Implicit in this is the view that the government will continue with a stimulus i.e. it will increase spending on a wide range of social sector and infrastructure projects without reversing some of the cuts in indirect taxes that were introduced in the second half of last fiscal.

Market opinion appears divided on the level of fiscal deficit that is likely to be targeted in this years budget. One group believes that that the new budget will show a larger fiscal deficit than the interim budget target (5.5%of GDP) and perhaps even higher than actual deficit in 2008-09 (6.2% GDP). Implicit in this is the view that the government will continue with a stimulus i.e. it will increase spending on a wide range of social sector and infrastructure projects without reversing some of the cuts in indirect taxes that were introduced in the second half of last fiscal. This camp also believes that all sorts of political and operational barriers will get in the way of the disinvestment programme.

We on the other hand believe that the budget will take a step towards fiscal consolidation and the fiscal deficit target will be in the neighbourhood of 5.5 per cent. This means that the net and gross borrowing of the government is unlikely to be very different from the Rs 3,08,647 cr and Rs 3,61,782 cr figure announced earlier in the year. This involves two key assumptions:

We predict a roll-back (at least partially) of the indirect tax reductions announced as part of the December, 2008 and February, 2009 fiscal stimulus. These along with the natural revenue buoyancy associated with economic recovery should keep the interim revenue target supported through FY10.

The interim budget has made significant allocations to flagship programmes like NREG. While further increase in allocation is possible, it is somewhat unlikely that this will add up to a substantial increase in expenditure. We certainly believe the additional expenditure for the plan will be well below 1 per cent of GDP.

We believe that a programme of "creeping disinvestment" in a number of PSUs will yield the government significant capital receipts that can help fund the additional expenditure. Large allocations for income transfers such as the enhanced salaries for government employees (perhaps the only stimulus that really worked in the past few months) under the Sixth Pay Commission are already built into the interim budget. Additional allocations on this account are unnecessary.

Why would the finance minister want to follow a strategy of fiscal consolidation? We believe that the priority going forward to aid an economic recovery would be to ensure that investment expenditure starts to pick up. For this, two things are important in our opinion --- a) ensuring that government borrowing does not compete aggressively with private credit demand when investment demand begins to revive and b) helping sustain the turn in international investor sentiment towards India in order to encourage adequate debt and equity capital inflows.

An attempt at some degree of fiscal consolidation will go a long way in ensuring this. What does this mean for the fixed income market? While there is some reversal in trend over the past few days (particularly in the OIS market that has seen the renewal of receiving interest), bonds remain oversold in our view. This partly stems from the divide in market opinion on the level of fiscal deficit that is likely and the concomitant market borrowing it entails. Were our view to pan out and the deficit projection to print in at a level no worse than that set in the budget, we see a rally in the bond market that is likely to take the benchmark 10 year bond yield down to 6.25- 6.30 per cent. While an upward drift is subsequently likely given the risk of rising inflation and credit demand on the back of an economic recovery, a turn in the yield cycle may be temporarybut may provide a quick trading opportunity.

Understanding our projections
Our bet is that while the final budget figure will entail some increase in the allocation for planned expenditure and possible concession on income tax, proceeds from disinvestment and the 3-G spectrum auction process should provide a significant cushion to the FY10 fiscal deficit figure. Further, a selective reversal in the tax cuts undertaken since December, 2008 is likely to support the revenue target by accommodating for greater tax buoyancy than initially budgeted. This is likely to translate to a fiscal deficit to GDP ratio of close to 5.7%-slightly higher than the interim budget target of 5.5% but smaller than the 6-6.5% level built into market expectations.

How is this possible?

Non-debt capital receipts to provide windfall: While the exact procedure likely to be adopted by the government in divesting its stake in PSUs remains somewhat ambiguous, we are reasonably sanguine about both the likelihood and speed with which this process will be carried out. Apart from the Rs 1120 cr already accounted for in the budget from disinvestments, at least another Rs 20,000-25,000 cr will likely accrue to the government on account of PSU IPOs (such as NHPC and OIL) and stake sales. The most likely route of stake sale will be through a "creeping disinvestment" strategy wherein the government will seek to dilute a small portion of its stake in companies in which it has a shareholding in excess of 90%. This is likely to be preferred over other routes such as the strategic sale of PSUs that are likely to be politically sensitive given the opposition faced by it from select UPA coalition partners. Examples of some PSUs that may come up for disinvestment include CIL, MMTC, STC, NMDC and HMT.

Non-tax revenue to get small push: The interim budget already accounts for Rs 20,000 cr of revenue from the sale of the 3G-spectrum auction. However, we expect the reservation price for the auction to be revised upwards from its current level of Rs 2020 cr and set in line with total revenue gains of Rs 25,000 cr.

Tax revenue to gain on selective tax cut reversals and gradual pick-up in tax buoyancy: The interim budget targets a net tax revenue figure of Rs 4,97,596 crores or an increase of 6.8% over the FY09 revised estimates. However, this figure does not include the impact of a 2% excise duty cut undertaken almost a week after the interim budget announcement as well as a 2% cut in the service tax rate along with customs duty cuts on select products like cement and naphtha. If this tax cut were to be factored in, the FY10 tax figure would come in lower than targeted in the interim budget.

However, our sense is that the government will likely undertake a selective tax cut reversal for those sectors that have gained significant traction since the October-November, 2008 stress period. While early signs of industrial recovery seem tentative at best, there is reason to believe that small pockets of the industrial sector such as steel and cement are inching back to a period of sustainable normalcy. Similarly, as highlighted by the Q4FY09 GDP data, the services sector-even adjusted for the spike in community, social and personal services-has been especially robust to a slowdown in industrial growth. Indeed, services excluding community services grew by 7% in H2FY09, only slightly slower than the 12.7% growth recorded by them in H2FY08.

This should provide the government with some confidence in rolling-back a portion of the tax cuts enjoyed by these sectors while at the same time continuing its stimulus efforts to sectors still reeling under pressure like commercial vehicles and textiles. Besides, the following needs to be kept in mind:

While tax cuts might score over enhanced spending (at least theoretically) in terms of the speed with which they render stimulus initiatives, their second round impact on output expansion is substantially smaller than expenditure increases.
Additionally, quite a few manufacturers actually failed to pass on some of these tax cuts to consumers in terms of lower prices thus the efficacy of tax cuts seems a trifle exaggerated in the Indian case.
Thus, adding up the support from selective excise duty and customs duty cut reversals as well as the roll-back in the service tax rate cut from 10% to 12%, the tax figure outlined in February, 2009 is unlikely to fall sharply below the interim budget projections. Additional cushion may be provided by a possible cess on petrol and diesel prices to fund road construction and the restoration of import duty on crude oil imports.  

Where does this leave government stimulus effort?
While early signs of recovery in the private sector limits the case for a large stimulus akin to the one provided in FY09, there remains a case for supporting this revival by way of enhanced planned expenditure on infrastructure and economic development. The push to the interim budget revenue projections from disinvestment proceeds and 3G-specturm auction revenue will likely enable the government to increase planned expenditure by close to Rs 30,000 Rs 40,000 cr without significantly impacting on the fiscal deficit.

Major heads that may see an increase over previous allocations include rural development (NREG scheme), urban planning (JNURM), roads and highways, education, sports, water resources, human resource development and power. Additional allocation may also be provided for the implementation of the National Food Security Act wherein each poor family will get 25 kg of rice or wheat for Rs 3 per kg as per the details of the Congress election manifesto.

Further, reasonable demand support is likely to emerge from the second batch of the Sixth Pay Commission payouts but this is already accounted for in the interim budget and does not entail additional allocation The figure earmarked for the cash transfers works out to Rs 40,000 cr - Rs 15,000 cr higher than the payouts in FY09 that were crucial in cushioning domestic growth from external headwinds.

While government efforts in shoring domestic consumption have been successful so far, the next leg of economic recovery will likely entail a fiscal policy that will also encourage private investment. Thus, we believe that the core macro strategy of the government will remain centered on providing support to the economy within the broad confines of the fiscal deficit target stated in the interim budget and one that does not crowd-out a possible pick-up in private credit later in the year.

What does this mean for government bond yields?
For a market that has priced in a dramatic increase in paper supply and remains asymmetrically focused on the expenditure side of government balances, we believe that the final FY10 budget figures may well lead to a price correction in government bonds. While the interim budget entails net borrowings of Rs 3,08,647 cr for FY10 and Rs 83,283 cr for H2FY10, the market is factoring in an increase of close to Rs 50,000 cr in these numbers. At Rs 10,000 cr, our estimate of additional net borrowings is much smaller. This is likely to send the yield on the 6.05% 2019 paper lower to 6.25-6.3% from its current trading range of 6.9-7.0%.

However, it must be noted that the underlying bias for government bond yields is for an increase. As the monetary easing cycle of the RBI draws to a close and inflationary risks driven by higher international commodity prices ( CPI inflation is unlikely to move below the 8.5-9.0% by

 December,2009) begin to dominate monetary action, bond yields are likely to move higher close to the 7-7.25% by December, 2009. Further, a pick-up in credit growth by Q3FY10 should also keep demand for government paper subdued.