Out-of-box Budget steps needed to fund borrow


Cogencis, Thursday, Jan 16

Lakshmi Iyer, Kotak Mahindra AMC CIO (Debt) and head products, says to fund its market borrowing in FY21, the government needs to think innovatively and consider inclusion of domestic debt on a bond index, perhaps even test foreign issuance of sovereign bonds, among other steps.

By Suyash Pande, Bhakti Tambe and Alekh Archana

Inclusion Of Indian Debt Into An Emerging Market Bond Index Could Be One Of The Ways To Attract Foreign Demand.

MUMBAI – The government needs to think out of the box in the upcoming Union Budget for 2020-21 (Apr-Mar) to fund its massive market borrowing programme, said Lakshmi Iyer, chief investment officer (debt) and head products at Kotak Mahindra Asset Management Co Ltd.

Inclusion of Indian debt into an emerging market bond index could be one of the ways to attract foreign demand, she said.

"The inclusion into the EM (emerging market) bond index is hard pressing... They did announce that they will do sovereign bond in the last Budget but they have not done that," Iyer, who oversees debt assets worth 1 trln rupees, told Cogencis in an interview.

According to Iyer, while fiscal expansion in the Budget seems inevitable, the government bond market will focus on the extent of the slippage and how the fiscal deficit will be funded.

The Budget for 2019-20 had pegged the Centre's fiscal deficit target at 3.3% of GDP and gross market borrowing at a record high of 7.1 trln rupees.

While the bond market has factored in fiscal slippage of around 50-60 basis points, a bigger deviation would be problematic, Iyer said.

The Centre's finances are under severe strain as a sharp slowdown in GDP growth has resulted in weak revenue collections. The stress has been aggravated by steps taken by the government to rev up growth, such as the sharp cut in corporate tax rates, which is estimated to cost the exchequer 1.45 trln rupees.

According to Iyer, the special open market operations recently introduced by the Reserve Bank of India should "ideally continue" as the central bank has ammunition in terms of its holdings of government securities.

Iyer sees the central bank keeping interest rates on hold at its policy review in February, and continuing with an accommodative stance. However, headline retail inflation has been on the rise over the past few months, primarily because of elevated food prices, leading to market talk that the rate-setting panel might change its stance to neutral.

"Probably, there will be views that you remove accommodation. Will it be en-masse vote for removing accommodation? I have my doubts," she said.

Iyer expects the yield on the 10-year benchmark 6.45%, 2029 bond to move in a band of 6.50-6.75% till the Budget. The yield was last at 6.62%.

Below are edited excerpts of the interview:

Q: What are your expectations from the Budget? There is a strong likelihood of fiscal slippage.

A: Fiscal expansion seems to be a given. The issue is, what will be the extent of slippage and how much of that will be funded through government borrowing. These are the two critical questions which markets will seek answers to. I would say one antidote in anticipation, probably, of an expanded fiscal deficit is the Operation Twist, where the RBI has been buying long bonds. What worries market about fiscal deficit is that supply will come and then bond yields will go up.

Markets would be keen to see what kind of expenditure you are going to incur as a government. Capital expenditure is more than welcome. Revenue expenditure looks unlikely but if you are going to do that then, why? Because it will be slightly punitive from the market standpoint.

How are you going to augment your revenue side as an economy so that growth gets back on path and in that pursuit, a small leeway on fiscal seems to be okay with the market. How small is that small, we need to wait and watch.

Q: What is your expectation in terms of slippage?

A: I don't have any assumption, but 50-60 bps is not going to be a material cause of concern. Most of them are factoring that in. Broadly, markets are kind of absorbing that there will be a kind surprise but if deviation from expectation is going to be way too high, then there will be a problem.

Q: Is the market fine with fiscal slippage, and the subsequent higher supply because of Operation Twist and do you think the Operation Twist is here to stay?

A: You can't take that assumption that Operation Twist is here to stay. We don't know the frequency of such announcements. RBI has some ammunition in terms of 2020 bonds. Will they stop at 2020 or will they also sell 2021 bonds? There are too many pieces to that puzzle at this point in time. You are buying and selling also, so you are not really expanding balance sheet. Logically, I don't see any reason for Operation Twist to not continue. Periodicity, frequency, etc, I really can't say.

My thought was that even if they have two in a month, it is not bad at all because there will be four supplies (four weekly auctions) of government bonds. One has to see if it will be front-loaded because you need money to be available when busy season starts with credit. They will probably have to take all that into consideration. Therefore, in my view, Operation Twist should ideally continue.

Q. Considering the possibility that gross market borrowing is going to remain elevated for some years, how is the government going to fund it? Do you think tapping foreign capital is the likely scenario?

A. The inclusion into the EM bond index is hard pressing, they need to do it. They need to walk the talk. They did announce that they will do sovereign bond in the last Budget but they have not done that. Again, there is no harm in doing an experimental (issuance). If you announce even a little bit of it through sovereign bond and it doesn't work, you can decide not to do another one. At least you will wet your feet and get a feeler.

I think what looks more probable between the two, there should be work done for an inclusion into the EM bond index. If that happens, it opens up a nice pipeline because some FPI (foreign portfolio investor) who just wants to be benchmark-hugging will also buy India bonds. You don't need to be overweight on India, and even if you are underweight, it is very unlikely someone will be at zero (investment), so even if you are underweight it will open up demand. Right now, you are dependent on the Indian financial system. If you have to pull through such a massive borrowing programme it is inevitable that you have to think out of the box.

Q. Do you think that for FPI participation through such bond indices we need to increase FPI limits?

A. I am saying first let them use the limits that are already there. The 6% limit is not even utilised. If you see, last year foreign investors net sold Indian bonds, they net bought Indian equities. I don't think this government will have any hang-ups because I don't think that side is constrained. It is the demand side that is constrained.

Q. But does an inclusion warrant an increase in FPI gilt investment limits?

A. That depends on how much you are going to be included. You cannot be cut-to-cut. What if someone wants to go overweight on India? You never know. They will have to keep some cushions there; we don't know if an inclusion is being planned and if yes, what will be the extent of that inclusion.

Q. Are we at the end of the rate cut cycle or it is just a matter of time when the stance of monetary policy moves?

A. Right now, it is (in an) accommodative mode. Whispers and murmurs have started over the move from accommodative towards neutral. Timing wise, you decided not to cut rates last time, you went by status quo, why can't you be on status quo once again and see if these are transient elements of inflation? Even the geopolitical risk (US-Iran tensions) is transient, we don't know on which side it will materialise. I still bet that there will be status quo (and) accommodation. Probably, there will be views that you remove accommodation. Will it be en-masse vote for removing accommodation? I have my doubts.

Q. Where do you see the yield on the 10-year bond till the Budget, and then for the three-month and six-month horizon?

A. Till the Budget, I see it moving between 6.50% and 6.75% because I don't see any material reason why it will pull below the 6.50% region. Around 6.60-65%, people will look to allocate positions because term premium is way too steep and there are pockets of money to be made. Conversely, if it goes lower, there can be profit taking. Liquidity is for the absolutely short end of the yield curve but for the long end and the mid end, you require visibility of rate action which at this juncture looks unlikely, at least for a couple of policies.  End

(This story is part of a series of Cogencis special stories in the run-up to the Union Budget 2020-21, to be presented by Finance Minister Nirmala Sitharaman on Feb 1.)

Edited by Mainak Moitra

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