The impact of lower fiscal deficit and government borrowings on bond prices

ISSUE

Indranil Pan
Chief Economist,
Kotak Mahindra Bank

The interim Budget for 2004-05 surprised the market with estimates on fiscal deficit turning out to be positive for the bond market.

The finance minister announced a correction in the fiscal deficit/GDP ratio to 4.8 per cent for the year 2003-04 (down from a Budget estimate of 5.6 per cent) and projected an even lower figure of 4.4 per cent for 2004-05.

This is despite a small increase in the absolute fiscal deficit for the year 2004-05, implying a strong real GDP growth assumption at around 8 per cent.

The news of fiscal consolidation and a lower-than-expected central government borrowing target for 2004-05 lifted the sentiment in the gilts mart and the 10-year benchmark yield dropped to 5.19 per cent from 5.24 per cent.

Now, is it possible for India to achieve a 4.4 per cent fiscal deficit/GDP ratio in 2004-05? What will be its implication on gilts?

A look at the revenue numbers for 2004-05 indicates a bullishness that might not finally be achieved. Gross tax collections are estimated to increase around 18 per cent in 2004-05.

Among its components, corporate tax collections are estimated to rise by Rs 16,560 crore (26 per cent) in 2004-05 compared with Rs 16,814 crore (RE) in 2003-04.

It's important to note that a large portion of the increase in the corporate tax collections in 2003-04 came because of increased profits for companies due to the compression of interest expenditure.

This is unlikely to happen in 2004-05 as no one is expecting lending rates of banks to go down significantly that year.

This also implies that for the target to be achieved, manufacturing sector growth has got to be really strong at around 9-10 per cent in 2004-05.

Overall, on the tax collection side, we estimate the slippage at around Rs 8,000 crore in 2004-05. On the other hand, some slippage is also likely on the PSU disinvestment account, estimated at around Rs 2,000 crore.

Furthermore, we expect real GDP growth to be at around 6.5 per cent in 2004-05 compared to the budget expectation of around 8.2 per cent. This, along with a fiscal slippage of around Rs 10,000 crore, is likely to push the fiscal deficit/GDP ratio to around 4.9 per cent in 2004-05.

There is unlikely to be any liquidity worries in 2004-05 even in the event of the government borrowing an additional Rs 10,000 crore as we expect a continuation of foreign exchange inflows.

However, today, liquidity surpluses have ceased to be the major driving force for the market. After the November 2003 mid-term review of monetary policy signaled a neutrality of domestic monetary policy, the mindset of gilt traders appears to have undergone a significant change.

There is also a realisation that the global interest rate easing cycle has eased, while the domestic growth outlook has improved tremendously with surprises being expected only on the upside.

For the medium term, even if the headline WPI inflation falls, we are not expecting players to build up positions very aggressively.

Gilt yields are expected to exhibit some volatility in the rest of this fiscal, and are likely to hover in a wide band of 5.10-5.25.

Yields will remain grooved

Arun Kaul
General Manager,
Punjab National Bank

The pleasant surprise in the interim Budget was the reining in of the fiscal deficit during the current as well as the next year.

As against the budgeted estimate of 5.6 per cent for 2003-04, the revised estimate of the fiscal deficit ratio to GDP is 4.8 per cent only.

For the next year this ratio has been further lowered to 4.4 per cent, which compares very favourably with the last 5 years average of 5.5 per cent.

This has been achieved despite a relatively lower dependence on 'borrowings and other liabilities', which have been projected to grow by 3.3 per cent only.

Of this, net borrowings from the market are estimated at Rs 90,502 crore only (Gross borrowing Rs 150,800 crore), against the revised net borrowings estimate for current year at Rs 82,992 crore (Rs 131,000 crore) The lower-than-expected borrowings by the Centre would have a direct impact on the asset portfolio of the banks.

Of late larger quantum of bank's funds have been parked in gilts. Thus during the current fiscal while the gilts portfolio of banks grew by Rs 107,392 crore, or more than 20 per cent, bank credit grew by Rs 62,774 crore or 8.6 per cent only.

During the next fiscal, unless there is a spurt in credit growth, the projected lower borrowings by the govt., prima facie, would lead to a lack of investment avenues for the banks.

The surplus liquidity would tend to push yields downwards and buoy the prices in the bonds market. The lower fiscal deficit cheered the bond market and an immediate reaction was buoyancy in prices, giving a thumbs down to the budget numbers.

However this simplistic relation between the net borrowings of the Centre and the bond prices would be tempered by other factors like liquidity in the system, inflation and global interest rates.

The liquidity in the system is expected to remain comfortable, which, in turn, is expected to reinforce the downward pressure on yields.

This downward pressure on the bond yields is expected to be further reinforced by the inflation figures.

The wholesale price index during the remaining part of the current year is likely to show a lower increase than the last year due to salutary effect of good monsoons on index of primary articles, recent reduction in duties, which to an extent would offset the increase in the price of commodities.

Thus, despite the increase in the wholesale price index, the inflation rate is expected to ease out from current levels due to the 'base effect'. A lower inflation figure tends to buoy market sentiment.

On the other hand, global recovery and the firming of the global interest rates would put upward pressure on yields.

Last week, the Bank of England again hiked its repo rate by 0.25 per cent, its second upward revision in the last three months.

Also the proposed market stabilisation bonds would help in mopping up long-term liquidity in the system, thereby offsetting the liquidity impact of lower government borrowings to some extent.

Large credit pick-up along with the recovery in the economy would also tend to put upward pressure on yields.

Thus, in view of the other contrary forces, yields in the other bond markets are expected to remain rangebound but slightly volatile.