Joydeep Sen

The Interim Budget presented by the interim Finance Minister, in the interim of the quarter was the interim event of the current government’s final months in power.

The debt market, as usual, obsessed over the fiscal deficit numbers for the current financial year i.e. 2018-19 and the projected numbers for the next financial year, for which the Interim Union Budget is being presented.

The perspective is, the projected fiscal deficit will give an idea about the Government borrowing from the market through issuance of bonds. Everybody knew that being election year, there would be some sops for the farm and lower/middle income segments. Questions was, how much and what would be the funding of that.

The initial reaction of the bond market was positive. The fiscal deficit for the current year, FY19, was pegged at 3.4 percent of GDP.

The street had already pencilled in a slippage from the projected 3.3 percent of GDP to 3.5 percent of GDP, due to shortfall in GST collections and doubts over PSU divestment targets.

To that extent, 3.4 percent was positive for the market. For the next financial year, FY20, the concern was over the size of the ‘farm package’ from the ‘election budget’ perspective.

The size of this ‘farm package’ was announced as Rs 75,000 crore, which is not as humongous as some section of the market had apprehended, which was more than Rs 1 lakh crore.

The fiscal deficit target for FY20, at 3.4 percent of GDP, may be an aberration from the targets of Fiscal Responsibility and Budget Management Act as it ought to have been lower, but still not as bad as it could have been, given the current situation.

However, as the fine print started being read and realized, the bond market gave up the initial gains (i.e. yields coming down, bond prices moving up) and sold off (i.e. yields moved up, prices down).

The government borrowing target from the market, through issuance of bonds, is projected at Rs 7.1 lakh crore (INR 7.1 trillion) in FY20, much higher than the street estimate of Rs 6.5 lakh crore (INR 6.5 trillion).

The net borrowing at Rs 4.73 lakh crore (INR 4.73 trillion) is also palpably higher than the market expectation. Hence though the ‘percentage’ projection for next year, which is fiscal deficit of 3.4% of GDP, is within the expectation band, the absolute borrowing quantum is a dampener.

Mind you, this is only the borrowing of the Central Government, the States have a substantial borrowing as well to fund their respective deficits. At the time of writing, the current 10-year benchmark Government Security (7.17% 2028) is trading at 7.62 percent, 13 basis points higher than the low of the day, and the new 10-year G-Sec (7.26 percent 2029) is trading at 7.38 percent, also quite higher than the low of the day.

What’s the way forward for the bond market? There is an event in the immediate term, the RBI Policy Review on 7 February ’19.

Inflation has undershot RBI’s projections consistently and the Interim Union Budget does not provide for anything pro-inflationary, the fiscal deficit target of 3.4 percent of GDP is within the expectation range. In this background, there is a strong case for the RBI to change its policy rate stance from ‘calibrated tightening’, meaning bias towards policy rate hikes, to neutral.

Ideally, given the benign current and projected inflation numbers, one would have expected the RBI to execute a rate cut on 7 February itself, but it would be too much to expect a rate cut within the ‘tightening’ policy stance. From a realistic point of view, change of stance from tightening to neutral is the minimum expectation.

This would be the first Review under the new Governor; yesterday’s announcement of removing three PSU Banks from PCA framework shows the dynamic intent of the new regime. In the subsequent review meetings, April onwards, it is expected that the RBI would ease policy Repo rate from the current 6.5 percent, by 25 to 50 basis points, depending on inflation and other relevant parameters.

Though we have discussed that the Government borrowing from the market next year is higher than expectations, the RBI has been executing Open Market Operations (OMO) purchase of G-Secs, which reduces the effective net supply of fresh bonds to the market.

If system liquidity remains tight next financial year as well and the RBI continues OMO purchase of G-Secs, the net supply would not be as high. Globally, interest rate movement scenario looks positive as the US Fed has paused recently from hiking interest rates and other leading central banks like Euro Zone or Japan are not hiking interest rates in a hurry.

The situation is positive for debt / debt fund investments. Having said that, it is advisable to invest in shorter maturity products, like Short Duration Funds, to have a relatively lower volatility risk in your portfolio.