Red flags emerge for India's bond market as farmer bailouts rise

Uttar Pradesh set off domino effect by saying in April that it'll waive off loans worth Rs 36,360 cr

Investors in India’s bond market are already raising red flags on the potential impact from populist farmer bailouts being engineered by different state governments.

Yields on the so-called state development loans (SDLs) climbed at the most recent auction, widening their spread over sovereign rates. The increase comes amid concern that waiving billions of dollars in farm loans will worsen already strained states’ finances. Debt sales by regional administrations are set to rise this quarter, and could pose a challenge for the federal government’s borrowing programme.

“Loan waivers will have a negative impact on state finances” said C Venkat Nageswar, the Mumbai-based head of treasury and deputy managing director at State Bank of India, the largest lender. “At least part of this additional burden will be financed through market borrowings, which could push up SDL spreads.”

Uttar Pradesh, the most populous state, set off a domino effect by saying in April that it will waive off loans worth Rs 36,360 crore ($5.6 billion). Maharashtra, Karnataka and Punjab have announced similar bailouts, while farmers in Gujarat, Madhya Pradesh, Haryana and Tamil Nadu are clamouring for the debt relief, which if granted could cost hundreds of billions of rupees more.

The cut-offs at a June 27 auction of 10-year debt by various state governments saw their yield spread over similar-maturity sovereign bonds widen to a range of 74-83 basis points, from 63-73 basis points at the previous sale on June 13. The gaps were around 50 basis points in October.

That’s “the new normal,” said Vivek Rajpal, a Singapore-based rates strategist at Nomura Holdings. “I wouldn’t be too keen on assuming that spreads will narrow over time.”

With populations as large as 200 million people, Indian states are massive, and also wield enormous budgets. The bailouts come at a time when their finances are already strained as they roll out pay hikes for several government employees and acquire debt piled up at state-run power distribution companies under a 2015 federal plan to revive the utilities.

States plan to borrow a combined Rs 98,000 crore to Rs 1.05 lakh crore this quarter, showed an indicative borrowing calendar released by the central bank this week. That compares with announced debt sales of up to Rs 75,000 crore for the same period last year and as much as Rs 77,700 crore for the three months ended June 30.

Country-wide waivers may reach 18 per cent to 20 per cent of India’s estimated outstanding farm loans of Rs 17 lakh crore, according to Emkay Global Financial Services. However, the details of how each state will fund its deficit are yet to be laid out, with some likely to cut down on expenditure to fund a part of their bailout. Some others may choose to finance the deficit over multiple years.

“Higher state-bond premiums will likely lead to higher federal government yields with a lag,” said Amit Agrawal, a strategist at Societe Generale in Bengaluru. He predicts the 10-year sovereign yield, which was at 6.54 per cent in Mumbai on Thursday, to rise to 7 per cent by end-2017.