Corporate tax cut – A game changer policy for India
The Government has announced a major fiscal stimulus by reducing corporate tax rates across the board through an ordinance. The changes made to the income tax are listed below.
* Corporate tax rates have reduced from 30% to 22% for companies that are not availing any exemption/incentive. The effective tax rate for these companies shall be 25.17% inclusive of surcharge & cess.
* Tax rates for any new domestic company incorporated on or after 1st October 2019 making fresh investment in manufacturing, to 15% from 25%. This is conditional upon the companies not availing any exemption/ incentive and commences their production on or before 31stMar'23. Effective tax rate works out to be 17.01% inclusive of surcharge & cess.
* MAT rates for companies who are paying tax at concessional rates or zero rate have been reduced to 15% from 18.5%.
Fiscal slippage a necessity to boost growth given low inflation
Tight fiscal and monetary policy over the past few years coupled with major structural changes have taken a toll on growth. Given current growth inflation dynamics, some amount of fiscal slippage is unlikely to stoke inflation. On the contrary we believe that fiscal slippage is necessary and will go a long way in boosting growth given that India doesn't have a twin balance sheet problem like 2013. As per Government estimates the tax break will cost the exchequer `1.45 lakh Cr. of which ~60-65% will be borne by the states. Therefore the tax cut will cost the central Government ~55-60 thousand Cr. which has already been financed by the RBI which transferred `148,000Cr. to the Govt as compared to budgeted estimates of `90,000Cr.
The tax cuts would increase profitability for companies at the highest tax bracket by ~14% which would be used by the companies to stimulate growth through price cuts and by increased investments in new capacities. Increased investments would boost growth over a period of time which would in turn lead to higher tax collections and thus lower fiscal deficit in the long run.
RBI has room to cut rates further as inflation is expected to remain low
Monsoon situation has improved significantly and is at a 9% surplus as of 28th Sep'19. Improving monsoon situation would keep food inflation in check while falling commodity prices would lead to lower manufacturing inflation. As a result we expect inflation to remain below the RBI's target of 4% which would allow the RBI to cut rates further despite fiscal slippage.
G Sec yields have moved up lately from ~6.3% to ~6.7% despite a 35bps rate cut by the RBI in it's August MPC meeting as markets are concerned about significant additional Government borrowings due to revenue shortfall on account of economic slowdown and tax cuts. However we believe that the RBI would step in at some point of time in the near future and push down yields through Open market operations (OMO).
We believe that accommodative monetary and fiscal policy is the need of the hour to bolster growth as inflation rates are unlikely to pick up given significant spare capacity in the economy. Low crude prices and relatively stable food prices would also go a long way in helping contain inflation. We expect the RBI to cut rates by 40-65bps from here on over and above the 110bps of cuts so far.
Q1FY20 GDP number of 5.0% probably the bottom in terms of growth rate
Rate cuts and large transfer by the RBI, Improving monsoon situation, relief for FPI's from additional surcharge and tax cuts announced by the Government should help in reversing sentiments going forward. The Q1FY20 GDP growth number at 5.0% probably marks the bottom in terms of growth rate. Hence we believe that the worst is over and growth rates should start improving from Q2 onwards driven by Government spending while private spending is expected to pick up from the second half of FY20.
US-China trade war throws up opportunity for India
The trade war between US and China has already caused global growth rates to slow. The OECD has recently cut its GDP growth estimate for FY19 from 3.2% to 2.9% while growth rate for 2020 have been cut to 3.0% from it's earlier forecast of 3.4%
While the US China trade war is having an adverse impact on global growth India is relatively immune given low share of exports to GDP as compared to some of the other Asian countries. The US China trade war however is an opportunity for India as some manufacturing capacities would be moving out of China in order to de-risk their supply chain. With tax rates in India now comparable to some of the other emerging economies we would be in a better position to capture the opportunities thrown up by the disruption caused by the trade war.
IBC has forced out the Stress in Corporate India…
Indian banking sector had been under severe stress as NPA levels had spiked from 3.8% in FY2014 to 11.9% by the end of FY2018. This was largelydriven by stress from few key sectors like Iron & steel, Infrastructure and Power and Textiles. NPA recognition was accelerated on account of the Insolvency and Bankruptcy Code which was introduced by the Government in 2016. It replaced earlier laws like the SICA which were antiquated and were ineffective in dealing with stressed assets.
Under the IBC inefficient promoters and management were forced out of their companies which were sold out to more efficient players. One of the key highlights of the IBC was resolution of some very large Iron & steel accounts, wherein the banks were able to recover a significant portion of their loans which would have been unthinkable under the previous acts. We believe that the worst of the NPA cycle is behind us now and credit costs for the banking sector is expected to normalize over the next few quarters.
Central banks easing to reverse liquidity outflow from India
Major central banks are cognizant of slowing global growth and have taken preemptive action. The US fed has now cut rates by 50bps and has also stopped unwinding it's balance sheet while the ECB has cut it's deposit rate by 10bps to -50bps and has restarted it's QE program at EUR 20bn per month.
With major central banks printing money global liquidity should improve from here on and India should be able to get a disproportionate share of the liquidity going to emerging markets given the latest move by the Government which indicates that growth is of paramount importance to them and that they are willing to foster and reward a compliant culture.
Earnings upgrades post corporate tax cuts keeps valuations attractive
The tax cuts would increase profitability for companies at the highest tax bracket by ~14%. Post the tax cuts Nifty earnings are expected to be revised upwards by 8-10% led banks and consumer companies which are paying taxes at the highest rate.
Most analysts on street are incorporating only the direct impact of tax cuts in their Nifty earnings estimates. We believe that there would be a second round of impact on growth as the increased profits would be used by the companies to stimulate demand through price cuts and by investments in new capacities. This will help boost growth over a period of time which would in turn lead to higher tax collections and thus lower fiscal deficit in the long run.
Over the past 18 months midcaps have borne the brunt of the correction and are currently trading at levels last seen in 2013, when India was staring at a twin balance sheet problem which subsequently led to a major currency crisis. We believe that valuations have become attractive especially with the recent round of historical reforms. We believe that one should use any corrections in the markets to build a well diversified portfolio consisting of high quality stocks.
While we are very constructive on the markets f rom a 12-18 months perspective we believe that one should focus only on quality businesses with strong moats and avoid companies which either don't have very strong moats or are highly leveraged or where management integrity is questionable.
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