The federal budget of FY12 has come and gone, unable to galvanise a rumbling opposition or a demoralised populace. Total budgetary outlay for FY12 is projected at Rs 2.77 trillion, (+8%) against the revised target for FY11. The tax revenue target is set at an ambitious Rs 2.07 trillion
(+23%) with the budget deficit projected to be Rs 849 billion (4% of GDP). The onus of financing the deficit has been placed largely on domestic financing sources, which means that the government will remain the main borrower in the economy. Federal subsidies are projected to decline from to Rs 166 billion, from Rs 395 billion in FY11.
From a capital markets perspective, the key dampener in the short-term is the maintenance of status quo on capital gains tax. Over the past couple of weeks, an expectation had built up that some sort of relaxation would be provided in the capital gains tax. But with no such relaxation forthcoming, last fortnights rally of 250 points may dissipate.
However, apart from capital gains, the budget is relatively benign from the capital markets perspective. The removal of exemption of General Sales Tax (GST) on fertiliser, which was made in March 2011, has been continued. However, because fertiliser manufacturers enjoy pricing power, this impact is likely to be passed on to farmers.
There are a few positive measures from the point of view of corporate profitability. One comes in the form of discontinuation of the 15% flood surcharge and Special Excise Duty (SED) levied in March 2011. This will help corporate bottom-lines improve from the September 2011 quarter.
The anticipated increase in the tax rate of the banking sector did not materialise either, which will help improve sentiment in key stocks like MCB and UBL. In terms of tax cuts, the reduction in Federal Excise Duty (FED) and SED in cement will reduce taxes by approximately Rs 20 per bag. In the short-term, this will help improve sentiment in the sector. Any lasting earnings improvement, however, will depend upon the pricing power of manufacturers, and whether they are able to improve margins as a result of this duty cut.
POLICY CONFLICT: IMF VS THE PUBLIC We believe it is important to step back from the micro-aspects of the budget and look at the bigger picture as well. Truth be told, the budgetary process highlights the deep policy dilemma that the Pakistani government currently faces. It is seeking to perform a difficult balancing act, with the IMF on one side, and the public on the other.
It is well-known that the IMF is a strong proponent of introducing stabilisation measures in developing economies that face an economic crisis. Pakistan is no exception. Typically, these include raising interest rates, removing subsidies, reducing the fiscal deficit, and increasing tax revenue. Since 2008, the IMF has been recommending economic reforms along these lines to the Pakistani authorities.
The IMF-prescribed stabilisation measures are bitter medicine; necessary for the patient to recover in the long-term, but not altogether pleasant to administer. For one thing, growth is compromised in the short-term with tightening of fiscal and monetary policies. At times, inflation is stoked as well, particularly when key subsidies in food, fuel, and electricity are removed. With such adverse impact on growth, employment, and inflation, it's no surprise than IMF policies are unpopular with the public.
For now, the government is walking a tight line; trying to appease the IMF whilst keeping the burden on the people manageable. Reconciling such contradictory mandates is difficult, particularly for democratic governments. At the moment, both parties are not satisfied. The IMF has delayed payment of the final tranche due to delays in implementation of Reformed General Sales Tax (RGST), continued electricity subsidies, and over-shooting of fiscal deficit targets. Meanwhile, the public is disgruntled from rising power tariffs, rampant inflation, and an increasing tax burden.
BUDGETARY COMPROMISES ARE UNDERSTANDABLE With such policy conflicts at the macro-level, budgetary lapses are to be expected. The three main problem areas in the budget of FY11 have been PSDP expenditure, provision for subsidies, and the tax revenue target. We expect them to be problematic in FY12 as well.
Of these, PSDP expenditure probably suffers from the greatest credibility challenge. Recurring divergence between PSDP targets and actual spending has led many to believe that PSDP is a balancing number within the budgetary accounting, adjusted downwards during the year to keep the fiscal deficit within acceptable limits. For example, in FY11, federal PSDP expenditure was initially budgeted at PKR 321 billion, but later revised downwards to PKR 218 billion. In FY12, federal PSDP expenditure has been projected at PKR 355 billion, but faces the risk of downward revision if fiscal targets are not being met. The breach of the PSDP target should come as no surprise however; current expenditure by its very nature is more fixed and short-term in nature, and a result, difficult and painful to reduce.
The provision of subsidies in the budget is another area of interest. In FY11, the actual subsidies provided (Rs 396 billion) far exceeded the initial budgeted amount of Rs 127 billion. In FY12, federal subsidies are projected at PKR 166 billion, but the risk of upward revision is high, in our opinion. The significant upward revision in subsidies is understandable. The IMF is a strong advocate for elimination of subsidies, and to get their approval, budgeted subsidies tend to be low. However, it is not politically or economically palatable to eliminate the large electricity subsidy in a short span of time, particularly in times of rising oil prices.
In FY11, the FBR also struggled to meet the tax revenue targets set in the budget, and this trend is likely to continue in FY12. In FY1, an additional flood surcharge levied in March 2011 helped get closer to the tax target, in spite of which the revised estimate fell short of the initial target by PKR 99 billion. Without interim tax measures, the 23% increase budgeted in FY12 may also prove to be a stretch. However, it is understandable that a democratic government is hesitant to increase taxes significantly at the time of the federal budget, when such measures are in the limelight and attract much criticism. Bringing in tax hikes during the year is much less disruptive than presenting them at the time of the federal budget. So, when seen in the broader context of macro-policy conflicts, the poor budgetary record with regards to PSDP, subsidies, and tax revenue targets is understandable.
MACROECONOMICS TO REMAIN CHALLENGING We believe that the direction of equity markets in FY12 will largely be determined by how macroeconomics pans out. FY11 has seen handsome returns despite rising interest rates and slow economic growth, driven by strong performance from non-cyclical stocks in the oil and gas, fertiliser, and power sectors. However, further market re-rating depends crucially on macroeconomic improvement.
The data at the moment shows a mixed trend. The definitive improvement is on external front, with a current account surplus achieved through higher exports and remittances. This has led to stability of the exchange rate. However, the overall economy remains under deep stress. Subsidy reduction is likely to continue, as we prepare for another round of electricity tariff increases in FY12. This will adversely impact both inflation and growth. Interest rates are unlikely to come down significantly, as reliance on domestic borrowing for deficit financing remains high. This will continue to crowd out private sector credit. Structural issues relating to energy and taxation remain largely unaddressed. Foreign investment will remain shy till social, economic and political stability is more forthcoming.
In such a scenario, expecting a meaningful economic improvement in FY12 is optimistic. As mentioned earlier, the domestic policy apparatus is compromised at the moment, with IMF prescribed stabilisation, taking precedence over growth considerations. An external shock can provide the necessary tailwind. Barring that, equity investors are likely to be disappointed in FY12.
(The writer is head of equity research at Next Capital)