Budget’s approach will impinge on the fiscal-monetary tango

The budget can nudge growth through higher government spending.

India’s bond market awaits another annual government borrowing programme even as it keeps eyes peeled on the turn in the monetary policy cycle. The dynamics here will have a bearing on the interest rates next fiscal. As for long-term rates, underscored by the benchmark 10-year government security (G-sec) yield, other macro factors will also matter.

Long-term rates ease in FY25

This fiscal, between April and January, the 10-year yield has slipped to an average of 6.9 percent, compared with 7.2 percent average in full fiscal 2024.

With the repo rate unchanged at 6.5 percent, the term premium, or the spread between the G-sec yield and repo, fell to an average of 40 basis points (bps) for the fiscal so far, the lowest in over a decade.

The expectation of lower inflation, reduced fiscal deficit and borrowings, decline in crude oil prices and comfortable liquidity (supported by the cash reserve ratio cut in December) lowered the yield.

Pertinently, this swing in G-sec yields is in contrast to the pandemic period, when they rose despite a significant ease in liquidity and cuts in the repo rate by the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI).

To be sure, during the easing cycle (March 2020 to April 2022), while the overnight call money market rate fell by over 150 bps, yields on G-secs rose 65-70 bps and yanked up the corporate yields as well. This restricted the transmission of lower interest rates to the rest of the economy, especially to the longer tenure instruments.

It led to a de facto monetary easing

Nevertheless, this year’s softening of yields bodes well for other interest rates in the market. When G-sec yields fall, the borrowing cost for the government reduces. But since it is also a benchmark for long-term interest rates in the economy (state development loans and corporate borrowings), the sharp drop in yields reflects a de facto easing of monetary policy.

With the MPC yet to start cutting the repo rate, some more easing in the yields is expected over the coming months.

More easing depends on the interplay of four factors

One, inflation expectations and the depth of the rate cut cycle: In December 2024, consumer price inflation, the central bank’s monitored target, softened to 5.2 percent from 5.5 percent in November but food inflation remained elevated at 8.4 percent. Recent data on food prices suggest a sharp drop in food inflation in January, which should bring the headline inflation closer to the MPC’s target of 4 percent.

The visibility of a sustained decline in the headline inflation to the target, led by lower food prices and the expectation of non-inflationary budgetary allocation for fiscal 2026, should open the path for rate cuts.

Meanwhile, the RBI has continued to rely on liquidity management as a key tool to influence interest rates in the system. In addition to the December’ CRR cut, the January 27th announcements which include purchasing government bonds through open market purchases, conduct of variable repo rate auctions and entering into USD/INR buy/sell swaps with banks should inject liquidity and ease financial conditions in the absence of policy rate reductions.

Two, a tighter fiscal belt: The government has remained committed to its deficit reduction path, bringing down the fiscal deficit to a budgeted 4.9 percent this fiscal from 9.2 percent of the gross domestic product in fiscal 2021. It plans to further bring it down to below 4.5 percent as mentioned in the July 2024 budget.  A smaller deficit on-year, which brings down net market borrowings, accompanied by repo rate cuts and liquidity easing, should ease the pressure on benchmark yields.

Three, lower crude oil prices: Given a large oil import bill, India’s macro parameters, including the G-sec yield are sensitive to global crude oil prices. After a brief spike, prices softened in recent months on expectations of strong supply and relatively weak demand for oil. The US Energy Information Administration expects crude oil prices to fall to $74/barrel in 2025 from $81 per barrel in 2024. Some upsides due to the recent sanctions on Russia’s oil sector could be a possibility, but prices would still be lower on-year.

Four, a rise in US yields, leading to foreign capital outflows: This fiscal, foreign capital chased rising US government bond yields. Yields rose to almost 4.5 percent in November from 3.8 percent in September. In the base case, policy developments in the US are expected to push up inflation expectations, reduce the scope of sharp policy rate cuts and boost yields in the short term. If that were to happen, foreign capital outflow from debt markets in emerging economies including India, could put some upside pressure on the 10-year G-sec yield.

As global shocks mount, a supportive domestic policy environment that strengthens growth, is non-inflationary and builds resilience against domestic and global shocks, must be harnessed.

This will require fiscal and monetary policies to complement each other. The impact on interest rates due to this fiscal-monetary tango remains a key monitorable.

Today, interest rates in the economy are up, lending norms are tighter and credit offtake has slowed.

The budget can nudge growth through higher government spending, while a normal monsoon, leading to healthy agriculture incomes and a less disruptive external environment, can propel growth. However, easing of rates and ensuring transmission of lower interest rates can improve the credit flow and drive demand for consumption and investment.

This is where the coordination between fiscal and monetary policy will matter the most.