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March 03, 2020

Indian Economy: Shape of yields to come

A 0.5% slippage in fiscal deficit for fiscal 2020 raises two immediate concerns: stressed finances constrain the government’s ability to spur growth through spending, and the upside to interest rates in the market.


In theory, a higher fiscal deficit would typically push up the central government’s gross market borrowings. A flood of government securities (G-secs) would lower bond prices and raise yields. And since a number of market instruments (such as corporate bonds, state development loans and even small savings) are benchmarked to G-secs, interest rates, in general, would also harden. Such a scenario would not be conducive, and indeed, work at cross-purposes with the monetary policy, which is trying to ease interest rates to support growth.


But are these fears actually playing out in the Indian context?


True, higher fiscal deficit is feeding stress. Also, a larger proportion of expenditure is also moving ‘off the budget’. Such expenditure is usually incurred by central public sector enterprises to use internal resources or raise debt by issuing bonds. The obligation to service such government-guaranteed debt does not directly fall on the Centre, but then, it could. While such debt does not directly influence G-sec yields, it indirectly puts pressure by increasing bond supply in the market.


On the other hand, there is also a growing disconnect between fiscal deficit and market borrowings. The government is placing greater reliance on borrowings from the National Small Savings Fund, though bulk of the deficit is still financed by the market.


Our analysis finds, apart from fiscal deficit, other macroeconomic factors also play a major role in influencing bond yields. These are: the Reserve Bank of India’s (RBI) accommodative monetary policy stance, open market operations (including the Operation Twist), a supportive external environment with low policy rates in major advanced economies, and falling crude oil prices. These factors have been found to significantly influence short-term movements in 10-year G-sec yields. For instance, in fiscal 2020, despite the 50 basis points (bps) slippage in the budgeted fiscal deficit, 10-year G-sec yields have fallen significantly, yet again, due to the five rate cuts by the RBI and falling crude prices. And more recently, as the RBI maintained its accommodative monetary policy stance despite inflationary pressures, yields dipped further.


This suggests that, despite a higher fiscal deficit/higher borrowing requirement, 10-year G-sec yields might not see a large upside in the near term. Thus, our analysis concludes: high fiscal stress does not always lead to higher bond yields.