Budget 2022: Ridham Desai Is Disappointed Over One Thing

Morgan Stanley India's Managing Director Ridham Desai was disappointed by the lack of clarification on the tax issue around fully accessible route bonds in Budget 2022.

"A couple of things need to be fixed over there. Withholding tax as well as income tax return filing for global bond investors who are in no position to do that," Desai told BloombergQuint's Niraj Shah in an interview.

If India wants to be included in the MSCI Bond Index, then these things need to be addressed, he said. "I was actually quite confident that it will be done in this budget because all the signals were there. From the government to the RBI, everybody wants this to happen."

"Now it has not happened and I don't know why. Maybe it will happen in the next six weeks or in the next three months," he added.

Investment banks expect the index inclusion to prompt one-off flows of $30 billion to $40 billion into Indian bonds.

According to Desai, when it happens, it's going to take a lot of pressure from the bond market and the banking system. "Today banks are the primary funders of the deficit. And it will therefore fulfill the government's strategy of crowding in private investments because it will release domestic capital for credit because foreign investors will do some of the heavy lifting on funding the deficit of the government."

Watch the full conversation below:

Here are the edited excerpts of the interview:

What do you make of the budget?

Ridham Desai: I'm going to give you a slightly lengthy answer. So just be patient and I'll request your listeners also to be patient. So, you know, we have to step back a bit. There have been three refrains that people have had for both the market, as well as you know, macro-observers in India about the budget. One is that the government spreads are not productive, the second is that the fiscal deficit targets lack credibility and transparency and the third is that budgets in the past have lacked any strategy. So, you know, they just address the problem of the moment rather than having a long-term vision or some strategy. I think I'm going to step back a bit because it's not about this one budget. I think you should look at how things have evolved in India over the past few years, particularly since this government assumed office in 2014. So, in 2014, and I'm addressing the first part of it, which is productive spending, the total cash dole outs that the government was making was about 3% of GDP. So, this was being done through subsidies through, you know, through Rural Employment Guarantee Schemes and various other things that the government did, which is doling out cash to poor people. There was another aspect of these dole outs and in fact, you know, if you add up these dole outs going back 30 years, they add up to half a trillion dollars, so we really gave a lot of money away, doesn't seem to have made much impact, because India still has a lot of poor people and the reason historically was that these schemes were ridden with leakages, middlemen, and therefore money never reached the intended beneficiary. Now two things have changed. One is that this government has started compressing these cash dole outs and in fact, just pre-pandemic, we had reached a number of one and a half percent of GDP, which is a multi-year low. It had halved in the preceding four years and the other thing was that the cash rollouts were linked to Aadhar, so I would say the efficacy and the reach of this cash was far more efficient than it had been in the past and, in fact, I think the leakages are now probably dropped to a negligible amount. So, the cash was reaching the right people, which meant that the government would actually reduce the headline cash that was being given out because then it is, you know, probably 50% earlier and now, even though the headline numbers suggest that leakages are down 50%, they weren't really down in the hands of the beneficiary. So, a lot of money is saved for the country and for taxpayers. This number, of course, shot up in the pandemic and went all the way back to fold up naturally, because the pandemic caused a lot of pain for poor people, and the government needed to respond. Now, starting with last year's budget, and with this year's budget, this number is now sub two%, and I think, it'll probably go back to one and a half percent and even lower in the years ahead. This is a major shift. What has the government done with this money? It has basically transferred this to building productive assets. So, everything that the government builds in infrastructure is running at record highs, and the spending cumulatively has increased quite a lot over the past few years, including this budget. Now, I know there is a bit of debate whether there was actually a 25% increase in capital spending because the budgetary allocation for capital spending went up 25%. But then there were extra budgetary resources that could be reduced and maybe the total Capex did not go up as much as the headline numbers suggest. But I think that is not really of concern to me, what I am focused on is this transfer of non-productive spending to productive spend as a trend, which has continued this budget has reemphasised that and has restated the Government's intention to go back on, to be on this path of productive strength. So, first point addressed, second one is with respect to transparency and credibility. Now, obviously, you know, the governments in the past have, have kind of, massaged numbers in the budget to achieve a certain fiscal target. There has been this unmentioned pressure on India, that credit rating agencies will take higher fiscal deficit negatively and therefore you need to pursue lower deficits, year after year and of course, the government itself wanted to be on the path and it's a good path to be on, but it is clearly the path that India needs to be. But it did take the flexibility of previous governments to expand the deficit in years where it was required, for example, pandemic was one such occasion, but the more structural reason for the government to use the deficit as a tool when private investments are down, and the government needs to respond to low private sentiment to bolster the economy and this government has not been hesitant to do that and that is I think a welcome change. Hopefully, the fiscal deficit will not be persistent, and the Finance Minister keeps reminding us that she is on the glide path down and if that is done, then I think this ability to use the fiscal deficit as a tool to revive the economy, I think, is a welcome shift in government thinking. Along with it, we've seen that the government has taken a lot of off-balance sheet items back on the budget. So, one of the reasons why this year's deficit did not fall as much, is because this trend has again continued. Last year it was Food Corporation of India this year, it was a lot of PSUs that spend on capital which the government is not doing on its behalf. So, there's a kind of cleanup of the balance sheet. So that takes care of the aspect of transparency and credibility and again on the point of credibility, my observation as well, as a lot of people think that the revenue may be easily achieved. You know, you go back in the past and we have really struggled to justify revenue estimates of previous governments. That's not the case anymore and the good thing is that the divestment revenue also has crashed, in the sense that it responds to the fact that you never achieve your stated targets or why run such high targets and create a problem and credibility of the fiscal, in the third point is strategy. So, I have mentioned this in our Diwali conversation, and I think in the previous budget, I see the strategy very clear. The strategy is and I'm borrowing from the Finance Minister's speech is that private investments need to be crowded in and the government will support that until we get private investments going. So, there's one more year that the government is going to support and hopefully in the next 12 months, we did a private investment cycle. Now the context here is we circled back to 2003, Corporate private investments were at about 4% of GDP, in the peak in 2010 they were at 17% and they went all the way back down over the previous decade to 5%. So, we're sitting at pretty low levels of private investments to GDP. The government cannot do the heavy lifting of investing on behalf of the economic it can only do it when there is a cycle which is depressed and that is where we are right now. So, the government is stepping in and trying to crowd in private investment and has done various things to do that. We will not go into those details; it will consume too much time. But that's the strategy, now where does this thing take us? So hopefully in the next 12 to 18 months, we can get a pretty reasonable visible Capex cycle in the private sector. The government can then cut back on its capital spends. What that does is, it allows the fiscal deficit to fall. In fact, I think because the growth cycle improves, as a consequence of higher private investments, tax revenues go up and come in next budget and for sure, I think the budget after that, which is February just ahead of the election year, the elections there's going to be scope in that one year between 2023 and 2024 and this may not necessarily be a budget event because GST rates are no longer in the budget. They're outside the budget. There may be a recalibration of GST rates. Now what that will do is basically give a fillip to consumption because it puts money back into the hands of households and households will be able to consume few more, which is the virtuous cycle to start by crowding in private investments, then results in higher consumption and back into more investments and I dare say, the growth cycle gets extended from a normal say to a three-year period to five or six years. So, I see that strategy at place. What could you know upset this? Well, I think the most important thing is what happens globally, if Fed falls behind the curve, then I think we may have a little bit of a problem. If there's a geopolitical event which causes oil to keep surging then we have a problem, but otherwise, domestically, I think we are pretty much on this path of a new growth cycle where India's growth could go back about trend, I think it's almost a given in the next couple of years. A trend I reckon is between six and a half- seven% yield growth and we could go about trade, which we have not seen since the middle of the first decade of this meeting. So, I may have answered a few other questions that you were going to ask but I took this opportunity to put the whole thing down. We have got productive spending, we have got a credible fiscal deficit and we have got a strategy in place, and I think that's why the stock market is so happy with it, off course, the stock market is happy anyway, because earnings are coming back. The budget has not done much to upset it. Just one last point before I hand it back to you, is that one nice thing about this budget is the continuing recognition of the importance of risk capital. So that was made last year and again, it was made this year. It was not just a statement that, you know, we love risk capital. The government is backing it up with, you know, subtle changes, like what it did for long term capital gains and the equalising of surcharges that whether the risk capital comes from the secondary market nor the primary market, there is no point in differentiating the two, risk capital is risk capital private, and I think that's a very strong signal and that's what the finance minister has said in various interviews over the last 12 or 18 months. It's a very strong signal to households who are currently upping their equity exposure and my view is that this this domestic bid on stocks is not going to go away in a hurry because the environment is very conducive for domestic investors to continue buying equities. So, we'll see this bid I think, persist for a fairly long time. We've been seeing this now for three or four years, the seeds were sown, when NPS and Provident Fund were allowed to invest in equities, those like the 1980 401k movement in the U.S. and I think we're seeing continuing delivery of both policy as well as, words from the government supporting household actions in support of equities.

It was, of course heartening to see in the press conference later that they adhered to the point, you made that the divestment numbers had lost the credibility and therefore, it was important to bring that credibility back. Just two or three quick follow ups. On both the credibility question as well as the Capex question. While it seemed optically 35% a number of people pointed it out that against the headline Capex growth of 35%, the actual number, as per the budget revised estimates for FY 22, is nowhere close to 35. So, is this the best that the government would have done, you reckon and do could it have been worded better but could it have been worded better, because headline number is 35. But compared to the revised estimates, we all now know it's no longer 35% in the actual sense, right?

Ridham Desai: You are right. But you know, one argument that I heard from somebody who was talking in support of the government, was that it was a budget that was being presented and not the overall balance sheet of the country. But yeah, let us step back. Yeah, that will be an area where we could have seen, at least in the press conference, for example, there was probably less room in the budget speech to go into such granular details. But maybe in the press conference, there could have been some more debate and discussion around this. So, there are many things that happen on Capital spending. It's not a straightforward thing that the central government is the only agency that spends. There are the public sector companies that are the states. There are other undertakings of the government, there are private or unlisted entities of the government and when you aggregate all of that, actually, we don't know what the Capex is. We really don't know. See, what we are doing right now is based on what has been revealed to us. We are making an estimate and saying it's not 35, maybe it's 15. Okay, now within that I can cite so many things, which are not known to us, for example, the Finance Minister said that this year we are going to have 25,000 kilometers of new Highway contracts and big boost on construction. So, this is a doubling of the pace of Highway construction from last year. There you go into the budget documents, the total spends on highways, budgetary support plus NHI is flat here. So how is that possible? In fact, the NHI number is zero and what I reckon is happening here is that NHI still does not clearly know what number will be there because there is a parallel activity going on monetisation. So, you're selling known assets. The budget, remember, is a financing document. Okay, so if you sell assets and use that money to create new assets, the net budget impact is zero. But from an economic perspective, from a macroeconomic perspective, I'm interested in the gross numbers, what is the new asset created? The sell down of assets is not a destruction of assets, it is just using equity. In fact, this is another thing where I think the bond market may have missed the plot, which is that there is a lot of equity using that the government is going to do over the next four or five years in lieu of borrowings, that these public sector undertakings actually did, to do their Capex, whether it is a load railway or in airports. There is a whole bunch of monetisation that is happening, which is equity being used to fund new asset creation rather than debt. So again, while we know that the Central government borrowing is 14 and a half lac crores plus, we actually don't know what the gross public sector borrowing is, for example, we don't know what the States are going to borrow, and we also don’t know what public sector undertakings are borrowing. So, I think the truth is somewhere between 15 and 35. You know, I may as well say that, you know, nobody actually knows the precise number if this will only unfold in the next three, four months. I'm not so fussed about this; I will refocus on the strategy is too crowd in private investments with a robust dose of public capitals. Last year, it happened this year. Now whether the number is 15, or whether it's 25 will not make such a material difference so far as the government can execute. To me the key risk is execution, not what the actual growth in Capex and these Capex growth numbers can always be revised through the year because, remember, they are they are heavily dependent on what government revenue collection, and the government revenue collection includes divestment, it includes 5G auction, on top of taxes, on top of oil taxes, we don't know where the oil prices are going, will they have to reduce oil taxes and so there are a few imponderables here. I'll focus on what the intent is and then we'll see the execution as it happens through the year.

While some people said that it was a gamble, maybe it’s the strategy worth doing because I think this is probably the way out. The heartening thing was there were no big dole outs, as so many people anticipated ahead of state elections. Would there be dole outs and it was refreshing to see that that number was kept to a minimum?

Ridham Desai: Let me come on it, because it's a very important point. You know, when the budget speech was over, the first thought that hit my mind is, Oh, my God, inflation, RBI is going to hike very quickly and fast, but then when you dig into the budget documents, it's actually not such an inflationary budget because the headline expenditure growth is only four and a half % which is sub-inflation, sub-normal GDP growth, so even when you're spending less than inflation, you're not going to generate inflation. It's the mix of spending which causes this reaction, if you strip out the Capex, okay? The non-Capex spending of the government is close to 0.9%. year on year. This is a very, very important thing and then if you strip out, say interest and subsidy, the expenditure growth is 7%. So, it is not a Spendthrift budget. My reaction, you know, instantaneous reaction without looking at the numbers of pump priming, but it is not such a pump priming budget. It is pretty conscious of the fact that we're dealing with inflation risk, and it has not, I think, burdened the RBI with the heavy lifting, because there is no major headline growth in spending that will have to deal with.

Is there anyways, a problem and a baggage of how the nature of the government expenditure is, that is a worry, per se, because I mean, simple question as we spoke about before are we headed into a bit of a debt trap because of the fixed non-discretionary nature of the spend that India anyways has?

Ridham Desai: It is a very important question. Good you asked this question, because the world is facing a problem, not just India. Debt levels have shot through the roof during the pandemic. Notably in China and the US, in fact, in the entire Western Hemisphere and in China. India is not an exception because governments have had to spend in order to offset the loss of output from the pandemic. Now, the only thing that goes in India's favour is demographics. All these countries that I mentioned in the Western Hemisphere, in China have an ageing population. So, the growth is slowing down, arguably, our growth is accelerating. So, the government does have the hope that tax revenues will be materially higher than they are today, in order to pay up for this debt that we have raised during the pandemic. The number that I focus on is primary deficit, which is over 3%. What is the primary deficit? It is the money that the government is borrowing to pay interest costs, now, if a corporation did that, we would call it a bankrupt corporation, right? If you are going to borrow money to pay interest, that means you're in debt trap, for a government that is not the case because the government has a lot more levers than a corporate has to exit that and my hope is that, you know, there will be a greater room in the future, as tax revenues stabilise and you know, the heartening thing is that tax revenues are doing very well. You know, GST revenues as a percentage of GDP is now 60 basis points higher than what it was pre pandemic. So, all the scepticism about GST having failed should be put aside, I think the GST has been a very strong success, in improving tax revenue collection, compliance, etc. Okay, and the chances are that this will go much higher because the economy is still not back to complete normalcy, so I think in my views, we are not in a debt trap, but we have to be conscious of the primary deficit, ideally, the primary deficit should be zero. So once you get to that position, then we're not borrowing any money to pay interest costs. We have walked out of a debt trap. India can do that. I'm not so sure about other countries because they will have to work a lot harder to do it.

Okay. We at BloombergQuint went into this budget, with our tagline of 'No Indian Left Behind and one of the things that maybe a lot of people who are watching us, we were certainly watching was, whether there is something of how I say, aid given to the marginalised, to the MSME because they really presumably needed it. I mean, corporate after corporate in the listed space has come and told us that we gain market share, but the others from whom we have gained market share are in a tough spot right now. You think that was something that could have been done and was not?

Ridham Desai: No, I don't think that should be done. So as a one off during the pandemic doing it was different because you had to prevent the tail risk of going up. I think the economic survey has very well-articulated by using the word barbell. Okay. So instead of a waterfall strategy, this government has chosen a barbell strategy, which is, a barbell means that you have equal bags, you are trying to protect the retail risk of blowing up and at the same time you are trying to revive growth. So, I think during the pandemic, the effort was to prevent a blowup because if firm after firm blew up, then it would put so much pressure on the banking system, will never walk out of it. Now, I don't think that type of support is required. Even so the government has gone ahead and extended some of its you know, ongoing support and even increased it, but the fact is that when the tide rises, all the boats will be lifted. So, focus on lifting the tide, which is focused on lifting growth. When growth goes up, MSMEs will be back. The reason why we have had concentration is because growth has been low when growth is low, large firms very well. When growth is back, everybody in fact, I would say smaller firms will do a whole lot better than the larger ones, this is not about GST, this is about growth and about the fact that growth has been sub-par. Now not for 1,2,3 but for almost 10 years. Okay, so you cannot have sub-par growth for 10 years and hope that smaller entities in the economy would do well. So, I think this will change in the next three or four years.

You mentioned at the start of this interaction that you think that the bond markets may have missed a trick. The scepticism out there in the market suggests that maybe, this elevated yields maybe further tightening of the yields could happen. What's your view on how the bond markets behave because I know you also keep a keen eye on whether the MSCI bond index happens and the impact that it has and consequently, what is the impact therefore on equities if indeed yields stay elevated?

Ridham Desai: I think one of the disappointments of me from the budget was that the tax issue around the Fully Accessible Route Bonds was not addressed. A couple of things need to be fixed over withholding tax as well as income tax return filing for global bond investors who are in no position to do that. If India wants that inclusion, then these things need to be addressed. I was actually quite confident that it will be done in this budget because all the signals were from the government all the way to the RBI, everybody wants this to happen. Now it has not happened. I don't know why. Maybe it will not happen in the next six weeks, maybe it will happen in the next three months. I hope it happens. It's going to take a lot of pressure from the bond market, when it happens, it takes a lot of pressure from the banking system, when it happens, because today banks are the primary funders of the deficit, and it will therefore fulfil the government's strategy of crowding in private investments because it will release domestic capital for credit because foreign investors will do some of the heavy lifting on funding the deficit of the government. So, I hope that happens in part, If I came across as saying that the bond market may have reacted incorrectly, maybe that's not the right message that I want to give because the fact is that the borrowing program of the government starts immediately. All the other upside that may happen which is that you know, NHAI may monetise assets or you know, the statement on a lower deficit or fully accessible route bonds become a reality and bond infusion is something in the distant future or in the one quarter, two quarters away. Right now, the government will start borrowing, so the offer on the tenure was probably justified and since the market was surprised negatively by the headline deficit, maybe not so much on the gross borrowing of the system as a whole, the bond market reacted. Now it’s impact on the equity market, I think is not really that much, because the equity market only cares for growth. In the matter of when and if the numerator, which is the number of cash flows, is going fast enough, you can easily tolerate a small shift in the cost of capital. This is not a dramatic shift. It's not like 100 basis point more or 200 basis points more. So, I don't think the equity impact is that much in fact, if anything, the bond market is saying it looks like growth is coming back, I need to have yields higher, and if it is not disruptively done, which is that the RBI does not surprise us negatively or does not fall behind the curve, this is not necessarily negative for stocks, and this applies even with the Fed. You know, the Fed is trying to manage the market debate on its exit and you can see the volatility. So, we'll be faced with volatility. Yes, we will. Will share prices go up, maybe they do, will returns be moderate year on year. I certainly think they are moderating so we should not look at 2021 as any base case for 2022. But overall is the bull market index and is it getting disrupted by you know, slightly higher earnings, I don't think so.

My final question and this is from an equity market watchers perspective completely, what should be the strategy because if I look back at your recent notes and strategy notes that have come out and I read some of them with very keen interest, on the back of the truck and load financials or your recent interaction when you talk about how some of the things which may not have performed thus far and have a case for performing fundamentally, you might actually see equity market support too, how do you see equities in the year 2022.

Ridham Desai: I think financials seems to be the very obvious trade here, it is almost certain that the RBI exits this year. The debate is, you know how much interest rates go up by, but we are a little higher than the consensus, so if we are right then financials will do well because financials actually need higher short-term yields to make money. credit costs certainly peaked we do see that across the banks and credit costs are tightly linked to profits. So, profits are rising with a lag, credit cost peaks. Okay, so the reason why credit costs elevated, the profits are falling, right? If you don't have profits when it comes, and credit growth also is a lagging variable of economic activity. So, the economic activity which in our view is picking up credit goes to follow suit so it will soon enter into double digits and maybe we'll climb to the mid-teen levels. So, you add all this up, banks need higher interest margins and higher credit growth and lower credit costs to make money, so, I think they will make lots of money in the next two years. So, this is the period to be invested in banks, large banks, I think, and small banks will all do well. So, if that's the single trading market, and that's the one, I think consumption will do well, because there is going to be a very good recovery in jobs and in wages and as Capex unfolds, more jobs will be created. So discretionary consumption should do well, and industries because I think Capex looks good. So, industrials will do those. So those are the three sectors we like and then if you have to be underweight stuff, then you want to be in the global sectors, we are underweight energy materials and we continue to be underweight IT. It is just very painful, but I'm kind of getting stubborn now and maybe old, as I said, IT is a good, solid, absolute story. My concern is whether it will be able to beat financials in 2022.