- Budget estimates of fiscal deficit and borrowings for FY21 conservative
- Crowding out effect is reduced by govt reliance on small savings
- Progress on tax collections, disinvestment, AGR will decide if yields shoot up
- Higher FPI, NRI participation in bonds may aggravate volatility
While the Union Budget 2020 seems to have sorely disappointed stock markets which had built up hopes for everything from a Long-Term Capital Gains tax exemption to a magic pill for the economy, it seems to have given bond markets some reasons to cheer. The following broadly, are the implications for the bond markets from the Budget proposals.
No big deficit overshoot
A key fear that kept bond markets on tenterhooks months before the Budget, was the extent by which the Centre would overshoot its fiscal deficit estimate of 3.3 percent of GDP for FY20. With numbers from the government accountant showing big shortfalls in the direct tax revenues and the lack of traction in the disinvestment programme for FY20, worries were rife that the fiscal deficit would top the 3.8 per cent mark.
But with the Budget estimating the fiscal deficit at 3.8 per cent for FY20, staying within the ‘escape clause’ of 0.5 per cent allowed by the FRBM Act, the deficit numbers for this year are very much in line with market expectations. It is also a positive that, having used the escape clause to the hilt this year, the Centre plans to try and rein in its fiscal deficit to 3.5 per cent next year. That was pretty much the market expectation too.
This effectively means that the 10-year government security yield which, after shooting up to 6.8 percent in December 2019 on deficit fears has fallen to about 6.5 percent now, may remain rangebound with no particular reason to either fall sharply or shoot up, owing to the Budget.
Muted market borrowings
The main reason why high fiscal deficits send bond prices tumbling (and yields shooting up) is the fear of the Government going on a borrowing binge to bridge its deficit. When the government – the safest borrower in the market – goes on a borrowing spree, most bond buyers will flock to government bonds, thus forcing private sector borrowers to offer high interest rates to woo them. This is what is described as the ‘crowding out’ of private borrowers by the government.
Big borrowing plans from the government may have been particularly injurious to private borrowers this year, given that yields on corporate bonds are already trading at a high spreads (premiums) over government bonds after the recent string of downgrades and defaults.
But the government borrowing plans outlined in the budget allay these fears. For FY20, despite the fiscal deficit overshooting original budget estimates, the Centre hopes to borrow only Rs 7.1 lakh crore on a gross basis sticking to what it originally outlined. For FY21, it pegs gross borrowings at Rs 7.8 lakh crore, when the bond market was expecting something in the region of Rs 8 lakh crore.
While gross borrowings are at levels expected by markets, the Centre has also managed to substantially rein in its actual bond issues in the market (net market borrowings) by leaning heavily on the small savings schemes to bridge the gap. Against a gross borrowing of Rs 7.1 lakh crore in FY20, it sourced Rs 2.4 lakh crore from securities against small savings, resulting in net market borrowings of Rs 4.98 lakh crore. In FY21, with Rs 2.4 lakh crore again planned to be sourced from small savings, net market borrowings are again expected to remain at a moderate Rs 5.35 lakh crore.
Given that small savings schemes are funded by inflows from retail savers who aren’t big bond market participants, the move to route a significant proportion of Government borrowings from these schemes, reduces the ‘crowding out’ effect on private borrowers in the market.
As a result, the extra returns that corporate bonds offer over government securities may not have any reason to shoot up due to the Budget proposals. They, however, will continue to respond to instances of corporate defaults and downgrades in the months ahead.
More credible numbers
While the immediate impact of the Budget on the bond markets depends on the projected deficit and borrowing numbers, the medium-term impact depends a lot on how the actual numbers pan out against the Budget projections.
On this count, FY20 held many nasty surprises for bond investors, with nominal GDP growth (the denominator for the deficit) sharply under-shooting estimates, revenues falling hugely short and the deficit blowing out the projected levels.
For FY21 though, the government seems to have learnt some lessons from this and stuck with more conservative projections on nominal GDP growth and tax collections. The nominal GDP growth projection, at 10 per cent for FY21 against a projected 12 per cent growth in FY20, seems attainable. Even if real GDP growth is only at 5.5 to 6 per cent next year, the rising inflation rate promises to make up the gap.
The gross tax revenue for FY21 has been budgeted to grow at 12 per cent over the revised estimates of FY20, broken down into a 12 per cent growth in corporate tax, 11.5 per cent in income tax and 14 per cent in GST. While these are not over-the-top expectations, achieving them will depend on how growth pans out next year and how close FY20 actuals are to the revised estimates assumed in the budget.
One aspect on which the Budget revenue estimates do seem a little ambitious are on non-debt capital receipts (mainly telecom AGR dues etc) where it hopes to rake in Rs 2.25 lakh crore and disinvestment receipts, where it has budgeted for Rs 2.1 lakh crore. While the former looks dicey, disinvestment targets will be within reach if the government manages to push through the strategic sales of profitable PSUs like BPCL/Concor and manages to list LIC (which is expected to fetch Rs 80,000-90,000 crore).
Given the ifs and buts around both these tax and non-tax revenue projections though, bond investors will need to watch developments on the tax, AGR and disinvestment front closely to gauge market direction in the months ahead. Bond yields may well shoot up if glitches materialise on any of these fronts.
More buyers for Indian bonds
Along with all the above, the budget has also announced many new moves designed to allow new sets of buyers to participate in domestic bonds. The overall limit for Foreign Portfolio Investors to participate in Indian bonds is proposed to be raised from 9 percent to 15 percent of the outstanding. Concessional withholding tax rates for foreign investors buying local bonds have been extended until 2023. NRIs will now be permitted to invest in certain categories of government bonds. A dedicated g-sec ETF, following the PSU bond ETF that has already been launched, can give retail investors direct opportunities to buy government bonds, expanding the basket of buyers.
All these measures improve the ability of the domestic bond market to absorb higher bond supply both from government and corporate sources. Overall, there’s nothing in Budget 2020 to send domestic corporate bond or g-sec yields shooting up in panic. However, given that the new participants are likely to be more active traders than domestic banks/insurance firms, investors should brace for volatility in domestic bond and g-sec yields, with more two-way moves likely.
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