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India: bond yields to creep up as government springs borrowing
surprise but fears of more slippage are overblown
Government announces
higher-than-expected 2H borrowing program…
Rudely surprising markets, the
government announced a significantly higher second-half borrowing
calendar than was budgeted. In line with budget assumptions,
markets had expected authorities to issue Rs. 1.7 trillion of bonds
in the second half of the year. Instead, the government announced
issuance of Rs. 2.2 trillion in the second half, exceeding
expectations by Rs 520 billion (~0.6 % of GDP).
As a consequence, the 10 year
G-Sec benchmark yield rose 10 bps to 8.44 % and could creep up
further as the market internalizes the larger-than expected weekly
bond auctions for the rest of the year.
….says fiscal deficit
on track but composition of financing had to be
changed
Authorities were quick to clarify
that the extra issuance was not on account of a
higher-than-budgeted fiscal deficit. Instead they reiterated that
they expect to meet the budgeted fiscal deficit target (see below
for a fuller discussion on the plausibility of this)
Instead, higher bond borrowing was
necessitated by a shortfall in other sources of financing the
fiscal deficit. Specifically, authorities indicated that the
opening cash balance was lower-than-budgeted by Rs 170 billion and
there was a shortfall of Rs 350 billion in collections from small
savings scheme. The latter is not unexpected in a high interest
rates environment when bank deposits typically benefit at the
expense of small savings schemes. As a result, though, the total
shortfall is Rs 520 billion and will be compensated by higher bond
borrowing of an equivalent amount.
For market this is
tantamount to fiscal slippage, but fears of more slippage are
overblown
In a sense, though, the damage has
been done. Even if there is no slippage on the fiscal deficit,
increasing bond borrowing by Rs 520 billion is tantamount to the
deficit slipping by 0.6 % of GDP.
Yet, the relevant question now is
whether there will be more slippage from here on end, on account of
the widening of the fiscal deficit itself? Is the 4.6 % target
achievable?
We continue to believe that, in
contrast to the market consensus, fears of significant slippage of
the fiscal deficit, itself, are overblown. It is undoubtedly the
case that there will be short-falls and slippages on individual
line items within the budget, vis-à-vis the budget targets. But as
we discuss below, disappointments on the disinvestment front are
likely to be largely offset by buoyant direct and indirect tax
collections. Similarly, on the expenditure front, it is undoubtedly
the case that subsidies – particularly oil subsidies – appear
under-budgeted. However, savings on other fronts (e.g. NREGA) are
expected to offset these subsidy over-runs.
Buoyant tax
collections poised to offset disinvestment
disappointments
It has become increasingly clear
that the disinvestment target set out in the budget (Rs 400
billion, ~0.4 % of GDP) will likely be missed by a significant
margin, given the elevated risk aversion levels that are
characterizing global and domestic equity markets.
However, what is not appreciated
is that gross tax collections are running significantly above
budgeted. This is not surprising given that the budgeted tax
collection was based off a very conservative nominal GDP growth
rate of 14%, the economy is slowing more gradually than many had
expected, and inflation continues to remain at elevated levels,
leading to tax collections benefiting from an “inflation tax” of
sorts.
As a consequence, indirect tax
collections are running at almost twice their budgeted target, with
customs tax revenue and service taxes growing at a particularly
buoyant rate. The customs tax buoyancy is not surprising, despite
the cut in oil duties, because non-oil imports have accelerated
sharply in recant months. This reflects both strong domestic demand
and a substitution effect -- as firms have begun to import what
they could have produced/procured at home -- to avail of the
significant inflation differential (which has now been wiped out
given the currency’s sharp depreciation).
The strength of direct tax
collections has been masked by the different accounting of tax
refunds between last fiscal and this. This is the first year that
authorities have moved to an electronic tax refund system,
resulting in refunds being dispensed in an accelerated manner, as
opposed to being spread out through the first half of the year. As
such, any comparison of direct tax collections – which includes the
refund effect – for the first few months of the year compared to
last year, will misleadingly suggest weakness in direct tax
collections this fiscal. Adjust for this timing effect in refunds,
and direct tax collections remain strong and above budget
targets.
In sum, therefore, even accounting
for an appreciable growth slowdown in the coming quarters, it is
likely that gross tax collections will exceed budget targets by
between 0.2 to 0.3 % of GDP, thereby serving to offset even a large
shortfall of disinvestment proceeds.
Oil Subsidies clearly
under-budgeted….
Right from the presentation of the
budget in February, concerns have risen that subsidies have been
significantly under-budgeted. This is particularly true of oil
subsidies. Even after cuts in customs and excise duties and an
increase in retail prices of petroleum products in June,
under-recoveries are still expected to exceed Rs. 900 billion
(assuming the Indian crude basket averaged about $106 for the year)
and that the government would be expected to pick-up about 40
percent of this amount (Rs 420 billion) – a level consistent with
the fact that upstream companies would have been liable for a third
of total under-recoveries had the government not cut duties and
taxes. Recall, however, that unlike previous years almost Rs 240
billion has been explicitly budgeted this year (it is also true
that it was used to pay last year’s subsidy but a similar rolling
over is expected to occur this year). As such, the remaining
liability of the government is expected to be Rs 180
billion.
These assumptions, however, were
predicated on the USD/INR staying around the 45 level for the year.
If, for example, the USDINR stays at 49 for the rest of the fiscal
(not our central forecast, see. “Rupee down but watch for a sudden
reversal,” MorganMarkets , September 27, 2011), total
under-recoveries rise to about Rs 1150 billion, and the
government’s liability will rise by Rs 90 billion. As such, even in
the extreme scenario that global risk aversion keeps the rupee weak
but crude relatively high, the total oil subsidy over-run (beyond
what is budgeted) is expected to be Rs 270 billion.
….while fertilizer
and food less of a concern
Fertilizer and food subsidy
over-runs appear much less of a concern. The 3G revenue windfall
was used, in part, to clear arrears with fertilizer companies, and
therefore the government is likely to roll over some of these
liabilities into next fiscal. On the food subsidy front, Right to
Food Security Act will only come into force next fiscal and
therefore constitute no further liability this year. In sum, the
bulk of the subsidy overrun will be limited to oil, and expected to
be about Rs 270 billion or 0.3 % of GDP.
….but significant
savings expected in NREGA
Offsetting this is the fact that
actual spend on NREGA is expected to be significantly less than
budgeted (Rs. 400 billion). Recall, NREGA spend in the last fiscal
turned out t be about Rs 230 billion, lower than the Rs 400 billion
budgeted last year, which is not surprising given that the rural
economy experienced a healthy monsoon. As a consequence, the total
funds available for this fiscal (including unspent funds from last
year) are about Rs 570 billion. Another normal monsoon this year
has again meant that NREGA spend is tracking significantly below
that budgeted. Latest data (till the end of September) indicates
that only Rs 130 billion has been used in the first half of this
fiscal. If this run-rate were to continue, savings from NREGA would
completely offset the over-run on oil subsidies. Even if the
current run-rate were to double, the savings would still offset a
significant fraction of oil subsidies.
In sum, we continue to believe
that fears of a significant widening of the fiscal deficit itself –
above what is budgeted -- still appear unfounded.
Bond-yields likely to
creep up further but strength of credit growth remains the
key
The increased issuance of bonds –
above what was expected -- is undoubtedly going to put upward
pressure on government bond yields. Yields have already risen 10
bps to 8.4 % upon the announcement. While we expects yields to
continue creeping up towards the 8.5 -8.6% mark once the extra
supply hits the auctions, we don’t expect a sharp spike beyond that
unless there is a significant pick-up in credit
growth.
With banks holding government
bonds significantly higher than their SLR requirements, a sharp
pick-up in credit would reduce the incremental demand for
government bonds and pressure yields. However, with the economy
expected to slow further in the coming quarters and no sign that
the investment cycle is poised to take off sharply, a sharp pick-up
in credit looks unlikely. If anything, credit growth is expected to
moderate further, in line with the RBI's indicative target of
credit growth slowing to 17% oya from the current 20%
levels.
Conversely, an announcement of
OMOs by the RBI would put down-ward pressure on yields, but we
believe this is equally unlikely in the near-term given where
inflation is currently running and the desire of the central bank
to keep liquidity tight enough to ensure that monetary transmission
is not compromised.
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