A quantum jump for India

After several articles on Apple and Google, finally, back to a subject I like - Markets and the economy.

Of late, I have heard several people question the logic behind the rally in Indian markets. Nifty is approaching 5500 levels, and Sensex is over 18000. We are not far from the peak reached in early 2008. Considering that the global economy is still weak, and considering that other markets are struggling to go higher, how justified is the rally in India?

This article looks at some significant events that have happened recently, or are likely to happen over next few months - events that will have a massive impact on India.

Everyone is aware of the bonanza that the government received from 3G auctions and BWA auctions. Over Rs 100,000 crores was raised from these auctions. That is 1 Trillion Rupees, or about $22 Billion. That is pretty massive by any standard, but for a country with a GDP of about $1.1 Trillion, 22 billion is a nice 2% of GDP. That is the kind of money that can make a solid dent in India's fiscal deficit.

One would have thought that getting such a big bonanza would have reduced the urgency for the privatisation programme - but thankfully, this has gone ahead as planned. In a masterstroke, the FM managed to get SEBI to pass guidelines for the minimum level of free float of listed companies. The 25% minimum impacts mostly government owned companies like ONGC, SAIL, NTPC, etc. The govt is able to raising money from secondary sales in several PSUs, using SEBI's guidelines as an excuse - employees, communist parties and even allies of the government can no longer protest these stake sales, because it is mandated by SEBI.

Not just this, the government has taken some major steps towards decontrol of retail petroleum prices. This should significantly reduce the subsidy burden from petroleum. On the petroleum front, the government has started seeing some money because of Oil and Gas production coming online in Rajasthan (Cairn), Andhra (Reliance), etc. This will only accelerate as production ramps up.

All of a sudden, the fiscal deficit that was at worrying levels just 6 months back, seems to be a lot more manageable. This enables the government to move ahead with reforming direct and indirect taxes.

Everyone has heard of the New Draft Tax Code, and how it radically alters the tax brackets for direct taxes. I am not sure how many people realized this - when the Draft Tax Code becomes law, 99% of Indians will be paying tax at rates that are LOWER than some of the lowest tax jurisdictions in the world - even lower than Hong Kong and Singapore! For income upto Rs 25 Lakhs, even if you claim absolutely no deductions, not even the statutory deductions, your effective tax rate works out to 14.8% - which is lower than HK's 15% rate. Once you factor in just the regular deductions (PPF, Insurance, Mortgage payments, and non-taxable allowances), you can get almost 35 Lakhs in income at an effective tax rate below 15%! Even for people earning significantly more than 35L, Indian tax rates work out much better than the rates seen in most countries (except HK, Singapore, Dubai, and the tax havens).

These low tax rates operate at several levels - at the obvious level, they put a lot more disposable income in the hands of the consumer. They reduce the incentive to avoid paying taxes, thereby bringing in most of the black economy into the white economy. Also, with lower rates, people tend to make investment decisions based on the merits of the investment itself, rather than the tax implications - this will allow efficient deployment of capital.

There is a lot happening on the indirect taxes front as well - after years of discussions, it finally looks like GST will get off the blocks by April 2011. While a lot has been written and said about GST, there are some very interesting implications of GST that people have not focussed on. Remember, back when VAT introduction was being considered, there were several reasons thrown about - like VAT is more efficient, as it prevents cascading taxes, etc? Consider a producer buys inputs for Rs 100, paying a VAT of Rs 12.5, does some value addition and sells a product for Rs 200, collecting VAT of Rs 25. The producer needs to only pay Rs 12.5 to the government - which is the difference between the money he has collected and the money he has already paid.

GST has this exact same feature VAT, with one important difference. Under VAT, only VAT paid and received were offsettable. Whereas under GST, since it is a common tax for both Goods and Services, you can offset your Goods tax collected against your Service taxes paid. In the previous example, assume the same manufacturer had telephone and internet costs of Rs 10, on which he paid Rs 1.03 as Service tax - in the old system, this Rs 1.03 was lost to the government. Under the new GST system, the GST paid on the telephone bill can also be offset! So the producer only has to give Rs 11.47 to the government. Not just manufacturers - even service providers benefit - for instance, if Infosys gets a domestic IT contract, on which it charges Service Tax - it need not give this entire money to the government. They can offset this against the VAT they paid to buy computers to execute the project.

In a country where about 50% of the GDP is in Services, moving to a GST based regime will being in massive efficiency gains. Because pretty much everyone pays some service tax - if nothing else, at least on telephone bills, this service tax will now be offsettable and recoverable against GST payable on their product sales. This might seem like a very small amount, but remember this amount goes directly to the bottom line - so a company that has 10% margins could see 11% margins - effectively increasing earnings by 10%! A 10% increase in Earnings is not small at all.

So, on the one hand, there will be more money in the hands of consumers to buy products made by manufacturers, and on the other hand, the manufacturers will make more margins on their product sales. The combination of these 2 factors, is going to have a massive impact on corporate earnings, and therefore on the stock market.

As we get closer to April 2011, and as we see more clarity on the New Tax Code and the implementation of GST, I expect to see analysts upgrading the companies they cover.

It is anybody's guess as to whether the markets have already priced in these gains - but considering that none of these Direct and Indirect tax reforms are a done deal yet, I think it is safe to assume that markets have not priced this in.

Despite all the positive buzz from these reforms, can India still perform well if global markets tank? Back in 2008, everyone who was talking about decoupling got shit on their faces. Has anything changed? Is decoupling possible today, when it was not possible in 2008? I believe so, and will explain this in my next article.