Union Budget 2007-08: Analysis and Outlook

Union Budget 2007-08: Analysis and Outlook

Crisil Research

Review and Outlook

Growth: Monetary tightening expected to moderate growth

The fiscal 2006-07 has been characterised by robust growth buoyed by the strong performance in the industry and services sector, despite weak agricultural growth and a significantly high base. The growth scenario surpassed expectations, so did the inflationary scenario - resulting in a series of monetary tightening measures adopted by the central bank. While monetary tightening is expected to moderate growth in the next fiscal, an increasing contribution of investment, to the overall GDP, with every passing fiscal suggests sustainability of the current growth momentum.

Outlook: Given the growth momentum and prevailing buoyancy in both the industrial and services sector, we expect the momentum to continue even during the next fiscal, albeit with some moderation. The monetary tightening undertaken over the last two years, is expected to affect corporate bottomlines, along with moderating the overall demand situation in the economy. We expect the overall GDP to grow in the range of 7.9 - 8.4 per cent in 2007-08.

Inflation

The rate of inflation based on the wholesale price index, scaled up to a high of 6.7 per cent - against the RBI's target range of 5 - 5.5 per cent for the year. The average inflation for the year increased to 5.2 per cent (till the second week of February) in FY07 from 4.5 per cent during the corresponding period of the last fiscal. Supply constraints pulled up the primary articles inflation to more than the five-year high of 12.3 per cent for the week ending February 3, 2007, forcing the government to impose a ban on the exports of these items for a few months, and further taking a recourse to imports at lower or zero duty.

Outlook: Even though the recent dip in global crude oil prices and the downward revision in the domestic prices of petrol and diesel have limited the pressures on the WPI inflation for the moment, continued effort from OPEC is likely to keep the pressure up to push it back, thus not providing a sustained comfort for headline WPI inflation. In the medium-term the incorporated monetary tightening rate hike is expected to curb the pressures emerging from the demand-side, the duty cuts and fiscal policy measures will further help ease the overall situation. We expect the average inflation for the fiscal 2007-08 to remain in the 5 - 5.5 per cent range.

Interest rates

During its current monetary tightening, the RBI increased the reverse repo rate by 150 bps from a low of 4.5 per cent in August 2004 to 6.0 per cent, and the repo rate from 6.5 per cent to 7.5 per cent now. The RBI also hiked the cash reserve ratio by 100 bps during the fiscal 2006-07 to curb excessive liquidity in the system, so as to control inflationary pressures in the system. Widening of the spread between the reverse repo rate and the repo rate to 150 bps brought in more volatility in interest rates. With the first leg of the CRR hike being incorporated, the overall liquidity in the system has tightened, hardening the yields across tenors.

Outlook: We expect 10 year G-secs at around 8 per cent in 2007-08.

Fiscal

The fiscal scenario has shown distinct signs of improvement and the FRBM targets now appear within reach. Even the central government debt, as a percentage of GDP, has come down in the last 2 years.

Outlook: Our analysis indicates that the revenue targets for 2007-08 are a bit optimistic, and there is a risk of slippage if the industrial momentum moderates. We expect the industrial growth and corporate profits to moderate. Accordingly, our calculations indicate a risk of slippage of about Rs. 5,000 crores in revenue targets.

Exchange rate

Overall economic buoyancy, together with bullish domestic stock markets, boosted investor sentiments thereby attracting robust capital inflows into the economy in 2006-07. However, significant intervention by the central bank to check the export competitiveness of the rupee, restricted significant rupee gains.

Outlook: A significant interest rate differential with respect to international markets, together with an upbeat sentiment, would attract significant capital inflows into the economy, thereby adding liquidity to the market. However, significant influx of capital inflows could offset the RBI's objective of monetary tightening, Further, any significant appreciation in the currency is expected to be monitored carefully by the RBI, so as not to hamper export competitiveness. In balance, we expect the rupee to trade at 44-45 against the dollar by the fiscal year end.

Overall fiscal trends

The dividends from high growth are clearly visible in the revised fiscal accounts for 2006-07. Revenue buoyancy more than offset the overshooting of the budgetary targets for 2006-07. As a result, fiscal deficit at 3.7 per cent of GDP improved upon the budgeted target of 3.8 per cent. A part of the reason why the fiscal numbers look good, compared with budget estimates, is the positive surprise from growth. The advanced estimates of CSO peg GDP growth at 9.2 per cent in 2006-07 - higher than what the government had anticipated. The growth momentum picked up in 2003-04 and, since then, has remained on course. The economy clocked an average of 8.5% during 2003-04 to 2006-07. This has resulted in considerable revenue buoyancy for the government - both via the direct and indirect tax routes.

A more heartening feature of this growth momentum has been the revival of the manufacturing sector, a key source of indirect tax revenue for the central government. Besides, the improved government finances also owe a lot to the Fiscal Reform and Budget Management (FRBM) Act, which by prescribing a gradual reduction in deficit ratios has forced the government to contain its expenditure within a reasonable level. Since 2003-04, central government finances have improved gradually. On the expenditure side, there was overshooting of non-plan targets, whereas the plan spending was as budgeted. The pressure from non-plan expenditure is a source of worry. Similarly the trends in revenue and capital expenditure are not particularly encouraging. While revenue expenditure overshot the budget target by 3.8 per cent, capital expenditure fell short by 1.2 per cent. The fiscal deficit in value terms exceeded the budget target by 2.4 per cent. It is the revenue buoyancy and the expansion of base (GDP) that has reined in fiscal deficit/GDP.

Automobiles

Economic growth and demographic transition will continue to propel demand

▪	The market size of the automobile industry is expected to touch Rs. 1,620 billion in 2006-07, a robust growth of 25 per cent over 2005-06.

▪	Rising disposable income and lower EMIs have contributed to the continued growth in personal vehicle categories, while sustained economic growth and easy access to low-cost credit have enabled high growth in commercial automobile categories.

▪	Margins came under pressure due to an increase in material costs, which were partly offset by price increases and an improvement in value mix. While margins declined in two-wheelers, cars and commercial vehicle segments, they improved marginally in tractors.

▪	In 2007-08, automobiles are expected to grow by 12-15 per cent, mainly driven by continued economic growth. However, growth is expected to be slower than in 2006-07, mainly due to a higher base, besides upward pressure on prices and cost of finance.

Product Category	2006-07 over 2005-06		2007-08 over2006-07
	Growth % (E)	Growth drivers	Growth % (E)	Growth drivers
Cars & Utility vehicles	21	Growth in disposable household income, excise duty cut on small cars and new model launches	12-15	Growth in incomes and new model launches. EMIs expected to be maintained, despite interest rate hikes by increasing the loan tenures
Two-wheelers	16	Rise in disposable income in age bracket of 20-35, new model launches and high growth in exports	12-15	Continued favourable income demographics, new model launches and broad-basing of export destinations
Commercial vehicles	30	Growth in redistribution segment, lower base of 2005-06, ban on overloading sustained economic growth, increased demand from constrution and mining activities	10-15	Higher base of 2006-07, sustained economic growth, continuation of high growth in redistribution segment and demand from constrution and mining activities
Tractors	23	Near-normal monsoon, faster credit growth, rising custom hiring, increasing demand for farm power per hectare, increased player thrust	5-7	Rising custom hiring, unmet demand potential; higher base of 2006-07, concerns on channel inventories and worsening credit quality in a few states

Automobiles: Tariffs %	Customs		Excise
	2006-07	2007-08	2006-07	2007-08
New cars - Completely knocked down units (CKD) - Semi-knocked down units (SKD) - Completely built units New cars - Specified small cars ¹ - Others	12.8 61.2 61.2 - -	12.9 61.8 61.8 - -	- - - 16.3 24.5	- - - 16.5 24.7
Second hand cars	102.0	103.0	24.5	24.7
Utility vehicles - 6-12 seater₂ - 12 seater and above₂	12.8 12.8	12.9 12.9	24.5 16.3	24.7 16.5
Two-wheelers	61.2	61.8	16.3	16.5
LCVs	12.8	10.3	16.3	16.5
M&HCVs	12.8	10.3	16.3	16.5
Agricultural tractors	20.4	20.6	-	-
Road tractors	20.4	20.6	16.3	16.5
Steel items	5.1	5.2	16.3	16.5
Pig iron	5.1	5.2	16.3	16.5
Engine & Engine Parts - Four-wheelers - Two-wheelers	7.7 7.7	7.7 7.7	16.3 16.3	16.5 16.5
Drive transmission, Steering, Suspension & Braking parts - Four-wheelers - Two-wheelers	12.8 12.5	10.3 10.3	16.3 16.3	16.5 16.5
Electrical Parts	7.7	7.7	16.3	16.5

¹Specified small cars include cars with length not exceeding 4,000mm and engine capacity not exceeding 1,200 cc for petrol cars and 1,500 cc for diesel cars ₂Excluding driver

Impact

No Significant impact; marginally positive for tractors.

Company	Impact	Impact factors
Maruti Udyog Ltd		A, B
Hyundai Motros India Ltd		A, B
Honda SIEL Cars India Ltd		A, B
Tata Motors Ltd		A, B
Mahindra & Mahindra Ltd		A, B, C
Ashok Leyland Ltd		A, B
Eicher Motors Ltd		A, B
Tata Motors Ltd		A, B
Bajaj Auto Ltd		A, B
Hero Honda Motors Ltd		A, B
TVS Motor Company Ltd		A, B
Escorts Ltd		A, C
Pubjab Tractors Ltd		A, C
International Tractors Ltd		A, C
TAFE Ltd		A, C

Impact factors

A.	The reduction of peak customs duty on certain components from 12.5 per cent to 10 per cent will not benefit original equipment manufacturers significantly, due to high indigenisation levels and cost-competitiveness of the domestic auto ancillary industry.

B.	The reduction in central sales tax from 4 per cent to 3 per cent may be partially passed on to end-customers. However, this is not likely to have any significant impact on the demand for automobiles.

C.	The government's continued thrust on irrigation and agricultural credit will continue to support tractor demand.

Auto Components & Tyres

Auto components industry estimated to grow by 21 percent in 2006-07

▪	The auto-components industry is estimated to grow by 21 per cent in 2006-07, due to high growth in the original equipment (OE) and export segments. The growth is expected to slow down to about 13 per cent in 2007-08. The automobile industry is estimated to grow by 25 per cent in 2006-07 in value terms. CRISIL Research expects the growth in automobiles industry to slow down in 2007-08 and come closer to the long-term trend.

▪	Operating margins are estimated to decline by 100 basis points by the end of 2006-07, as raw material costs are estimated to increase by about 30 per cent during the year. However, on an absolute level, the quantum of earnings is expected to be maintained, as the fall in margins will be offset by high growth in volumes.

▪	In 2007-08, operating margins are expected to be stable, as no hike is expected in material costs. Furthermore, due to the decline in operating margins in 2006-07, downward pricing pressure from OEMs may be limited.

Tyres offtake growth in 2006-07 estimated at 9.6 per cent

▪

CRISIL Research estimates overall tyre off-take growth to be 9.6 per cent in 2006-07. While healthy growth was observed across segments, growth in the off-take of tyres for medium & heavy commercial vehicles (MHCV) was relatively slow, as the tyre replacement frequency has decreased after the SC order restricting overloading was implemented.

We expect a growth of about 8 per cent in overall tyre off-take in 2007-08.

▪	Natural rubber prices increased by about 55 per cent in the first half of 2006-07, but softened moderately in the third quarter. We expect average natural rubber prices in 2006-07 to be about 40 per cent higher than those in 2005-06.

▪	Operating margins decreased in the first half of 2006-07, despite an increase in tyre prices; however, the third quarter margins improved, on account of softening in natural rubber and petro-based input prices. Even though prices have slid from peak levels, raw material prices are expected to remain high. Flexibility to increase tyre prices further will remain constrained by competition and the import threat from China (even after imposing an anti-dumping duty). Thus, margins are expected to improve only moderately in the second half of 2006-07 and 2007-08.

Impact

Overall budgetary impact on Auto Components & Tyres not significant

Impact Factors

A.	Reduction in the peak customs duty on components is likely to result in a marginal pricing pressure for domestic auto part manufacturers, who have a large presence in the replacement market. For companies that supply mainly to OEM segments, the impact will be negligible due to the high level of product customisation. (The OEM segment accounts for 65 per cent of the demand.) For components with low replacement demand (such as crankshafts, camshafts, fuel injection pump and steering systems), the impact is expected to be negligible. Players like MICO, who import sub-components for their final product, will benefit from the customs duty cut.

B.	The negative impact of a reduction in the peak customs duty on tyres, will be offset by the cut in customs duty on raw materials for tyres (SBR, PBR, NTCF and rubber chemicals) and reduction in the CST.

Roads

Impact: Neutral

▪	There has been a marginal increase in allocations for the National Highway Development Programme (NHDP) from Rs. 99.45 billion in 2006-07 to Rs. 106.67 billion.

▪	Allocations for rural roads are expected to increase by around Rs. 40 billion, which is expected to come through the separate window under Rural Infrastructure Development Fund (RIDF). The budget has also made allocations for other ongoing road programmes.

▪	However, no significant policies or new programmes have been announced that would significantly bolster the prospects of the sector from its existing status.

What has the budget done for growth?

While the rise in inflation remains a serious concern, the government would be reluctant to initiate measures that would retard the growth rate of the economy, regardless of whether such growth rates can be sustained with the constraints discussed above. The policy challenge would be to ensure that the economy retains its current growth trajectory, without letting inflation get out of control.

An analysis of the components of aggregate demand in recent years indicates that it has been driven predominantly by a sharp increase in domestic consumption (C) and private & public investment (I). While exports have grown consistently, imports have grown even faster, which means the 'net exports' component of aggregate demand is negative. For the fiscal year 2005-06, approximately 92 per cent of the increase in aggregate demand over the previous year could be ascribed to increases in domestic consumption and investment.

Summary

▪	The economy will maintain its high growth trajectory, but addressing inflation concerns will be of crucial importance.

▪	Investment, both public and private, will continue to increase and the impact will be higher because of the increasing efficiency with which capital is being used.

▪	Further growth can be sustained only with easing of infrastructural bottlenecks which are posing a huge supply side constraint on growth.

▪	Public investment in agriculture and in rural development, particularly in the health & human services and infrastructure sector will need to be increased further to reduce infrastructural bottlenecks and make growth more inclusive.

▪	The phenomenon of jobless growth will have to be addressed seriously.

Infrastructure - Where are we?

Despite inadequate infrastructure the kind of economic growth the country has witnessed in past three years is unprecedented. In fact, growth not only has remained on track, it has made us pause and think that if the economy can attain such a rate of growth with this level of infrastructure, what would have happened had the infrastructure been better? Does that mean that even if the infrastructure is not improved, we will continue to grow at the rate of 8-9 per cent? Perhaps not, as due to poor infrastructure, transaction costs are very high. Therefore, as the wage and other cost pressures begin to shave off the competitive advantage enjoyed by Indian manufacturers and service providers, better Infrastructure by reducing the transaction cost can playa critical role in restoring the competitive edge. What follows, therefore, is an assessment of this year's budget with regard to various infrastructure initiatives announced to spur and sustain the growth momentum.

How much has the government budgeted for infrastructure in 2007 -08? A glance at the budget figures suggests that the growth in plan expenditure on infrastructure spending in 2007-08 as compared to 2006-07 has declined from 27 per cent to 21 per cent. However, the picture across the individual sector differs. While the growth in plan expenditure on sectors such as shipping shows an increase of 51.7 per cent in 2007-08 as compared to 20.6 per cent in 2006-07, it shows a decline from 8.2 per cent to -2.8 per cent for road transport and highways for the same period. Although there has been a decline in the growth of plan expenditure in case of railways as well, the heartening feature is that the entire growth in plan expenditure of railways is financed through internal and extra budgetary resources (IEBR) rather than budgetary support.

A Summary Assessment

While the Union Budget 2007-08 has laid emphasis on improving both - physical and social infrastructure, the key again would be how effective is the implementation. All of the risks and threats to effective implementation still remain. Thus, perhaps there is no alternative except to wait and watch.