Note on the Union Budget 2021-22

Note: The Union Budget is a mammoth exercise covering a wide range of sectors and stakeholders. Since our prime focus is on investing, this note centers around the implications of budget announcements on financial markets.


The Union Budget 21-22 had taken the market by surprise, and rightly so. On the budget day, Bank Nifty rose by 8.26% to close at a record high while Nifty rose by 4.74%.

The reason for market euphoria is twofold: One, none of the previous seven budgets of the Modi government featured large policy announcements.


Most policy measures -- including GST, Jan Dhan Yojana, demonetization, Pradhan Mantri Awas Yojana, Ayushman Bharat, corporate tax rate reduction, or bank mergers – were announced outside of the budget.


But this year’s budget announced several policy measures. These include the privatization of two state-run banks (besides IDBI Bank) and one general insurance company, an increase in FDI (foreign direct investment) limits in the insurance sector from previous 49% to 74%, the proposal to create a bad bank to manage the bad loan stress of the banking system, and more. The government also announced recapitalization in state-run banks to the tune of Rs 20,000 crores.


Two, the policy measures announced are expected to jumpstart economic growth.


Consider the proposed privatization of state-run banks for instance. This proposal follows the mega-merger of public sector banks in 2019, which reduced the total number of such banks from 27 to 12. Privatization will not only help unlock value for these banks and their shareholders, including the government, but also hopefully lead to operational efficiencies that will reduce bank losses and improve loan growth.


Furthermore, infusion of Rs 20,000 crore into the struggling state-run banks could help kickstart credit growth in the country, which saw the worst contraction since 1952 owing to pandemic related stress.


While private banks, backed by better capital adequacy, sufficient provisions, and more conservative lending, successfully raised as much as Rs 70,000 crore as equity from the market, the public-sector banks struggled to justify higher valuations than what they presently enjoy. They therefore relied more on capital bonds and private placements for funding. The infusion of Rs 20,000 crore in them, though not sufficient, would therefore aid growth.


The proposal to create a bad bank is also a welcome move, well celebrated by the markets. What does it mean? And how could it help mitigate the asset quality pressures faced by banks in India? To learn, you may read my 2017 column in Mint newspaper here.

In brief, these measures are positive for the banking sector as a whole.


THE SIZE OF THE BUDGET


In the current financial year, that is FY2020-21, the budget size was estimated to be Rs 30.4 lakh crore. This is nothing but the total estimated expenditure (spending) by the government of India.


But owing to the pandemic, the government expects to spend an additional Rs 4.1 lakh crore, thereby increasing the size of the budget to Rs 34.5 lakh crore. For the next financial year or FY22, the budget size is kept flat at Rs 34.83 lakh crores.


This increased expenditure is expected to raise the fiscal deficit in the ongoing year to 9.5% of the GDP, from the originally estimated 3.5% of the GDP. Note: Fiscal deficit is nothing but government expenditure minus government revenues. If expenditure is higher than revenues, then it is called fiscal “deficit”.


What makes this deficit tolerable is the fact that most of it is expected to be spent on capital expenditures that could create long-term assets and jobs – in sectors such as infrastructure (housing, roads and highways, water, urban transport such as metros, and more) and healthcare. The budget for capital expenditure has been raised to Rs 5.54 lakh crores, a rise of 26% from previous year’s Rs 4.39 lakh crore.


To fund this capex (primarily in infrastructure), the government has proposed to create a development finance institution (DFI) with an initial corpus of Rs 20,000 crore.


What are DFIs?


These are normally institutions owned by the government with an aim to fund specific sectors on a non-commercial basis. They may raise funds directly from the government (or even the market) and then lend to specific projects (for instance, infrastructure) at affordable rates.


The specific DFI proposed by the finance minister in the budget aims to fund Rs 5 lakh crore to the infrastructure sector over next 3 years. While more details are awaited, it is anyone’s guess that an infrastructure push is likely positive for a host of cyclical sectors, several companies under which may provide attractive opportunities.


HOW DOES THE GOVERNMENT EXPECT TO FUND ITS EXPENDITURES?


How does the government expect to spend more than the revenues it expects to receive?


Primarily by borrowing funds!


The government had set a target of Rs 12 lakh crores for borrowings in the next year. To be sure, this is lower than this year’s estimated borrowings of Rs 14 lakh crore. Though normally higher borrowings tend to spook rating agencies, triggering fears of a sovereign rating downgrade, the fact is India may have risked a rating downgrade anyway if growth did not return. What provides comfort is that the money raised through borrowing would be put to good use.


The government also expects to raise Rs 1.75 lakh crore from disinvestments, mainly LIC, BPCL, Air India, Concor, and more.


This likely explains why the government may have preferred to stay away from tinkering with taxes. Any increase in either capital gains taxes, or securities transaction taxes, or income taxes would have spooked the stock markets, thus making it difficult for the government to raise equity by selling stakes in these public sector companies. A bull market makes it easier to raise funds.


The higher borrowing may put (upward) pressure on interest rates. This is because higher borrowing by the government tends to crowd out funds available for the private sector to borrow.


This scarcity of funds in turn raises the “cost” of borrowing or interest rates. Higher interest rates, in turn, means lower bond prices, making debt (fixed income) an unattractive investment. Remember, bond prices and interest rates move in opposite directions. Higher rates also make it tougher for companies and consumers to borrow, thus impeding economic recovery.


Lastly, one fine print from the budget proposals that stands out is the “disallowance of depreciation on goodwill”.


To understand what this means, one must first understand what goodwill means. From an accounting standpoint (and in simple terms), goodwill is an asset that is created when a company acquires another company by paying an amount greater than the book value of assets. Remember that book value is nothing but total assets minus total liabilities (in other words, equity).


Let’s take an example: Assume that Company B has assets worth Rs 500 crores and liabilities worth Rs 400 crores in its books. In this case, its book value would be Rs 100 crores (which is 500 - 400 crores).


If Company A acquires Company B for Rs 150 crores, then the difference of Rs 50 crores would be reported as goodwill in Company A’s balance sheet. As an accounting practice, goodwill is typically depreciated over the years.


This makes sense because, like any physical asset such as a building or machinery, goodwill (which may include brand value besides trademark, copyright, patent, and such) too depreciates over time unless maintained through routine “repairs” (in this case, marketing spends). But any way …


This depreciation appears as an expense on Company A’s income statement and thus reduces taxable income (and therefore taxes).


The government realized that some companies may intentionally inflate the value of goodwill so as to report higher depreciation expenses and avoid paying taxes.


It therefore proposed disallowing depreciation on goodwill in all cases. This may likely impact future mergers and acquisitions – even genuine ones – as companies may not be willing to pay higher multiples to acquire a company if they don’t see tax benefits accruing in future.


On the whole, the Union Budget hit the right notes. Higher fiscal deficit and borrowing has been planned to pull the economy out of the record slump witnessed this year, yet most of this is expected to be spent on long term asset-creation that may create jobs and improve economic output.


The government also stayed clear of most populist pressures – no rise in taxes or COVID cess or other doles, though customs duty has been raised on a number of items including auto parts.


Other proposals such as the creation of a bad bank and DFI, privatization of state-run banks, increase in FDI in insurance, recapitalization, and more would improve credit growth and thus economic output.