The silent fiscal innovation: The government’s gross borrowing projection for FY25 has triggered a fall in yields Financial Express 6th Feb 2024

 

The 10-year bond yield was around 7.14% on the eve of the presentation of the interim Budget. Once it was presented, it fell by around 8 bps, and market experts believe this will be the new range for the paper.

The efficient markets hypothesis states that if all participants have access to all the information related to the price of the subject and thus take rational decisions accordingly, the price discovered in the market will be the most efficient one. Though used generally in the context of stock prices, this also holds true for bonds where price/yields are market determined.

The 10-year bond yield was around 7.14% on the eve of the presentation of the interim Budget. Once it was presented, it fell by around 8 bps, and market experts believe this will be the new range for the paper. Add to this the fact that a new 10-year benchmark is to be announced, as the outstanding limit for the existing bond has crossed Rs 1.5 trillion. There is added pressure in the downward direction.

The reason is that every time a new benchmark is announced by the Reserve Bank of India (RBI), yields usually come down by 3-5 bps. Therefore, there would be a natural instinct for a further decline in the yields once this is announced. A level of less than 7% is not being ruled out. But why did the interim budget have such a deep impact?

The interim Budget for FY25 projects a lower fiscal deficit ratio—5.1% of the GDP—with only a marginal decline in the net borrowing programme of the government (Rs 11.75 trillion projected against the Rs 11.80 trillion in both FY23 and FY24). But the market is more interested in the gross borrowing programme of the government, which is projected to be lower, at Rs 14.13 trillion as against Rs 15.43 trillion in FY24.

This was the main trigger for the decline in bond yields, besides the headline fiscal deficit ratio being lower. The market always gets perked up when there is knowledge that there will be less borrowing from the market even though it is for the coming fiscal year. The difference between the gross and net numbers are the redemptions, which are estimated to be Rs 3.61 trillion. In this case, the gross borrowing should have been Rs 15.36 trillion—almost the same as FY24’s. But it has turned out to be lower for a specific reason.

The lower gross borrowing programme is due to the transfer of Rs 1.23 trillion from the GST compensation fund towards these repayments. This is probably the first time that repayments have been made from a source other than fresh borrowings. This has lowered the pressure on the market.

The GST compensation fund, it may be pointed out, was created to compensate states for any shortfall in revenues from the pre-assigned growth rate of 14%, but was to expire in five years. This was used and exhausted during Covid, when there was a fall in GST collections.

Now that the revenue raised has increased substantially over the last two years, there is enough buffer left, which has been used in both FY24 and FY25. Interestingly, for FY24, too, there was a recovery of Rs 78,104 crore from this fund, directed towards redemptions. In a way, this method has been a gift to the markets as it has brought down yields and raised prices.

The financial system has been in an unrelenting deficit over the last two months, with the RBI providing funds through the variable repo rate (VRR) auctions on a periodic basis. This was reflected at the lower end of the tenure while the 10-year yield was driven more by sentiment.

Hence, statements made by the Federal Reserve tended to influence this bond; and ever since the Fed indicated that there would be no more rate hikes, there has been a downward tendency. The spread between the US and Indian 10-year bond has now come within the 300 bps range. Lower yields are always good for the banking system as it will help to book treasury gains by the end of the year. However, it needs to be seen whether or not the lower end of the spectrum would also witness the softening of yields.

The interesting fallout here is that the treasury management in the interim Budget has been very cogent, where innovative techniques are used for managing funding. Instead of letting resources lie in the reserves, these have been used for repaying debt. This gives an idea that all such avenues need to be explored as the government works towards lowering the fiscal deficit even further, towards its targeted level.

This is also the time when the economy is expected to keep growing at an accelerated pace, thus necessitating higher demand for funds by the private sector. By keeping the gross borrowing programme under check, not only are more funds available to banks, but bond yields are lowered as well. Therefore, treasury management will become more important going forward. In fact, the states too could be taking a hint here to explore if such opportunities do exist for moderating the pressure on their budgets.

It can be seen that the government has been using various innovative methods that go beyond the conventional raising of tax revenue, which is dependent on the state of the economy. Asset monetisation is another such idea which has a very strong potential, as it not only brings in funds but also adds dynamism to the financial markets. A fast-growing economy requires such measures to be taken continuously to ensure a smooth transition to this high growth path.