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Indian bonds slumped on Thursday after the government set a slightly wider-than-expected budget deficit target for the next financial year, while shares clawed back earlier bigger losses as investors welcomed spending in key areas of the slowing economy.
Finance Minister Arun Jaitley set the government's fiscal deficit at 3.3 per cent of gross domestic product for the 2018/19 financial year, higher than market expectations of 3.2 per cent.
But analysts said the falls in bonds may not be sustained in the near term given the widening in the deficit was not as large as some investors had feared. It's the last full-year budget from Prime Minister Narendra Modi's government before a national election due by May 2019.
Shares initially sold off after Jaitley announced a new capital gains tax on long-term equity investments. However, they later erased most of their losses as investors welcomed a budget that allocated billions of dollars to the rural sector and lowered corporate taxes.
"The government should be commended for sticking to fiscal discipline. While a small amount of slippage did occur, the larger point is that populist measures have been avoided, and all initiatives are centred around development, growth," said Sunil Sharma, Chief Investment Officer at Sanctum Wealth Management.
The yield for the benchmark 10-year bond rose 17 basis points to 7.60 per cent from the previous close.
The broader NSE share index fell 0.1 per cent, having earlier fallen as much as 1.35 per cent, after Jaitley announced the long-term capital gains tax.
India currently does not tax capital gains on equities if the investments were held for more than a year before selling.
The rupee weakened to 64.0150 per dollar from its 63.58 close on Wednesday.
India's economic growth had been hampered by a chaotic rollout of a goods and service tax last year and a shock move to ban high-value currency notes in late 2016, creating complications for the government in its efforts to craft a balanced budget.
India was expected to loosen its fiscal deficit targets, which were previously set at 3.0 per cent of GDP for 2018/19, but investors had said they would be willing to accept a modest widening in the budget shortfall as long spending was targeted at key sectors.
India's economy is expected to grow 6.75 per cent in the year to March, but is projected to pick up to 7.0 to 7.5 per cent in the next fiscal year, once again becoming the world's fastest-growing economy..
Nonetheless challenges remain in the outlook for markets, as a spike in inflation has hit bond markets, with the 10-year bond yield having risen more than 80 basis points since July - the biggest spike since the 2013 rupee crisis.
The Reserve Bank of India is due to hold its next policy review on Feb. 6-7 amid worries it could raise rates in coming months after inflation hit a 17-month high in December, well above its 4 per cent target
Stocks have been more resilient, gaining 4.7 per cent this year and hitting records amid signs earnings are recovering after years of poor performance.
But the imposition of a long-term capital gains tax (LGCT) raised concerns about whether it would deter foreign investors, especially after India cracked down on investments routed through countries with beneficial tax agreements with India.
Overseas funds have injected $94 billion into Indian stock and debt markets since the start of 2014.
"Foreign institutional investors would have additional compliance since now they would have to pay (LGCT) tax," said Amit Maheshwari, managing partner at tax advisory firm Ashok Maheshwary & Associates.
"They also have no recourse to the Singapore and Mauritius treaties which helped them to avoid capital gains tax."