A V Rajwade: The Budget and the financial markets

The policy actions especially with respect to mutual funds are well thought out.

Several features and announcements in Finance Minister P Chidambaram's Budget speech are of interest to the equity and bond markets. Bringing close- and open-ended equity funds on par for tax purposes is a welcome move. Hopefully, it will encourage investments in close-ended funds; this should help both the investor and the market:

The time horizon of equity investors needs to be long, three to five years being about the minimum. Therefore, close-ended funds make more sense, assuring the fund manager of the availability of funds on a long-term basis, and facilitating their fullest and proper investment.

Close-ended funds are also good for the market in general as, unlike open-ended funds, their investment/dis-investment is not cyclical. The average investor is attracted to invest in rising share markets and disinvest in the opposite scenario. Redemptions in a falling market force funds to sell equities, further pressuring prices. (A long-term investor should be doing exactly opposite "" buying equities when prices are falling and selling them when they are high). Close-ended funds would avoid such redemptions.

Still on mutual funds, limiting investment abroad only to companies which have invested in India, was illogical in any case. (I had criticised the stipulation when it was introduced). While lifting this limitation is welcome, whether this will lead to actual investments up to the revised limit of $2 billion is anybody's guess: a rising domestic currency and share market are hardly incentives for going in foreign markets "" the earlier limit of $1 billion had hardly been utilised.

As for the bond market, it seems that the Central government's net borrowing requirement (net of maturing bonds, including under the market stabilisation scheme) may go up by 50 per cent in 2006-07 as compared to 2005-06. Again, the demand would fall to the extent the recapitalisation bonds are converted into tradable, SLR securities. There is a modest increase in the ceiling on foreign institutional investor investment in G-Secs, but this is nowhere near compensating for the changed demand-supply. With credit demand continuing strong, a further rise in interest rates can hardly be ruled out. Several analysts have predicted 8 per cent yield for the benchmark 10-year-bond, which seems possible. I had earlier argued for greater flexibility to FIIs for investing in the corporate bond market (see World Money, January 16). The increase in the ceiling from $0.5 billion to $1.5 billion goes some way in that direction.

As for the structure of the market, extension of the NDS OM electronic bond trading platform to mutual funds and provident funds is welcome "" and so is the announcement to bring the corporate debt market also on the electronic platform. While on the subject, I would like to reiterate a point made earlier. The Patil Committee has recommended that the day count conventions for both the corporate and G-Sec markets should be identical. The reform should be to change the G-Sec market practice from the artificial 30/360 day count convention to the actual/actual day count, which is more logical and realistic. Incidentally, this would bring bond market practices on par with those in the interest rate swap market, and closer to money market instruments.

Turning to the external sector, the Prime Minister's Economic Advisory Council (EAC), in its report on the balance of payments outlook, has opined that "at almost 3 per cent of GDP, the CAD [current account deficit] may still be in the comfort zone provided it goes to finance productive investment." But the EAC does not seem very comfortable as, first, the use of the word "may" signifies. Second, the proviso about the deficit going "to finance productive investment". One is also not sure about the accuracy of the estimate quoted, namely 2.9 per cent of GDP. Assuming a GDP of $720 billion (GDP at current prices Rs 32,00,000 crore, Economic Survey, Table 1.1, at Rs 44.50/dollar) in the current fiscal year, this translates into a current account deficit of around $21 billion. To me, this does seem to be an underestimate, given the trend: $0.5 billion in the first half of 2004-05, $6 billion in the second half of 2004-05, and $13 billion in the first half of 2005-06. In other words, the deficit has grown in each of the last three half years. What is the reason why it would drop to say $8 billion in the second half of 2005-06? And, if not, does it still remain in the comfort zone?

Tailpiece: The row over the provident fund interest rates has surprisingly not touched upon the issue of "real", that is, inflation-adjusted, interest rate. Surely, even the Left would appreciate that the 12 per cent nominal rate is too low when inflation is in double digits, and too high when inflation is in low single digits as now. The correct issue should be the real rate on provident fund savings, an issue that has not come up in the political controversy.