Will governments lower FY18 borrowing result in lower fiscal slippage?
The last couple of weeks have been a rollercoaster ride for the bond markets to say the least. It all started on December 27--- bond prices tumbled as markets feared an additional borrowing of Rs 10000 to 20000 crore in January--- and right on cue, the very next day, government announced an additional borrowing plan of Rs 50000 crore for January and February. This sent the bond markets into a tizzy with prices sliding and the yields hardening.
The next day, that is December 29, there was a minor correction largely thanks to year-end buying. A few days later, the action picked up once again after RBI deputy governor Viral Acharya read the riot act to the banks who were seeking more time to provide for bond losses. In no uncertain terms, Acharya said "nothing doing" and bond prices crashed sending the yields higher.
Yesterday, bond prices hit their lowest level in two years as the market feared about the appetite for government bonds in the wake of Acharya's comments. However the government applied a balm of sorts on the wounds--- it announced a scale back of its Rs 50000 crore additional borrowing plan to Rs 20000 crore. This pushed the yields lower and bond prices higher.
CNBC-TV18's Latha Venkatesh caught up with Ananth Narayan Market Expert Professor, SPJIMR, A Prasanna Chief Economist ICICI Securities PD and Badrinivas NC Hd - Local Mkts Treasury Citi India to find where this leaves the government's borrowing plan, does this mean lesser fiscal slippage this year? Where does this leave the bond market and the fate of the 10-year yield?
Below is an excerpt from the interview.
Q: What was the take-home from the cut in government borrowing, extra government borrowing by Rs 30,000 crore? What kind of fiscal deficit number are you working with for the current year?
Prasanna: We are working with 7 percent. From the beginning that was the number we were working with. But of course, when the government announced a Rs 50,000 crore extra borrowing that left us a bit puzzled. So we were wondering or we were fearing whether the deficit could be higher, but now that they have scaled it back, we are sticking to our 3.7 percent estimate.
Q: But nevertheless, how would the government have managed this number in just two weeks? Is it likely that they have planned expenditure cuts? It looks like the reaction was to the market's fall yesterday, the bond market fall on January 16. In 24 hours what could have possibly changed the fiscal math?
Prasanna: It is possible that yesterday's movement could have been the last straw that broke the camel's back, but if you look at it, ever since they announced the extra borrowing, I think the volatility has been very high and in a couple of auctions, they have were not able to raise the full amount. So all these things would have factored into the calculation.
Now, on the other side, in terms of the finances, what probably changed is we saw some news item that the RBI might be giving an extra dividend to the government. We do not know how far that is true. There was also news item that the government is holding back income tax refunds which could artificially boost revenues this year.
And of course, like you pointed out, there could be some spending cuts also which is always possible. The government has quite a bit of leeway on that. They just have to push some spending from March to April to optically show a lower spending and a lower deficit this year. So, it seems like they had these levers in place and what kind of pushed them into this action of reducing the borrowing is the market movements over the last couple of weeks and I guess yesterday was the last straw.
Q: The way in which the bond markets, the ferocity with which the bond markets reacted, the immediate counter coming from the government indicates that the government can be disciplined by the market. Do you think this message will be retained that bond markets are not prepared for higher borrowing? Will that impact the kind of fiscal deficit and market borrowing number for FY19?
Prasanna: Absolutely. I think should be notched up as a minor victory for bond vigilantes in the Indian market. Of course, product by RBI, so some of the credit should go to the RBI Deputy Governor also. So a couple of years back also we had this kind of an episode, prior to Budget when the bonds sold off and at that time, the then RBI Governor had also given a speech lecturing the government about the need for fiscal consolidation. So this all plays, I would see this current year's episode in similar vein.
So 3.7 percent is our estimate for this year's fiscal deficit. So next year, we think that automatically 0.3 percent can easily be achieved. That is because the March GST collections are due in April. So our 3.7 percent is essentially a technical number. So that 0.3 percent which is due in March automatically comes to the government in April. So we are easily going to 3.4 percent and right now, that is our estimate for next year's fiscal deficit.
Now if the government stretches itself a little bit more from 3.4 getting to 3.2 should not be that much difficult. So like you said, if the government had internalised the message from the bond market that is completely possible. Now of course, the issue for bond market is that actually we are operating in a vacuum in terms of Fiscal Responsibility and Budget Management (FRBM). There is no FRBM in place, the recommendations of the FRBM Committee have not been accepted. They have probably been punted to the Finance Commission.
So there is no anchor in place. I think that is one of the reasons why the market reacted so viciously when the extra borrowing was announced. So this is the only way the government could be disciplined since there was no self-discipline. That is the only slight worry which one would have ahead of the Budget.
Q: Do you think the ferocity of the bond market reaction and the immediate chastened government reaction in terms of lower borrowing will be a lesson learnt and will reflect on the deficit next year, FY19?
Narayan: I am not so sure and sanguine. First of all, next year is an election year and I am sure Budget and elections is a heavy mix. I am not sure they are going to be worried about things like borrowing costs. I am not even sure if what we saw today in terms of a reduced borrowing programme is a direct consequence of what we saw in yields. I am really not sure if you can draw a causal relationship there.
Q: Why would you say that? In terms of time, it has followed, one, a 20 basis point rise in yields and early morning, even at 9:15 just when the markets were opening, we got the message from the Department of Economic Affairs Secretary's tweet. You would not say this is causally related?
Narayan: As I said, I am not sure. It could be well be causally related in which case, I am happy because it means the Ministry of Finance is actually watching and taking steps with alacrity. I would only ask the question that couldn't all this have been done in the end of December and a whole host of pain avoided for the market. Going down from Rs 50,000 crore to Rs 20,000 crore in 20 days has caused a lot of hardship to the market.
But be that as it may, I think the bigger problem from my perspective is a lot of the Budget math for the next year depends on 2-3 factors. One is how do oil prices play out, which none of us have a complete picture of.
Second is, how does the goods and services tax (GST) play out. Even on February 1, when the Finance Minister presents his Budget, I am not sure he will have a full handle on how this year's fiscal GST numbers will look like. I think next year will be a lot better. If you see by history, when GST is implemented in a large country, typically the first year actually sees a dip in collections and the next year sees a catch-up and more. So I will not be surprised if we see a good 20-25 percent increase in GST collections the next year. But it will still be a shot in the dark, it will still be a projection which we will have to see how it actually plays out.
And the third part is of course, the global context, what happens with Fed unwinding, European Central Bank (ECB) unwinding and so on and so forth and therefore, how the global context looks like. So because of that, I am not sure you can only go with a constraint of what bond prices are indicating. I think it will be a whole host factors and bond factors might be one of the lower ones in that hierarchy really.
Q: Do you think up until the Budget, yields are going to meander in the current range or can there be moves even leading to the Budget. And just a wild guess on how can yields go after the Budget in the first quarter, calendar 2018?
Prasanna: I would think that they should largely stay close to where we are seeing them today assuming the government does not throw further googlies between now and the Budget largely because a lot of the direction will be set by the Budget. So in that sense, 10-year around 7.25 centric, probably with lower volatility compared to the last couple of weeks is what I would look at. Post Budget of course, I think it obviously depends on the Budget what numbers we are getting and secondly also what the Monetary Policy Committee (MPC) is going to say in the February review.
So my sense is obviously it will be a reiteration of the neutral stance. Now whether the MPC explicitly takes away the possibility of a rate cut which is a logical conclusion one should draw based on recent data or it remains vague in its guidance, that will also matter a lot. So, based on what we think is going to happen in both the Budget and the policy, my sense is I have not changed my view. By and large the 10-year should trade in the 7.25-7.5 range. But again, I would emphasise that we do expect the volatility to be far more lower. That would be the bigger positive for the market rather than the level itself coming down.
Q: Assuming the deficit comes in at 3.2 or 3.4 as you are saying for the next year, when are you pencilling in a rate hike at all?
Prasanna: Our base case still remains that we are not pencilling in a rate hike in the current calendar year. That is based on our view that inflation stripped out housing and all those other one-off effects, both headline and core will average below 5 percent which we think is pretty much within the tolerance zone for the MPC. Now of course, the risk is of course, that there are upside risks the inflation and like you pointed out that the Budget also, if we get higher deficit, so the risk is definitely of a rate hike. So we will reassess that call after the Budget and probably after the February MPC review.
Q: First up, what was your takeaway from the way in which the government reacted today? Are you getting a sense that this is a chastened government and therefore, you can scale down the fiscal deficit of next year as well? Fiscal prudence will be the order of the day?
Badrinivas: Definitely looking at next year, we do expect the government will be on the path of fiscal consolidation. So wherever they end this year, the next year numbers should be a tad lower on the fiscal deficit side. The key data is of course, the GST collections for this quarter. If you look at the GST trends over the last few months, it has been a bit below what was initially expected. How the quarters collections perk up will be obviously a very crucial determinant in where the fiscal deficit eventually comes from.
Q: Our reporter is picking up lately the direct tax collections are good, but as a bond expert, what is your reading in terms of where bond yields will go not just for this month, but say for this quarter and in fact, for all of 2018?
Badrinivas: If you look at it, in the near-term it is true that a lot of negative news is in the price. However, there are still uncertainties in the fiscal side as well as on the inflation and you are seeing how oil is pretty much trading on the highs of recent months and quarters. So all of these, it is still a little uncertain and all of these, how they resolve themselves over the next coming few weeks will determine how bond yields trade in the very short run.
My sense is that in the very short run, the most crucial will really be the oil price movements as well as the demand in the auctions which will set the tone. But if you go back from deciphering this whole move in yields and interest rates over the last few months, it is important to understand that not long back, we had interest rate cut by the RBI. As of August last year, they cut rates and there were expectations in the market that you will probably get one more rate cut by the end of the year. Subsequently, we had the inflation move up, the oil move up and market first had to unwind this view.
And then, we saw the additional borrowing come through and of course, inflation has crossed five percent and some sections of the market are even thinking about or calling for a rate hike in the coming months. So the whole market had to shift in a very short time from a rate cut and an accommodative RBI view to a view where you are probably talking about rate hikes. And that is why you had such a significant move up in interest rates. In the medium term, beyond the short tenure demand supply dynamics, in the medium term, it will be more the inflation trend and the MPC's monetary stance which will actually determine how the yields move.
Q: What is your own sense? Do you smell a change in the stance of the RBI sometime soon, as early as February or will it be April and maybe even a rate hike this year? What are your own guestimates?
Badrinivas: If you look at the inflation trends, clearly there is some need for caution and to have a cautious outlook. In the December print we saw 5.20 number. The core inflation has also moved a tad higher closer to 5 percent. So, while it is tempting to say that it is all because of food inflation and base effects and the house rent allowance (HRA) increase, it is true that there are a little bit more generalised move up in some of the inflation data.
And we are also having further increases in cement prices and commodity prices. The oil price hikes this month have also been quite reasonable. So all of that means that there is a need to be cautious on the inflation front. At the same time, there has been a pickup in growth indicators as well over the last 2-3 months. Having said all of it, I still think it is premature for one to call for an immediate rate hike. I still think that one has to look at how the growth numbers, whether the recent growth numbers actually hold up in the coming quarters, coming months.And on the inflation as well, whether it is forming into a more generalised, whether there is output gap closing and demand pressures coming through, I think it is a little premature to make a conclusion on all of that. Therefore, while the RBI will express caution and sound cautious, it is too premature to call for a rate hike in the next policy definitely.