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Budget 2022 Effects: Why are Indian Government Bond Yields Rising?

Editor, TRANSFIN.
Feb 4, 2022 2:14 PM 5 min read
Editorial

Much has happened since GoI unveiled record market borrowing targets in Budget 2022.

The new target for FY23 is a stupendous ₹14.95Lcr ($200bn), 40% higher than the borrowing slated for the current fiscal and higher than the ₹12Lcr ($160.6bn) anticipated by the market.

However, reports began emerging yesterday that GoI may reduce this borrowing target by ₹63,648cr ($8.52bn) because apparently officials failed to factor in the latest bond switch between RBI and the Union Government in Budget estimates (that would be quite a glaring oversight, if true!).

Be that as it may, even the skimmed-down borrowing plan has some observers shaking their heads. To top it all, Nirmala Sitharaman has said the Union Government will target a fiscal deficit of 6.4% (vis-a-vis FY22’s 6.9%), as North Block endeavours to narrow the deficit down to 4.5% by FY26.

Now, all these numbers are both critical and, to many, untenable. 

What’s That?

Ratings agencies like Fitch have rung alarm bells, saying GoI needs to focus on cutting debt and adding that its deficit targets may be recklessly optimistic, given that India has "limited fiscal space as it has the highest general government debt ratio of any BBB-rated emerging market sovereign at just under 90% of GDP”. (For context, the debt-to-GDP ratio was about 72% on the eve of the pandemic.)

What's more, investors seem to share these concerns. Since Budget Day, Government bond markets have devolved into an unforgiving selloff, with the 10-year yield touching a two-and-a-half-year high yesterday. In fact, so far this year, 10-year G-Secs have risen from 6.47% to 6.9% (propelled also in part by the Fed's looming tapering). Furthermore, analysts expect yields to continue rising and breach 7% by H1FY23.

To most of us, these may seem like minute changes, but in the world of bonds and G-Secs, these minor shifts can be the difference between jolly economic growth and an agonising slowdown.

 

What’s What

In case you're lost in the terminologies… A bond is basically a loan, and the yield is the rate of return you garner from the bond. G-Secs are basically bonds issued by the Government - and you can invest in them too

Now, when there is high demand for a certain bond, its price naturally goes up, but because of the increased demand the rate of return will go down. Conversely, if there is a market selloff happening (as is now), the bond-issuer (in this case, the Union Government) has to offer increased yield to attract investors. Ergo, bond price and yield are inversely related.

(If all this went over your head, you might want to read up on our earlier explainers on bond markets here and here.)

 

What’s Up?

Now, to be fair, bond yields have been rising for a long time now. Inflation fears, rising crude prices and, of course, the Fed’s u-turning on its u-turning have enabled a broad belief among investors that the era of low interest rates and easy monetary policy is coming to an end. And if interest rates rise, bond prices go down. As such, they become less lucrative investments. Which explains the flight of capital.

The element of increased Government borrowing is acting as a catalyst in the Indian scenario. If GoI wants to raise more money, that means more activity in the bond markets in the near-term. Rising yields, meanwhile, mean the price tag of borrowing goes up (FYI, it’s taxpayers like you and me who will eventually foot this heftier bill). This also makes achieving a fiscal deficit rate of 6.4%, let alone 4.5%, akin to grasping at straws.

For their part, investors are already seeing the writing on the wall. The ongoing selloff aside, Indian bond yields have been climbing for weeks now. In the recent state development loan auction (SDL), for instance, 10-year securities elicited yield demands of up to 7.28%.

 

What’s It To Me?

If your portfolio has exposure to G-Secs, you might be forced to follow the market trend and sell your holdings, given that there’s no saying when the falling bond prices will stabilise again. If the mutual fund scheme you’ve subscribed to has G-Sec exposure (aka a debt fund), you may see the net asset value (NAV) fall. And because the economy is a multifarious mesh of interlaced intricacies, a fall in Government bonds will inadvertently impact corporate bonds and equity markets alike. 

Besides, even if you have no stakes in bond investing, significant bond market movements will inevitably impact you nonetheless at the end of the day. That’s because of…

 

What’s Next?

Say we truly are in the endgame of the pandemic and no more COVID-19 waves await us. A post-pandemic economy would naturally warrant normalisation of monetary policy aka an increase in repo rates. That would be particularly non-negotiable in a scenario of high inflation (India’s retail inflation rate remains within the RBI’s comfort zone, but if trends in other major economies are indication, the 6% threshold may soon be breached).  

Either way, a return to the status quo of the Central Bank as primarily an inflation regulator would mean an increase in interest rates. Which translates to a decrease in Government bond prices. Which in turn translates into further rising yield. Which, as we have seen, isn’t exactly good news for GoI’s sunny fiscal targets or for the public purse.

That said, there is one entity that may be able to step in to buy excess G-Secs and help tame yields over the coming fiscal year: the Central Bank itself. 

The RBI’s monetary policy arsenal includes open market operations (OMOs) and auctions (remember Operation Twist?). But given the tenuous state of economic growth, red-hot retail prices and elevated wholesale inflation, policymakers may find it difficult to justify emergency monetarist interventions in a post-pandemic non-emergency landscape. The easier alternative would be for GoI to revise its borrowing targets further down. That, however, would also mean less money to fund the Budget’s big-bang infrastructure targets. Talk about being caught between the devil and the deep blue sea!

Either way, we likely won’t be left in suspense for too long. The RBI’s next monetary policy meeting is on February 9th. We can expect more clarity then. (And if the murmurs of an increase in the reverse repo rate are true, hawkish monetary policy may be coming back with a bang!)

FIN.
 

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