Union Budget: The Good, The Macro & The Bond Market (Opinion)

The Good

The Budget exercise over the past few years has undertaken the important initiative to progress along the path of transparency. This has had multiple facets: Bringing below the line financing above the line, clearing up arrears, and projecting conservatively.

This has meant that fiscal expansion since the pandemic has in fact been even more responsible than what the headline numbers indicate, once these items are adjusted for. Also, alongside building more credibility, it has provided important fiscal flexibility for the government; perhaps for the first in many years.

This means that instead of wondering a little after mid-year as to how deficit targets will be met and what revisions to market borrowing may have to be undertaken, the bond market has instead been able to look forward to almost boring predictability on the numbers landing in the area of where they were projected.

The current Budget takes this exercise in transparency forward. It starts with assuming the nominal GDP growth rate at only 11.1 per cent; more conservative from market by at least a percentage point. Capital receipts generally show the same conservatism in projection. Reliance on resources of public sector entities continues to shrink progressively.

Thus one has reasonable comfort again at the start point that there are fiscal flexibilities that still reside in the Budget and the bond market may not have an additional bitter pill of uncertainty to swallow on bond supply as the year progresses.

Additionally, one cannot fault the direction taken in quality of spending. As the table shows, capital spending is projected to grow handsomely, while revenue spending growth slows down. Total expenditure growth is much slower than the assumed nominal GDP growth, thereby noticeably compressing expenditure to GDP in the year ahead.

The Macro

The above positives are decidedly also those for macros. However, there are other dimensions too to consider under this head including the context set by existing domestic macro set-up as well as the global situation. As is well known, India didn’t go overboard with the fiscal response to the pandemic. In fact, as highlighted above, adjusted for the clean-up, the actual expansion is even lesser than what the headline numbers indicate. Also, the context was an already slowing economy in the run-up to the pandemic, and one in which government spending was de-facto having to be the largest anchor to growth. The context of this Budget was still an incomplete economic recovery, especially as far as private consumption is concerned.

The prognosis for private sector capex has been improving, but aggregate capacity utilization still isn’t at the threshold that translates such prognosis into an immediate, foreseeable reality. This is especially true as private consumption in aggregate is still lagging and the robust export momentum thus far can’t be fully relied upon, if one expects some slowing down of global trade in the year ahead.

Given the above context, it isn’t hard to see why the government chose to continue to play a significant role, probably with a mind to secure the pace of recovery. However, like with everything there are trade-offs. A notable spot of bother lately for India has been the significant rise lately in the current account deficit (CAD). Thus while we saw a significant correction in the CAD with the collapse of investment / consumption in the immediate aftermath of the pandemic, quite worryingly the deficit has come roaring back with the recovery underway over the past few months.

This indicates that, even as at an aggregate growth is just about above the pre-pandemic state, the savings – investment balance is already turning quite adverse. Indeed, the last quarter CAD run-rate may have reached somewhat uncomfortable proportions.

This is all the more noteworthy in context of the recent US Fed pivot and the probability of meaningful tightening in global financial conditions ahead. This observation shouldn’t be interpreted as the manifestation of an alarmist streak, especially given our proven ability to draw capital flows and the starting point of a very robust level of forex reserves.

However, the recent CAD developments definitely serve to define the boundary set for policy choices. In following a shallower path for consolidation the government has chosen to somewhat nudge this boundary set, in our view. To put this point clearly, an alternate path could have been to consolidate the fiscal deficit somewhat more aggressively, thereby easing the savings- investment gap on the margin and allowing for that much room for the private sector to dissave.

To reiterate though, given the context there may not have been much of a choice. Also, the conservative accounting may be underestimating the extent of compression at first glance. However this still leaves the problem of absorption of the mammoth bond supply, a point we turn to next.

The Bond Market

The bond market has had a relatively rough ride over the past month or so. This has been mostly in sympathy to global developments, but also to some extent with market’s assumption that RBI will intervene sporadically getting frustrated.

In fact quite the contrary, the central bank has been selling bonds in the secondary market since mid-November, even as it has seemingly signaled to the market from time to time through auction devolutions. In fact, RBI had provided robust arguments in December on how our macro-dynamics were quite different and hence we needn’t follow what’s happening in the US. The assessment had in fact been quite dovish and therefore the January shock to market participants was all the more painful.

With this backdrop, the bond market had gone into the Budget with two expectations: 1) A gross borrowing programme of around Rs 12 lakh crore; 2) Some clarification on the path towards global bond index inclusion, most likely via rationalisation of capital gains tax for foreign investors.

However, as it turned out both expectations were frustrated. The gross borrowing number is close to Rs 15 lakh crore (although the repayment number prima facie doesn’t seem to account for the recent bond-switch exercise done by RBI with the government), which is significantly above expectations.

Also there has been no mention of the bond index inclusion roadmap. In the post Budget media interaction, Finance Ministry officials indicated that the negotiations / discussions on capital gains seem to be still ongoing. However, this didn’t seem very imminent.

All told, one can’t help but observe that there is a significant overestimation of the depth in the bond market. The format expected by the bond market was simple and straightforward: effective overnight rates are at emergency levels and need to be lifted.

However, RBI would support the absorption of the borrowing programme in a liquidity-neutral fashion (twist operations and variants of the same). This would be distinct from yield targeting or ‘molly-cuddling’ the market in any fashion, but would be in line with orderly evolution of the yield curve. As it turned out January was already off to a rough start and in absence of a clear line of sight of demand from an additional investor (RBI or foreign), participants may find an uphill task absorbing this supply despite the already staggering steepness of the yield curve.

From a strategy perspective, we continue to favour 4-5 year segment of the yield curve, predominantly via sovereigns. This segment has significantly outperformed 10 year and beyond over the past few months (tenor spread between 4-year and 10-year continued to widen).

However, we continue to believe that the bulk of flattening ahead will happen between 1-year and 4 /5-year (150 bps approximately currently) rather than between 4-year and 10-year (80-85 bps currently from around 55 bps a few months back). It is to be noted that there is no benefit of roll-down in the 10-year and plus segment and one plays this largely only for expectation of capital gains or a fall in yields.

Especially with the new borrowing programme, we don’t expect material prospects of sustained capital gains. A risk to the view (that is flattening happening between 4/5-year and 10-year) could be the new borrowing programme emphasizing issuances in the 5-year segment.

However, with the mammoth bond maturities lined up over the next few years we don’t think that this would be a prudent thing to do from a debt issuance management standpoint. Also, we continue to expect this to be a relatively shallow normalization cycle from RBI.

This view also follows from our expectation that we may be at or close to peak hawkishness with respect to the Fed currently. One has to note that this is happening as growth momentum slows and yield curve is flattening.

Thus US financial conditions are tightening and fiscal stimulus fading, alongside a notable fall-off in consumer sentiment, just as investors have started to expect almost anything at all in terms of hawkish reaction from the Fed.

To be clear, the Fed may very well follow on these expectations for now but we do believe currently that later in the year the growth-inflation dynamics may be reasonably different from what they are now. For this reason, even the Budget presented on Tuesday may well ultimately prove to be the right thing to have done from a macro-economic standpoint.

However for now, and all other things remaining the same, this may provide a greater incentive to RBI to persist with policy normalization. This is significantly underway with the variable rate reverse repo (VRRR) programme and may get followed up, maybe as soon as the February policy, with an explicit narrowing of the corridor.

Thus money market rates may remain volatile, thereby re-emphasizing the importance of bar-belling for conservative investors.

(Suyash Choudhary is the Head of Fixed Income, IDFC Mutual Fund. The views expressed are personal)

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