The midyear review of the economy by the Chief Economic Advisor (CEA) makes a strong case for fiscal loosening next year. The review argues that private investment and global growth are likely to remain anaemic.
Private consumption is recovering but not at a robust pace. That leaves public investment as the only available route to stimulate the economy. But the fisc will be reined in by the Seventh Pay Commission and One Rank One Pension (OROP) expenses on the one hand and still anaemic tax revenues on the other. Hence the need to push back the fiscal deficit timetable.
What the CEA appears to be overlooking is that fiscal stimulus is possible only if someone is willing to buy the extra government bonds. This year even with a 3.9 percent fiscal deficit, the total market borrowing of Rs 5.5 lakh crore has been very difficult for the market to swallow. So poor is the appetite that even after a 125 basis point rate cut by the Reserve Bank of India (RBI), the 10 year yield is at 7.8 percent, exactly where it was before the rate cuts.
Next year's borrowing calendar looks definitely scary even at a fiscal deficit of 3.5 percent of gross domestic product (GDP). The fresh borrowing will amount to about Rs 5.18 lakh crore (assuming a nominal GDP growth of 8.2 percent). Adding to this Rs 2.6 lakh crore of redemptions, the gross borrowing will be around Rs 7.7 lakh crore. If the market is not able to absorb Rs 5.5 lakh crore of bonds this year, how can it absorb Rs 7.7 lakh crore next year. In addition there will be state loans as well as the UDAY loans. Even if the RBI takes the repo rate to 6.25 percent, the ten year is unlikely to fall below 8 percent.
In fact the bond markets may well start reacting negatively even in the next few days. Foreign institutional investors (FIIs) have been deeply scarred in Emerging Market bonds. India has been a standout exception because it is a beneficiary of falling commodity prices and because of the promise of inflation targeting by the RBI and fiscal discipline by the government.The extraordinary improvement in India's macros this year in terms of falling inflation and improving current account and fiscal deficit, drew USD 40 billion of FII investments in debt, against a couple of billion dollars only in equities. But in the last few weeks, this appetite is vanishing. There is still some headroom for sovereign wealth funds to buy government bonds but they are not utilising that limit. That should be a big hint for the finance ministry. FII appetite for Indian bonds is falling short even in a year of monetary and fiscal rectitude. If the mid-year review's strong case for fiscal and monetary looseness is emphasised too much I don't see why FIIs won’t start selling out Indian bonds right away.
As it is, 2016 doesn’t look like a great year for bonds or Indian macros. This year FIIs had 125 basis points of rate cuts to take advantage of. Next year the consensus is expecting at best one more cut. But with this talk of fiscal looseness, even that one cut may be difficult for RBI.In any case if the rate cut comes in a market where the amount of government bond supply is set to rise by 15 percent, there will be no fall in yields. Instead there may be a sharp rise. One should be prepared to see some bond investors exiting soon. Even this 15 percent rise in net borrowing is based on a fiscal deficit assumption of 3.5 percent.With a 4 percent deficit, the net borrowing will rise by 30 percent if bond yields rise to between 8 and 8.5 percent, will there be any scope for base rates to fall? On the contrary they will rise, irrespective of where the repo rate is. While one can’t be very sure of the extent of growth dividend from public investment through an expanded fiscal deficit, one can be very sure that even the green shoot of consumption and investment will die if interest rates rise from current levels.
Short point: fiscal rectitude is a necessity in India, not an ideological choice any more.
And here’s another chilling thought: this rather onerous borrowing is planned to be conducted by an Independent Debt Office for the first time. I fear an ominous start to this office and tough times for the bond market, which in turn can’t be good for the economy.
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