Are bond markets sceptical of FM’s borrowing plans?  

March 15, 2010

In his Budget speech, finance minister Pranab Mukherjee had outlined a clear path for the government to pull back from its heavy borrowing position.

He had proposed to bring down the fiscal deficit to 5.5% of gross domestic product (GDP) by the end of the next fiscal year from the current 6.8%. This came as a relief to many economists as continued borrowings would have threatened to put inflation out of control. The bond markets, though, have apparently not yet taken the minister’s word on this matter.

Since the finance minister’s Budget day speech, bond yields have risen rapidly to cross the 8% mark, for the first time since October 2008. Yield on the 10-year government bond jumped to 8.01% in a matter of weeks. Bond prices have plunged, as investors are shying away from putting in more money in government paper. What is causing the bond market to be so cautious?

Apparently, investors on Bond Street are still fearful that interest rates are likely to pushed up on account of the high borrowing by the Central government. Despite all the talks about fiscal consolidation, investors are sceptical whether the government can actually deliver on its promises.

Axis Bank’ treasury head RVS Sridhar believes that yields are moving up because of the tighter liquidity conditions expected on the back of high government borrowings. “The Union Budget has projected high net borrowing of about Rs3.45 lakh crore in FY11. Given tighter liquidity conditions that are expected, such a high borrowing is expected to be detrimental to low yields. Bond markets have reason to be cautious about the high borrowings as liquidity conditions are unlikely to be favourable. The Reserve Bank of India (RBI) would need to step in with a suitable strategy to address the caution,” he said.

Inflation is an unavoidable corollary of the government’s borrowing binge.  Wholesale price-based inflation rose to 9.89% in February from 8.56% in the previous month due to increase in prices of certain food items such as sugar and the hike in excise duty on fuel announced last month.

Mr Sridhar said, “Inflation remains the major concern, given that high inflation, seen currently, could invite tough action from the RBI in the form of tightening, and push up yields. However, the market view suggests that inflation may ease to about 6% by about June or July 2010 and may provide comfort at that stage.”

In the face of this surge in bond yields, banks are now staring at huge losses on their income statement. It is customary for banks to provide for marked-to-market losses, as per RBI’s guidelines. This is where bank treasuries will feel the pinch.

Mr Sridhar believes that banks that may have excess statutory liquidity ratio (SLR) holdings are likely to face pressure due to rise in yields. “However, banks that have been hedging or those which have a nimble strategy could reduce the impact significantly. Also, banks would stand to gain on account of higher yields on their investments. Surely, that would be insufficient to take care of investment losses”, he added.

The markets are now bracing for some action by the RBI in its April monetary policy. Faced with mounting worries about inflation, it is expected to take a hard stand on the matter. It had hiked the cash reserve ratio (CRR) by 75 basis points to 5.75% in its December monetary policy review.

This time, the RBI is likely to raise the repo and reverse repo rates a couple of notches to reign in the excess liquidity in the system. Mr Sridhar is of the opinion that the RBI could hike CRR by about 25-50 basis points in its April policy, while hiking the reverse repo and the repo rates by 25 basis points each.

Rohini Malkani, economist, Citi India said, "Given the growing influence of structural factors, the WPI could likely remain in high single digits rather than the preferred range of approximately 5%. This in turn could potentially keep the rate structure higher. We expect the RBI to raise policy rates by a minimum of 125bps in 2010 with a first hike in its policy on 20^th April.”

Echoing the same views, Tushar Poddar, vice president and chief economist, Goldman Sachs (India) said, "(Due to) elevated food and fuel inflation, and signs of them spilling over into core (sectors), long transmission lags in policy, risks of rising inflationary expectations, and excess liquidity feeding through to asset and general prices, we continue to expect the RBI to begin withdrawing liquidity through the CRR of banks and to hike rates by 50 bps by the 20^th April policy meeting. The probability of a rate hike before the policy meeting has increased. Cumulatively, we continue to expect the RBI to hike effective policy rates by an above-consensus 300 bps in 2010, 150 bps by raising repo and reverse rates, and 150 bps by tightening liquidity." — Sanket Dhanorkar