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India Strategy - Weakness continues, Expect recovery in H2FY20

Recently released economic data further corroborates the ongoing weakness in the Indian economy but we see preliminary indications of recovery in H2FY20:

1. a) Tax collection continues to be weak with FYTD20 (till Aug-19) indirect tax collection flat and direct tax collection up 10%yoy (against budgeted 22%yoy growth in direct segment, FY20BE). Aug-19 central expenditure grew 26%yoy (led by strong Capex as well as Revex). Expenditure growth found support from RBI’s dividend payment of Rs1.48trn, which contributed to non-tax revenue collection for the month. Consequently, FYTD20 fiscal deficit utilization stood at 79% of BE, which is better than last two years. Going forward, we expect government to pursue disinvestment aggressively and seek more interim dividend from RBI. But these measures may not be enough to meet fiscal deficit target of 3.3%, as tax collection continues anemic. Consequently, we expect government to allow a fiscal deficit slippage in light of ongoing slowdown, instead of curtailing expenditure to maintain fiscal deficit. Thus we expect fiscal deficit for FY20 to settle at 3.6-3.8% of GDP.
2. b) Q1FY20 CAD expanded sequentially to 2% of GDP on account of wider merchandise trade deficit led by lower exports and higher imports (oil as well as gold imports). On capital account side, we saw FDI inflows at US$13.9bn (11 quarter high), which thus provided support to overall Balance of payments, leading a net forex accrual of US$14bn (same as Q4FY19). Going forward, we expect demand to strengthen in H2FY20 leading to widening pressure on merchandise trade deficit. That along with widening fiscal deficit are expected to induce depreciation pressure on rupee in H2FY20. We expect it to settle at Rs73/USD by Mar-20.
3. c) Core industries output in August contracted by 0.5%yoy on account of weak economic output and stronger than average rainfall in this year. 6 as well as 3 month moving average continue to move southwards with Aug-19’s 3 year CAGR (compared with pre-demonetization period) at mere 1%. A quick look at component wise movement indicates that steel is the only series exhibiting some durability in the output.

Outlook: We expect a widening pressure on fiscal deficit on account of a) revenue foregone with recent corporate tax rate cuts, b) weak GST collection and c) need to maintain government expenditure in light of weak economic backdrop. Consequently, we believe that the government will allow fiscal deficit to slip in FY20 and may settle at 3.6-3.8% of GDP, instead of 3.3% budgeted. Part of fiscal slippage will be accounted through increased borrowing by the government along with new supply of bonds worth Rs530bn arising from special dividend by RBI. Hence we maintain our view of hardening pressure on G-sec yields (FY20 10 year G sec yield target at 7%) along with a steepening bias in India’s yield curve. We also expect widening pressure on trade deficit that could weaken INR/USD further to ~Rs73/USD over the next few quarters. We expect RBI to allow this depreciation to happen.