State loan yields likely to rise further despite Centre's help

The Centre’s record high borrowing numbers in the Budget has resulted in states having to pay more for market loans, leading many to curtail their plans. However, costs may increase further in the next fiscal with the rise in yields on government securities, which act as the benchmark.

The cut-off yields for the 10-year state development loan (SDL), a term used for bonds issued by states, ranged from 7.24 per cent to 7.34 per cent, up about 13 basis points (bps) from the last week. The spreads, or the difference between G-sec yields and that of SDLs, now works out to 48 bps. This is lower than the 60 bps spread the market has seen in the recent past.

Even if the G-sec yields remain where they are, if the spreads have to normalise, the SDL cut-offs will need to rise, more so for weaker states.

There is a catch, though. It remains to be seen if states will borrow more from the market when the Centre is extending a 50-year interest-free loan worth Rs 1 trillion for infrastructure spending under the PM GatiShakti Master Plan during financial year 2022-23 (FY23). Most states will opt for this loan, and the borrowing number should, technically, reduce to that extent.

The states, however, are not doing great on their own revenue front. If anything, they have seen their share of tax revenue fall, while expenditure has risen. Health being a state subject, they cut capital expenditure to focus on fighting the pandemic. Hence, their economic condition is still depressed.

“The devolution of gross taxes to states has come down from 37 per cent in FY19 to 30 per cent in FY22, with much of tax collections shifting to central cess and surcharges,” said Ananth Narayan, senior India analyst at Observatory Group.

“While FY22 gross tax receipts are up 21 per cent over FY19 numbers, the devolution to states has stayed practically flat,” Narayan said, adding that with the Goods and Services Tax compensation ending June 2022, “state finances will remain precarious, in contrast to the relatively healthy picture at the Centre”.

Stretched finances may force states to curb capex, even as they incurred higher revenue expenditure compared to the Centre during the pandemic. The revenue expenditure is unlikely to fall even as the capex may get a boost thanks to the Centre’s loan.

However, experts also note that states are much more fiscally prudent than the Centre, and try to keep their deficit within the target.

“States do not use up entitlement and work at lower deficits keeping the buffer open in case of slippages. Therefore, there may not be higher borrowings from their end,” said Madan Sabnavis, chief economist of Bank of Baroda.

“States will probably borrow less as their aggregate deficit will be less than 3.5 per cent as large ones will keep at less than 3 per cent. Spread of 40-50 bps will be maintained. But the corporates could see the spread move up by up to 10 bps,” Sabnavis said.

States also have the comfort of the Reserve Bank of India’s (RBI’s) ways and means advances (WMA) and overdraft facility, but those are for the short term.

Bond dealers, though, do not expect any meaningful contraction in state borrowing and expect at least another Rs 10 trillion of SDL supply in the next fiscal.

This will push up costs, as G-sec yields will likely remain under pressure in the absence of any movement towards inclusion in global bond indices. It is not yet clear how much money the government can mobilise through

sovereign green bonds, but the market estimates it at roughly Rs 20,000 crore.

It is also difficult for the RBI to aid in the way it did in the last two years, stepping in to buy about Rs 3 trillion worth of bonds to cool yields. The central bank, which will announce its monetary policy on Thursday, is looking to normalise and remove excess liquidity to prevent a flare-up in inflation.