It's the pipe, not the water

The post-Budget rise in bond yields in India is more due to plumbing challenges than insufficient savings

As economies emerge out of the shadows of the Covid-19 pandemic, policymakers as well as the markets need to take stock of the economic damage done by the pandemic and recalibrate their fiscal and monetary responses. During the pandemic, policymakers had to guess the demand loss due to lockdowns and the disruptions in supply. With clarity emerging on both, they now need to assess whether they delivered too much or too little. For developed markets, it appears to be the former: The surge in funds parked by banks overnight at central banks, among other signs, suggests that the monetary response was excessive: These are surplus funds in the banking system. The fiscal stimulus also appears too large, particularly in the US, as retail sales rose much above trend, and drove global consumption goods higher too. The unwinding of the monetary stimulus in the US has started, and the fiscal stimulus should wear off soon.

India too has seen a surge in surplus funds in the banking system, though much of it was due to the Reserve Bank of India (RBI) having to sterilise excess dollars flowing into the economy. Fiscally, India’s pandemic-related spending was much smaller, for understandable reasons. Instead, the primary reason for the rise in its debt-to-gross domestic product (GDP) ratio from 75 per cent in the financial year 2019-20 (FY20) to 90 per cent 2020-21 (FY21) was a decline in nominal GDP. In normal years, a double-digit growth in nominal GDP grew the denominator, offsetting the growth in the numerator from fiscal deficits that ranged between 7 per cent and 8 per cent. This did not happen in FY21. However, a strong 18 per cent rebound in nominal GDP in FY22 brings it just 6 per cent below trend this year.

Why then, on a government assumption of 11 per cent growth in GDP in FY23, will the debt ratio still be 87 per cent, not much below the peak of 90 per cent in FY21, and much above the FY20 level?

That number needs many adjustments, in our view. For one, the government cash balance (state plus Centre) at the end of this financial year itself could be 3 per cent of GDP. This is higher than the current 2.5 per cent, as contrary to government assumptions of a year-on-year decline in taxes from January to March, tax collection is likely to grow. The acceleration in capital expenditure assumed in revised estimates for FY22 may also be optimistic. As discussed in last month’s Tessellatum (“The Difficulty in Spending”), the gap between state governments’ plans to spend and their execution, large enough in normal times, has widened substantially due to lockdowns. At a time when the tax-to-GDP ratio is rising, and could be higher by 1 per cent of GDP this year than the pre-pandemic levels, this means accumulating cash. Financial analysts are used to differentiating between “gross debt” and “net debt” for companies, the latter adjusting for cash on the balance sheet. Normally, this is not a material number for governments, but right now, it is.

Illustration: Binay Sinha

Second, the market consensus for growth in FY23 is 12 per cent, and we expect even stronger growth, which could bring nominal GDP within 3 per cent of the pre-pandemic path. Not only does this boost the denominator and bring down the ratio, it would also mean higher taxes, and thus a lower deficit. Third, the fiscal assumptions for FY23 are also conservative, as has been assumed by several commentators as well. Altogether, the debt-to-GDP ratio could be 6 percentage points lower than government estimates, reaching 81 per cent.

It is also interesting to see the drivers of the increase in this ratio from 75 per cent in FY20 to 81 per cent. Nearly 3 per cent points come from higher capital expenditure by the centre from FY21 to FY23. Nearly 2 per cent points from clearing of arrears (like for fertiliser subsidies and export incentives), and bringing into the Budget several items that were off-budget earlier, including a large part of the food subsidy that was earlier funded by the Food Corporation of India. This is just an accounting change — an off-balance sheet liability now a formal one. The rest was pandemic-related spending (like free grains, vaccination and higher MGNREGA demand) and higher interest costs (given the rise in debt), but some of these are offset by higher receipts. 

The debt ratio being meaningfully lower than currently projected and the increase in debt being for productive reasons show that the fiscal health is far better than what appears in headline numbers.

Why then have bond yields gone up so sharply after the Budget, pushing up the term premium, which is the gap between the RBI set repo rate and the yield on the 10-year government bond, to a record high 2.9 per cent?

The net market-borrowing target for this year is more than double the levels seen pre-pandemic, and markets are clearly worried that there are not enough bond buyers, particularly after the lack of progress on global bond-index inclusion, which would have brought in new buyers. However, this is less of a problem if one looks at aggregate financial savings. Financial savings-to-GDP is higher currently, and government borrowing as a percentage of incremental bank deposits, for example, is not materially higher than the pre-Covid levels. Further, nearly 1 per cent of GDP of higher deficit is just a change in the name of who is borrowing — the inclusion of off-budget expenditure into the Budget.

A sign that this is a plumbing problem and not one of availability of savings is that government bonds are cheaper than Indian equities. Implied returns on equities need to be higher than that on sovereign bonds: This is the equity risk premium (ERP) — the additional returns equity holders demand in order to hold securities that are much riskier than government bonds. This is currently negative. In all fairness, significant foreign ownership of Indian equities means that the risk free rate for several equity market participants is the US government bond yield, which is significantly lower. What a negative ERP does show, though, is that they are the cheapest they have ever been relative to equities.

The government appears to be willing to accept higher interest costs. Low foreign holding of Indian government bonds reduces the risk of instability: Higher rates paid by the government are income for domestic savers. However, they are also the benchmark for not only corporate bonds but also many bank loans, and premature monetary tightening can slow down the pace of recovery. It is likely that once government(s) see the cash pile continuing to build they would reduce the borrowing targets, but the risk is that they may wait too long, until when the second half borrowing is being firmed up.

The writer is co-head of APAC Strategy and India Strategist for Credit Suisse