Steady Rollin'

He didn’t. And it wasn’t because Chidambaram was keen to listen to investors. This year, he wanted to keep the Left happy; and he wanted to focus on the welfare schemes supported by Congress president Sonia Gandhi. The objective: to stay away from politically sensitive issues and woo votebanks for the forthcoming elections in five states. Not surprisingly, the mention of West Bengal, Tamil Nadu (Chennai) and Assam (Northeast)—all of them go to polls this April and May—features prominently in the FM’s budget speech.

So he went back to his old, but important, theme of fiscal correction. Kristin Lindow, senior V-P, Moody's, says "We consider the 2006-07 budget to be encouraging from the standpoint of fiscal consolidation, in spite of the expenses associated with some of the more populist promises of the CMP. With the luxury of healthy growth, relatively low interest rates and abundant capital, the fiscal deficit appears to be staying on a downward trajectory...which was not necessarily a foregone conclusion." But some feel that more could have been done in this respect. "India’s rapid rate of economic growth presents a golden opportunity to accelerate fiscal consolidation, yet the general government deficit has contracted by barely 2 per cent of GDP over five years," says Paul Rawkins, senior director, Fitch Ratings.

However, the FM has taken some macro measures that has enthused the markets. His stress on infrastructure, agriculture and rural development may enable India to grow at a high rate of 10 per cent by 2010 (current growth rate: 8 per cent). Creating infrastructure will result in lower costs for Indian firms. It will also lead to higher demand for products like steel, cement, engineering and project services. For instance, due to the emphasis on infrastructure in the past two years, cement demand has grown rapidly and is expected to rise by 10 per cent next year.

Similarly, spending money on rural development and measures that help increase farmer incomes will lead to higher rural consumption. Efforts in reducing the rural-urban divide through steps like electrification, irrigation, sanitation, housing, roads and telephony will help improve rural household incomes. While this will help improve the quality of rural life, it will also increase business prospects for corporate India like new avenues to penetrate the smaller towns. For instance, manufacturers of products like pipes and irrigation and farming equipment, fertilisers, and pesticides and seeds will benefit.

Despite appearing to be a bland non-event, experts have hailed the budget as ‘positive’. They feel it has done nothing negative to disturb the ongoing growth momentum. Says Saurabh Sonthalia, head (strategy and business development), DSP Merrill Lynch Mutual Fund: "Overall, the budget was very positive. People crib about lack of new ideas, but I’d say he’s signalling a continuation of reforms and policies. The kind of long-term framework the FM is aiming to build is very important for business and investment confidence." Adds Shahina Mukadam, head (research), IDBI Capital Market Services: "Medium to long-term should remain good; except MAT (minimum alternate tax), nothing has been done to affect corporate profits. We are looking at 15 per cent growth in corporate returns over one year."

So, will Budget 2006 really impact your investments and current market sentiments? Although investments should be primarily driven by financial goals and objectives, taxes can take a bite or two out of your income earned and, hence, lower the net return. And while it’s not evident easily, Budget 2006 has made a few changes on how your MF investments will be taxed, how your investment avenues may increase, how various transactions, including those on the stock exchanges, will cost more.

Closed-ended equity-oriented funds will no longer pay dividend distribution tax and are now on par with the open-ended equity-oriented funds in this respect. It’s a good move as several domestic MFs are planning to launch closed-ended funds this year. Says R. Swaminathan, national head (MFs), IDBI Capital Market Services: "Closed-end equity schemes promote long-term investment. Being on par with open-end funds will make their dividend plans attractive for investors."

Your portfolio in MFs may soon sport global stocks like Microsoft, Google and General Motors too. That’s because Budget 2006 has allowed MFs to invest in foreign equities and debt securities up to a limit of $2 billion, up from an earlier limit of $1 billion. Also, the earlier policy that domestic MFs could only invest in foreign companies that had at least a 10 per cent holding in any Indian company has been withdrawn. As Rajat Jain, CIO, Principal PNB Mutual Fund that manages India’s first foreign equity puts it, "We no longer need to look at only those foreign companies that have an Indian connection. Our universe of stocks gets much larger now." But the trend may not catch up fast as MFs are more than comfortable with the returns in the Indian bourses.

In addition, MFs can now invest up to $1 billion in foreign Exchange-Traded Funds (ETFs), which are benchmarked against a basket of securities like any stockmarket index and are listed on an exchange. These are passively managed funds that aim to mirror their benchmark and they don’t carry fund manager’s risk. They are an ideal investment vehicle if your domestic MF doesn’t have the necessary expertise to track the foreign markets on a day-to-day basis.

But the MFs that may be affected by Budget 2006 are the balanced funds, which invest 40-70 per cent of their corpus in equities and the remaining in debt instruments. The reason: a change in the definition of what qualifies as an MF under the I-T laws. Earlier, the I-T department and SEBI had different interpretations; the former qualified MFs as those that invest over 50 per cent in equities while SEBI’s threshold limit was 65 per cent. This meant that balanced funds enjoyed the income tax treatment as other MFs. Not anymore. As per Budget ’06, the I-T definition goes and the SEBI one stays. Therefore, balanced funds will cease to enjoy the income tax benefits, unless they increase their exposure in equities to over 65 per cent. Says amfi chairman A.P. Kurian, who believes this is an anomaly that needs to be corrected: "We will approach the finance ministry and try and salvage balanced funds."

All MFs will be hit by the increase in security transaction tax (STT), which has to be paid at the time of redemption of units. So will all market transactions. Ever since its introduction in 2004, STT, whose contribution this year is expected to be a meagre Rs 2,400 crore, has resulted in heated debates. So was the case this time, when the FM increased the rate by 25 per cent. The only difference was that most people were reconciled—and prepared—for a hike. "We were expecting it; almost a five basis point raise in STT," admits Andrew Holland, executive V-P (research), DSP Merrill Lynch. But experts contend that a better option would have been to accompany an even higher STT hike with the abolishment of the 10 per cent short-term capital gains tax.

Explains Aunali Rupani, a sub-broker with Motilal Oswal Securities, "Speculators somehow manage their short-term capital gains and don’t pay the tax. A higher STT on delivery-based sale trades in the cash market would be an efficient way to capture revenues from such evaders." Such an abolishment would have the additional potential of motivating investors to buy and sell shares more often and, therefore, increase the liquidity on the stock exchanges in terms of number of shares traded.

Budget 2006 has raised collective limits of FIIs in corporate debt from $0.5 billion to $1.5 billion and in government securities from $1.75 billion to $2 billion. The idea is not to revive a retail debt market in corporate debt, which is in doldrums as no trades have taken place in the current fiscal year on NSE, but to cool the rising interest rates. Explains Amit Chandra, Jt MD, DSP Merrill Lynch: "We seem to be heading towards a mismatch in deposit creation and credit growth. This may lead to a significant squeeze in credit and spike in rates. To possibly address such a situation, the FM has signalled a willingness to raise FII investment in Indian debt." But it won’t interest the FIIs, whose cumulative net investments in debt securities (as on February 28, ’06) was Rs 1,300 crore, which pales in comparison with their cumulative net equity investments of Rs 1,86,000 crore as on the same date.

The areas where the FM has clearly failed to deliver are investor protection and relevant issues raised by his own ministry’s Economic Survey 2005-06. In his budget speech this year, Chidambaram categorically said: "I propose...to set up an investor protection fund (IPF) under the aegis of SEBI, funded by fines and penalties recovered by SEBI. This will bolster confidence among retail investors who should be the key drivers of the capital market." What he failed to reveal—and what’s not even mentioned in SEBI’s annual report—is the amount that the market regulator has actually collected by way of fines and penalties. Going by anecdotal and circumstantial evidence, it won’t be much. Thus the IPF seems to be a non-starter.

The budget ignored two proposals suggested in this year’s Economic Survey. The survey urged that the size of the derivatives market should be increased by "reviewing the size of limits...limits which were established in the late 1990s (at a time of cautious experimentation with the introduction of derivatives trading in India) have clearly become out of touch with the growing market size." But nothing was done on this front. Similarly, Chidambaram was silent on the fallout of the ipo benami scam, even though the Economy Survey wanted the finance ministry to deal with the problem "of multiple bids by individuals seeking to profit from the quota for retail investors at the discretion of merchant bankers".

So, how will investors rate this budget? They’ll feel that the FM wishes to raise more money from them (through STT) as the markets are booming. They’ll think that to show that he’s interested in capital markets, he’s made a few technical changes, which will not yield any results. But they’ll know that he hasn’t touched any sensitive issues, he’s made sure that he doesn’t scare off the big institutional investors, both domestic and foreign.

By Kayezad E. Adajania, Rajesh Gajra and Vishal Chhabria with inputs from Tejas P. Bhope and Saumya Roy