Economy 2010-2011 - Neutral to Bleak

As I am writing this, we've just made our way in June, 2010. We're going to have budget speech on 5th of June this year. Some salient features expected in upcoming budget are here:

• VAT (Value Added Tax) regime to be enforced.
• Electricity subsidies to be abolished.
• Fertilizer subsidies to be abolished.
• CGT (Capital Gains Tax) to be enforced on stock market for the first time.
  
• Taxation target to be revised upwards by 20%.
• Debt Servicing outlay to be around 800 billion rupees.
• Defense expenditure to be revised upwards to 442 billion rupees.
• Government's regular revenues projected to go beyond 2000 billion rupees.

VAT has become a controversial bill, and above all, government has so far not been able to come up with some clear understanding of how and where it'll be levied. There's been a confusion since some time, and the debate is still on for whether it'll be levied on Health and Education sectors. Government is apparently of the view that it should be applied across the board other than eatable items. However, critics argue that VAT enforcement on Health and Education sector only makes sense if government provides enough of these facilities in Public Sector, which is not the case. Education budget has been decreasing as compared to the GDP, which means people are forced to opt for private sector education. If VAT is applied on private sector education, it means that it is going to be a luxury now. Same goes for health.

VAT on petroleum sector means something disastrous for the industry in general. Inflation figures which are already hovering around 13% will have enough room to cross 15%, thereby causing State Bank to hike interest rates by another 100 or so basis points.

Electricity subsidies abolishment will also be another factor of driving inflation upwards beyond 15%. Another thing to keep in mind regarding inflation is the lower base effect from around this time last year, which means there's a good reason to believe that the interest rates will be hiked by another 100 to 200 basis points. I see a strong case for that.

Taxation target is being revised upwards to go over 1700 billion. I think its a very optimistic target. I do not expect CGT to be a very lucrative avenue for the government in FY11. Stock Market apparently will remain under pressure because of government's excessive taxation from already taxed sectors and consumers' buying power will also remain subdued because of obvious price-hikes. VAT will also take a month or two to get enforced which means lower taxation in FY11 than projected.

Debt servicing will be around $10b, plus more than 400 billion for defense expenditures. All this means that State Bank's currency printing will have to pick up like all the previous years. Government doesn't seem serious as such about cutting back on its non-development expenses. Defense will apparently never reduce its royal incentives. Deficit is a norm, but the way it is getting out of proportions now is perhaps unprecedented. Early in this decade, Musharraf government had the opportunity of tapping in foreign aid and rescheduling debt programs, also privatization proceeds helped keep the reserves at a stable level, but now it seems its high time that Islamabad starts finding the solution in itself instead of looking out.

FORECAST:

Frankly, here are my projections for coming year:

• I see North Waziristan operation just around the corner, and keeping in view all the humanitarian crisis expected out of that, defense expenditure can cross 450 billion and hover around 500 billion. I do not have enough stats to come up with a reasonable figure of IDPs expected, but I expect it'll give the government a dent of around 25 billion.
• North Waziristan operation also means deterioration in law & order situation, which means further reduced foreign investment inflows. Rather, we might start witnessing outflows.
• Inflationary pressures are bound to come in. 10-15% inflation for coming year cannot be ruled out. Main inflationary drivers would be rising oil prices, lack of subsidies on electricity, fertilizer. Government borrowing from State Bank is also bound to pick up in coming fiscal year which will be another major inflationary driver.
• Interest rates might increase by 100 or 150 bps to 14%. However, there are chances that it comes down below 11% by FY11 end.
• Banking and LSM (Large Scale Manufacturing) sectors will remain under pressure.
• KSE-100 (Karachi Stock Exchange's benchmark 100 index) is hovering around 9200 points. At this level, it is offering some real good bargains. If things improve a bit, there's a good chance for it to cross 11500 level, but conservatively, 10,000 to 10,500 wouldn't be a bad level to sustain.