI in certain sectors: up to 49% under automatic route in the insurance and pension sectors; 100% in asset reconstruction companies; expanding the permitted set of investment instruments to include hybrid instruments; allowing FDI in a greater number of non-banking financial company activities; and the introduction of a 'Centre State Investment Agreement', which, if adopted by states will, ensure the fulfillment of obligations of states under bilateral investment treaties that India is party to.
In close step are the budget's proposals for reform of the financial sector and for promoting the ease of doing business. These include the introduction of a comprehensive 'Code on Resolution of Financial Firms', which together with the Insolvency and Bankruptcy Code 2015, will provide a comprehensive resolution mechanism for troubled entities; amendment of the RBI Act to provide statutory backing to the Monetary Policy Framework and a Monetary Policy Committee (which the governor is his recent speech has supported); measures for deepening the corporate bond market; providing statutory backing to 'Aadhar'; and amending the Companies Act, 2013 and enabling registration of companies in one day. Indeed, with respect to the ease of doing business, one of the least commented-on initiatives of the budget is its recognition of the requirement of modernizing land record systems for dispute free titles, and proposing to implement the "National Land Record Modernisation Programme" as a central scheme from April 1, 2016.
This budget also seems to be receptive to the voice of reason. In news that will surely come as a relief to foreign investors, the budget records the acceptance of the recommendations of the Justice A. P. Shah committee, and proposes to amend the Income Tax Act with effect from April 1, 2001 to clarify that minimum alternate tax (MAT) will not be applicable to a foreign company that does not have a permanent establishment or a place of business in India. Additionally, there is a proposal to introduce amendments to the Foreign Contribution (Regulation) Act, 2010 to exclude Indian companies with nominal share capital within the limits prescribed under the Foreign Exchange Management Act, 1999 from the definition of "foreign source", thereby significantly easing their ability to make contributions in respect of their statutory (and voluntary) corporate social responsibility obligations.
To provide further impetus to the development of international financial centres (IFSCs) such as the Gujarat International finance Tec-city (GIFT), the budget proposes (a) that dividend distribution tax will not apply to companies in IFCSs; (b) units located in IFSCs will be subject to a concessional MAT rate of 9%; (c) sales denominated in foreign currency of equity shares and fund units on a recognized stock exchange in an IFSC will be exempt from securities transaction tax and capital gains tax; and (d) and foreign currency denominated transactions for the sale of commodity derivatives on a recognized association in an IFSC will be exempt from commodity transaction tax.
In measures aimed at building confidence in domestic and foreign investors, the budget emphasizes its adherence of the fiscal deficit target of 3.5% and its support for public sector banks and their re-capitalization.
Evaluating the Budget
While some have criticized the budget for lacking "big ideas", it is important to note that "big ideas" can also cause big fiscal holes. This budget looks to plug holes rather than create openings for fiscal leakage or regressive taxation. Case in point of this approach is the adherence to the fiscal deficit target of 3.5%. The budget's adherence to fiscal prudence and past commitments calmed investors as is evidenced by the lowering of yields on Indian government bonds.
Although prevailing low commodity prices give the government more room to maneuver with the deficit targets, it is equally important to avoid the resultant spike in inflation that a ballooning fiscal deficit may cause. Also, these are times where it is best to consolidate and to inculcate fiscal discipline rather than accumulate debt that is cheap initially but extortionate thereafter.
Indeed, the overall idea this budget appears to put forward is that of consolidation and incremental measures. For instance, the budgets proposals to do away with 13 cesses that account for revenue collection of less than INR 500 million and its instructions to make the taxation process less adversarial are not only practical but laudable. The measures to encourage start-ups by providing a 3 year window for 100% tax deduction and exemption of capital gains tax in certain cases display vision and foresight – seed investment in start-ups will be encouraged and start-ups have a knock-on effect in that they are a source of innovation and employment.
While this may not be a "budget of dreams", it is a workmanlike budget. There is continuity in the message of the government that while it may have overstated its abilities to deliver on promises, it has certainly not written off those promises, and is now working to set the stage for the last-mile push to achieve these promises. Structural reforms seem to have begun with the rationalization of the tax structure and the introduction of insolvency resolution mechanisms and the development of physical infrastructure with a focus on the roads and transportation sectors. These form the base on which further structural reforms can be stacked up and it is crucial to get these in order. Combined with the RBI's message that banks will have clean and fully provisioned balance sheets by March 2017, both the government and the financial sector regulators seem aligned in their intent to proverbially swallow the bitter pill, so as to set the stage for better days to come.
For further information, please contact:
Sawant Singh, Partner, Phoenix Legal
sawant.singh@phoenixlegal.in
