FM's tax cuts: Prospects of higher govt borrowings spook bond market

10-year yield rises to 6.82% at 12:35 p.m. from yesterday's close of 6.64%; rupee gains 34 paise to trade at 70.98 a dollar

The bond yields soared on tax cut announcements by the Union Finance Minister on concerns that fiscal deficit would not likely get contained at 3.3 per cent of the gross domestic product (GDP), and may prompt the government to borrow extra in the later part of this fiscal.

The rupee, however, strengthened sharply following cues from the stock market.

The yields on the 10-year bond, rose to 6.82 per cent at 12:45 p.m., while the rupee was trading at 70.98 a dollar. The yields had closed at 6.64 per cent on Thursday, while the rupee had closed at 71.32 a dollar. Sensex was trading at 37,901.03 points, up 1,800.56 points.  

The tax cuts would cost the government some Rs 1.45 trillion. The government has recently received Rs 1.76 trillion from the Reserve Bank of India (RBI) in dividend and surplus transfer. The government will also put Rs 70,000 crore of capital in banks, and thus, the rest will likely to be bridged from extra market borrowing, say bond dealers.

The nearly 20 basis points jump in bond yields reflect this concern as the government remains committed to maintain the deficit numbers at 3.3 per cent of the GDP.

“The government now has few options – one, it can officially let the fiscal deficit to widen, which will hit its credibility. Second, the government can borrow from the market to bridge the deficit, which is extremely negative for the bond market, third, it can cut down its spending and increase the divestment on a good equities environment, which is the most preferable outcome for the bond market,” said a bond dealer requesting anonymity.

“However, it looks like the government will adopt the first measure as in a slowdown year numbers are not sacrosanct. But a spike in bond yields increases the interest rate no matter how much the RBI cuts rates,” the dealer said.

"The bond market did not take the fiscal announcement very well. Also, FM was unable to justify the fiscal concerns, thus the 10 year yield surged nearly 25 bps keeping rupee gains under check.Thus, unless USD/INR spot doesn’t end below 70.80, we expect prices to bounce 71.50 in next week,” said Rahul Gupta, currency research head, Emkay Global Financial Services Ltd.

The bond dealers are penciling in a fiscal deficit number at 3.8 to 4 per cent of the GDP after the latest corporate tax cuts by the government. On Thursday evening, RBI governor Shaktikanta Das had said RBI had room for more rate cuts even as the government had little room for a fiscal push.