India' s Shrinking Fiscal Headroom

 *Will India Cut Spending to Save Its Fiscal Deficit Target?

India's fiscal discipline is facing its biggest test in years. As the West Asia conflict pushes oil prices higher, the government is now exploring spending cuts to prevent its budget deficit from slipping off track.

The challenge is simple. Rising oil prices are increasing costs just when the government is trying to keep its finances under control.

*Key Highlights*

• India may cut spending to keep its FY27 fiscal deficit target at 4.3% of GDP

• Rising oil prices are increasing subsidy costs, especially fertilizers

• April fiscal deficit jumped to ₹3.6 trillion, nearly 2x YoY

• Fertilizer subsidies could rise from ₹1.71 trillion to almost ₹3.4 trillion

• Capex and defence spending are expected to remain protected

*The Oil Problem Is Becoming A Fiscal Problem*

Every dollar increase in oil prices creates pressure on India's finances.

India imports most of its crude oil, which means higher global prices quickly translate into larger subsidy bills, a weaker rupee, and higher inflation.

India's fiscal strategy now depends heavily on what happens to oil Price's over the next few months. If the West Asia conflict continues and energy prices remain high, the government may be forced to choose between spending cuts, higher borrowing, or missing its fiscal deficit target. For now, policymakers are hoping that careful spending management can prevent that difficult choice. But the prolonged West Asia conflict has complicated those plans

The government appears reluctant to touch two critical areas

Capital expenditure remains central to India's growth strategy, while defence spending has become even more important amid rising geopolitical tensions. Instead, officials are examining areas such as water resource allocations and loans provided to states.However, this creates a political challenge.Reducing welfare spending could impact rural communities, while cutting transfers to states may trigger opposition from regional governments already concerned about revenue sharing.

India – Strait of Hormuz closure Impact

We see the Indian Rupee as vulnerable and USD/INR likely rising above the 95 levels if the Iran and Middle East conflict is sustained and the Strait of Hormuz remains closed, with Brent oil prices returning back to the US$100/bbl.

In de-escalation case with oil ~US$80/bbl, 

USD/INR may trade closer to 93.50.

In US$100/bbl case, USD/INR may trade closer to 95.50

In US$120/bbl scenario, USD/INR may trade closer to 97.50 and even higher will look achievable. Of course, it is important to stress that there are many shades of grey here including the duration of the crisis, but overall we see these as reasonable given the meaningfully different nature of the crisis. 

INDIA IS DEPENDENT ON THE MIDDLE EAST ACROSS A RANGE OF ENERGY PRODUCTS, WITH AROUND 45% OF CRUDE OIL, 60% OF NATURAL GAS, AND MORE THAN 90% OF NATURAL GAS LIQUIDS SUCH AS LPG COMING FROM THE MIDDLE EAST. 

▪The indirect effects across a range of sectors could also be meaningful for India beyond the first order impact, and ultimately points to a stagflationary environment of higher inflation and weaker growth with a weaker Indian Rupee a key outcome as well.

MEANWHILE, OIL PRICES CLOSER TO US$100/BBL COULD IMPLY INDIA’S CURRENT ACCOUNT DEFICIT WIDENS TO 3% OF GDP FROM OUR BASE CASE OF 1.5% OF GDP

RBI recognizes downside risks to growth

 With benign CPI inflation prospects and a robust growth outlook, the Monetary Policy Committee (MPC) has opted to continue with the present repo rate of 5.25% while also continuing with a neutral stance.

 The growth for 1Qtr and 2Qtr of 2026-27 has been revised upwards to 6.9% and 7% and CPI inflation for these quarters is projected at 4% and 4.2% respectively. This is an optimal combination for the Indian economy at the present juncture as the growth rate in Half of 2026-27 is expected to be close to the potential growth of 7% as estimated by the Economic Survey of 2025-26. 

The CPI inflation is projected to average 4.1% for this period, just marginally above the MPC’s inflation target of 4%. 

The RBI recognizes downside risks to growth emanating from the continuing geopolitical tensions and volatility in global financial markets as also in international commodity prices. If any of these risks lead to an adverse impact on growth, the RBI may consider revising the repo rate downwards in its next monetary policy review. 

Venezuelan Oil and the Limits of U.S. Refining Capacity

RBI Notifies Transition to its Benchmark Rates from Overseas Borrowings

 With the imminent discontinuation of the publication of the London Interbank Offered Rate (LIBOR) by the end of 2021 for most currencies, the Reserve Bank of India (RBI) by its circular dated 8 December 2021 (Circular) amended the RBI’s Master Direction - External Commercial Borrowings, Trade Credits and Structured Obligations dated 26 March 2019 (ECB Master Directions) to provide for a risk free benchmark rate as an alternative to the LIBOR (which has been used since inception for majority foreign currency borrowings).

LIBOR has been a preferred benchmark rate for the syndicated loan markets and as a pricing source by financial markets globally and in India for a wide array of financial instruments including loans and derivative products. In view of the cessation of publication of LIBOR, the RBI in August 2020 had indicated to all the banks and the financial institutions to frame a board-approved plan, outlining an assessment of exposures linked to the LIBOR and the steps to be taken to address risks arising from the cessation of LIBOR, including preparation for the adoption of the Alternative Reference Rates (ARR) and putting in place a framework to mitigate risks arising from such exposures on account of transitional issues including valuation and contractual clauses.

The amendments to the ECB Master Directions provide much-needed clarity to the financial institutions, hedge providers and borrowers on the new applicable alternative reference rates for external commercial borrowings and encourage them to use any widely accepted ARRs as soon as practicable in lieu of the cessation of LIBOR from December 2021.

Increase to overseas investment limits for mutual funds

The Securities and Exchange Board of India has announced amendments to the overseas investment limits for mutual funds. The amendments provide that:

• mutual funds can make overseas investments subject to a maximum of US$1 billion per mutual fund, within the overall industry limit of US$7 billion;
• mutual funds can make investments in overseas exchange traded funds subject to a maximum of US$300 million per mutual fund, again within the overall industry limit of US$1 billion; and

in respect of investment limits to be disclosed in the scheme documents at the time of a new fund offer as specified in the relevant Circular and the investment limits on ongoing schemes as specified in the relevant Circular, such limits will henceforth be soft limits for the purpose of reporting only by mutual funds on a monthly basis in the prescribed format.

SEBI introduced a new rules for mutual funds companies.

 On April 28, 2021, SEBI introduced a new rule. They mandated key employees of asset management companies i.e. mutual fund companies to invest about 20% of their salary in the schemes they run or oversee. They’ll have to tie it up for 3 years or for the duration of the scheme, whichever is shorter.

Basically, it’s a diktat forcing fund managers and other key personnel to have their skin in the game. 

Rumour has it that SEBI only acted after Franklin (an asset management company) wound down 6 different mutual funds overnight sending ripples across the entire sector. Reports allege that the fund managers, in this case, took on inordinate amounts of risks, acted recklessly, and pulled out their money when things took a turn for the worse. A few days later they wound down the funds leaving hundreds and thousands of investors in the lurch. There were no consequences for their actions. No penalties, no harm, and no damage done.

Because remember, fund houses are paid despite how their schemes perform. Most companies seek a fee (1–2% of the sum you invest), without promising much. According to one report from 2019, 82% of active large-cap funds have underperformed the S&P BSE 100 index, which includes the 100 largest Indian companies. Imagine that — You could pick a passive basket of the 100 largest Indian companies and still outperform those who are paid ludicrous amounts of money to actively manage a mutual fund scheme.

Bottom line —Most fund managers aren’t really that good at managing money and it’s probably why you’re seeing some backlash from the incumbents. 

SEBI wants mutual fund companies to have skin in the game. But other key stakeholders in the industry want the rule gone. The only question remaining —What do you think?....