A study on the government finances and borrowing program: Standard Chartered, Interest rates trading desk, Financial Markets, Mumbai

Abstract

The aim of this project is to study the trends in government finances and key economic indicators to assess the direction of long term interest rates on government borrowing and the possibility of achieving the projected level of fiscal deficit; this project will also give insights into the level of under or over provisioning in the union budget (FY2012-13), taking into account, the recent macro-economic trends and events. This report can be used as a reference for Indian financial/ economic statistics, as all the data included have been taken from government databases. The government’s t-bill issuance over the years has always overshot the budget estimates; the dependence on non-tax revenues, (one-time revenues) and capital receipts like small savings scheme have gone up. This year’s budget also hinges on assumptions made on non-tax revenues (2G auctions). For the past two fiscal, the actual expenditure has also overshot budgeted estimates, the main reasons being insufficient provisioning for subsidies, interest expense and pension. The G.Sec yields are driven by demand-supply dynamics and the state of economy. The government borrowing program, announced in union budget, drives the supply side of government securities (G.Secs). Last year, the union budget projected a fiscal deficit of 4.6% but the actual was 5.9%; subsequently the actual gross market borrowings were 5.1 Lakh crores against a budgeted 4.17 Lakh crores. In the union budget FY2012-13, it was found that food and fuel subsidies were under provisioned. The Total subsidy last year was 2.43% of GDP; this fiscal, it is estimated as 1.87% of GDP which is expected to be an under-estimation. The demand side for bonds is driven mainly by the growth in bank deposits which results in SLR requirements; Assuming a deposit growth of 16%, and an SLR of 24%, banks net minimum demand for bonds would be Rs 2 lakh crores approximately. Whenever the demand is lesser than supply, the yields rise up, increasing the cost of government borrowing - RBI conducts Open Market Operation to supplement the demand. Another key determinant of interest rates is the state of the economy – the growth and inflation; Central banks, sets the short term rates vis-a-vis REPO and reverse REPO based on the indices for growth and inflation which in India are the IIP and WPI respectively. It was found that the 10 year benchmark yields lead the repo rate cycle by 2-3 months – i.e., 2-3 months before the reversal of the interest rate cycle, the 10 year yield rates reverses direction. The IIP growth year-on-year for March 2012 was - 3.5%; it was expected to be 1.1%. A trend analysis of the seasonality of IIP index revealed that this contraction was due to the high base effect of March index last year. The same is expected from the April index also – the April IIP figures will also be less than expected and the extent of it will depend on the overall growth trend which currently looks flattish implying a negative or a near zero IIP growth in April. The external position of the economy also influences the interest rates, but indirectly. India is a country with twin deficits (Fiscal and Current account); these deficits are financed through government borrowing and foreign capital flows. The fiscal deficit affects the government’s internal (within the country) borrowing rate and the Current Account Deficit (CAD) affects the external flows and the exchange rates. A CAD leads to a lower demand for the domestic currency and hence a currency depreciation. Any depreciation of INR hurts the foreign investors and threatens an outflow. External flows form a significant part of the demand side for G.Secs – allotment of additional debt limits in G.Secs to FII during FY2011-12 was 41000 crores which is 10% of budgeted borrowing program (8% of actual). Hence the external position also affects the G.sec yield rates. It is expected that FY2011- 12 will have a negative Balance of Payments (BOP) – the first time since 2008-09, despite the fact that India became the highest remittances country with 63.7 billion dollars. The recent figures for the trade balance for FY2011-12, which was at $185 billion (10.5% of GDP), shows that petroleum related imports grew 46% and coal/coke imports grew 82% year-on-year. Consequently, INR depreciated 17.6% in December 2011 y-o-y – this coincides with the highest yield rates in 10 year benchmark bond in mid-November.