The Union Budget holds some relevance for all the markets. From the perspective of investors in bonds and bond funds, the relevant variables in the Budget are the fiscal deficit and as a corollary, government borrowing from the market. On both the fronts, this Budget has been a positive.
On fiscal deficit, while the roadmap laid out earlier was reduction of the deficit to 3% of GDP in 2017-18, there are challenges in view of growth being impacted by demonetization and the need for the government to give a fillip. Recently, a committee called Fiscal Responsibility and Budget Management (FRBM) Committee headed by former revenue secretary NK Singh submitted its recommendations. While the committee recommended reduction of deficit to 3% by March 2018, the subsequent path is status quo for next 3 years. Among bond market participants, there were apprehensions whether the Finance Minister would stick to the 3% target or would he take some leeway as per the ‘escape clauses’ of 0.5% deviation as per the committee report. The target for fiscal deficit for FY18 has been set at 3.2% of GDP in the Budget and for the next two years i.e. FY19 and FY20 it has been set at 3%. Hence it is only a small deviation while broadly adhering to the roadmap.
The other concern for the bond market is the quantum of government borrowing. Issuance of G-Secs is the single largest supply of fresh securities in the bond market. The gross borrowing has been pegged at Rs 5.8 lakh crore against Rs 6 lakh crore in FY17. This in itself is commendable that in an economy with a double-digit nominal growth rate, the government is relying less on market borrowings to fund the deficit. Maturities in FY18 are Rs 1.57 lakh crore, leading us to a net borrowing quantum of Rs 4.23 lakh crore. In FY17, the net borrowing from the market was Rs 4.07 lakh crore i.e. it is only a small increase in the coming year. On top of it, the government intends to buy back Rs 75,000 crore worth of dated securities, bringing the net impact on the market, in terms of demand for funds, to Rs 3.48 lakh crore. In the Budget speech, the Finance Minister mentioned this number as the net borrowing from the market.
The reduction in borrowings in the Budget has been facilitated by re-allocation of small savings mobilizations in favour of the Center vis-à-vis States and the tax buoyancy upon demonetization.
The bond market, till now, has not cheered the lower deficit and borrowing numbers as much. The intended buyback of Rs 75,000 crore is ‘as and when’ i.e. not according to a pre-announced schedule and typically buybacks are of nearer maturity G-Secs. Pre-buyback, the net borrowing of Rs 4.23 lakh crore in FY18 is similar to Rs 4.07 lakh crore in FY17. In other words, the net supply of ‘duration’ papers (meant as 5 year and longer maturity) remains flat next year.
The road remains clear for bond investments. The fiscal discipline and emphasis on capital expenditure e.g. infrastructure in the Budget should give comfort to the RBI to continue with the accommodative monetary policy. There is a sanguine chance of policy rate easing in the Review on 8 Feb ’17 as inflation and twin deficits (fiscal and current account) are in comfort zone.
The US Fed, at its meeting yesterday, left rates unchanged as expected. The Federal Open Market Committee said in its statement, inter alia, “measures of consumer and business sentiment have improved of late” and that they see “some further strengthening” in the labor market and a return to 2 percent inflation. The market expects a gradual rate hike by the US Fed, in the range of one to two rate hikes of 25 bps each in 2017. As per US Fed Funds Futures, which gives the implied probability of rate hikes, shows a probability of approx 50% at its May meeting. The probability increases to approx 70% for their June meeting. This implies that the market is not expecting a hike in the immediate term, in spite of the noise of ‘Trumponomics’.
Key takeaways from the Union Budget for fixed income oriented investors:
- Fiscal consolidation i.e. reduction of fiscal deficit remains on course
- Net supply of government securities remains on the lower side due to the comfortable cash situation of the government
- The ‘mix’ of expenditure i.e. ratio of capital to revenue expenditure is favourable to capital expenditure in this Budget over the previous Budget
- The overall assumptions on the revenue side i.e. mobilization through direct and indirect taxes are conservative. That is to say, coming fiscal year, the finances of the government may be in a better shape than delineated in the Budget, depending on the implementation and near-term impact of GST on indirect taxes.
From our investment advisory perspective, emphasis should be on shorter maturity bond funds, not only to reduce volatility but also from the perspective that banking system liquidity being surplus, it will benefit the shorter end of the yield curve i.e. less than 5 year maturity. The buyback of shorter maturity G-Secs will be a bonus for the shorter end.
Joydeep Sen is Independent Bond Market Analyst and Author.
The views expressed in this article are solely of the author and do not necessarily reflect the views of Cafemutual.
