What do high borrowing, high fiscal deficit mean for bond mart

Risks to the macro environment are likely to rise in coming months

Indian bond market continued to trade on a cautious note.

In India, bond blues are likely to persist as a potential miss of the FY18 fiscal targets, high oil prices, a firmer inflation trajectory and rising US rates are likely to dampen the mood in the domestic debt market.

Ten-year bond yields have risen to 7.4 per cent this month, back to July 2016 highs and up ~90bps in 2017 compared with relatively flat movements in the region.

While risks to the macro environment are likely to rise in the coming months, we reckon that a fair amount of bad news is already in the price.

With 10-year yields now within striking distance of the 7.5% key technical level, we reckon that rates could settle into the 7.5-8.0% trading range in the coming quarters.

Meanwhile, there could be scope for dip buying in two-year bonds after the 20 bps yield surge in December, as the markets begin to factor in policy tightening moves by the Reserve Bank of India.

In the immediate term, focus is on the new ten-year security, upcoming state governments’ borrowing schedule and bank recapitalisation plans.

Fiscal developments under watch

The centre’s cumulative fiscal deficit between April and November 2017 ballooned to 112% of the full-year target, with four months still to go. Expenditure is on track, but revenues lag targets. Net tax collections are modestly weaker, reaching 57% of the budgeted scale (vs 59% last year). Here, lower GST collections have likely impinged on indirect tax receipts, as the former moderated to Rs 808 billion in December vs Rs 833 billion in November.

Cuts in GST rates, the shift to a quarterly filing system for smaller traders, compliance trends, and compensation to states also likely hurt centre’s collections. The other factor responsible for the worsening fiscal math is weak non-tax revenues (spectrum receipts, dividends/ profits from the Reserve Bank of India, and public-sector companies etc.), which disappointed at only 37% of the full-year target compared with over 60 per cent last year.

Non-debt capital receipts (mainly divestment proceeds) have been a bright spot, reaching 73 per cent of the full-year target vs 49 per cent last year.

March quarter is a seasonally strong period for revenues, while expenditure is scaled back to meet pre-imposed limits. The year-to-date weakness in the fiscal math, however, suggests that expenditure compression in the March 2018 quarter will have to be aggressive if the FY18 deficit target of -3.2 per cent of GDP is to be met.

Hence, risks of a miss to the targets have risen. The FY18 deficit might be pegged at 3.5 per cent of GDP (similar to FY17), which opens room for the FY19 target to be set at 3.2-3.3 per cent compared with the roadmap’s 3.0 per cent.

Simultaneously, bond borrowings are poised to increase. The government plans to borrow an additional Rs 500 billion (0.3 per cent of GDP) through dated securities this year, fuelling expectations of a miss in the deficit target.

While these higher borrowings are being offset by a planned Rs 600 billion reduction in treasury bills, a heavy supply pipeline at a time when demand is subdued is likely to weigh on sentiment further. The issuance calendar for the March 2018 quarter stands revised to Rs 150 billion/ weekly until February 9 and T-bills at Rs 140 billion weekly until March 28.

Furthermore, the FY19 budget deficit to be presented on February 1. Expectations are building for a populist budget, targeted at rural/ agricultural development, job creation, and effective implementation of social sector schemes.

A higher FY19 fiscal deficit to the tune of 3.2-3.4 per cent of GDP (vs 3 per cent in the roadmap) will imply higher net borrowings to the tune of Rs 4.8-5.2 lakh crore compared with Rs 4.2 lakh crore budgeted in FY18.

Apart from fiscal developments, inflationary concerns, high oil prices, and rising US rates also warrant attention. From 1.5 per cent in June 2017, inflation quickened to 4.9 per cent YoY in November, a 15-month high on higher food, fuel, and core pressures.

This compares with the target of 4.0 per cent (+/- 2 per cent range). High-frequency trends suggest food prices remained firm into December on unseasonal rains, which might keep the headline firm at 5.2-5.4 per cent range, with upside risks.

Over the next six months, inflation is likely to stay above target, much to the discomfort of the central bank. Thereby, concerns over generalised pressures and fiscal slippage are likely to see RBI settle into a long pause. Further increases in inflation and a narrower output gap might prod them to shift to a tightening bias in the coming months.

Having climbed 75bps since October, 10-year yields are now within striking distance of the 7.5 per cent key technical level that we highlighted previously. Despite the likelihood of further weakness in the macro environment, we reckon that a fair amount of bad news (fiscal slippage, upside surprise in inflation, and rising commodity prices) may have already been digested by the market.

While the budget for FY19 and rising US dollar interest rates are key concerns, we think that the bulk of the selloff in longer-term government bonds may be over. Instead, we think that 10-year yields should settle into the 7.5-8.0 per cent trading range in the coming quarters. Meanwhile, there could be scope for dip buying in two-year bonds after the 20bps

yield surge in December.

Short-term rates are already factoring close to three hikes by end-2019, more hawkish than our call for two hikes over the period.

We had noted that foreign investors (FPIs) had been unable to buy Indian bonds, given that the quota has largely been used up, despite small increases in recent months. A new framework for these limits (likely in February/March 2018) might be released and will be closely watched. An increase in limits could provide some much-needed support to bonds.


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