February 2010

India to follow the path of fiscal consolidation - beginning from FY11 with fiscal deficit target set at 5.5% of GDP, FY11 net borrowing numbers set lower at Rs. 3.45 trn, upward revision of FY10 GDP projections, implementation of CRR hike, domestic fuel price hike and partial hike in indirect tax were the key highlights of the Union Budget FY 11.

Globally, Central banks continued with unwinding of the monetary policy. Recently, Australia raised the key policy rate by 25 bps to 4%. This is fourth time since Oct'09 that the rate was raised. In a surprise move, US raised its discount rate (a rate at which commercial banks borrow from the central banks) by 25 bps as a part of moves to withdraw emergency support to the financial system. On other hand, China raised the reserve requirement ratio (similar to our CRR) by 50 bps - second increase in two consecutive months. Back home, India implemented the 75 bps hike in cash reserve ratio in two phases -sucking out the liquidity of Rs. 36,000 cr.

Indian economy is estimated to grow at 7.2% as against 6.7% in FY10 - driven mainly by industrial (8.2%) and services sector (8.7%). Poor monsoon resulted in negative growth for agriculture. Non -agricultural GDP grew at 8.5% (FY09: 7.7%). Growth received boost from fiscal stimulus and higher public spending. High-frequency data like industrial production numbers shows that IIP grew at robust 16.8% in Dec'09 (highest since Nov 1994), helped by domestic demand revival, base effect (Dec'08: -0.2%) and fiscal policy stimulus. In April-Dec FY10, IIP grew at 8.6% as against 3.6% in previous year.

Credit growth has shown rebound in recent months. After having declined sharply from 18% in April'09 to below 10% levels in Oct'09, the credit growth has improved to 15% plus by Feb 12. Sequential data is also showing revival. With this, we expect it to be within the RBI's revised annual target of 16%.

Inflation has become the rising concerns for policymakers in India. After remaining low during first seven months of FY (in fact, it was negative between June through August on base effect), inflation has spiraled and has touched 8.56% in Jan'10, driven mainly by primary articles (both food prices and non-food) and partially by fuel and manufacturing and unfavourable base effect. (RBI's year-end target is 8.5%). With the Finance Minister partially roll-backing the indirect tax cuts and hiking the domestic fuel prices, inflation is expected to move northward. Policymakers in their Budget documents have express fears of rising inflationary expectations.

13th Finance Commission report has given a roadmap on fiscal consolidation. According to the roadmap, the fiscal deficit as % of GDP should be brought down to 3% by FY14 from current 6.7% and public debt should be brought down to 67.8% by FY15 from present 78.8% in phased manner. Finance Ministry has accepted the 13th Finance Commission report in toto and the Budget mentions that it will soon come out with the medium term plan for fiscal consolidation. This and lowering of fiscal deficit to 5.5% of GDP in FY11 from 6.7% in FY10 clearly indicates the finance ministry's plan to bring down the fiscal deficit over a period of time.

In the Union Budget FY11, the Finance Minister has set a target for fiscal deficit at 5.5% of GDP as against 6.7% in FY10. This improvement in fiscal numbers is based on revenue buoyancy (in form of indirect tax partial roll back, tax buoyancy due to higher growth, 3G auction, disinvestment). High GDP base and absence of one time expenditure like 6th pay commission arrear will also helped in bringing down the fiscal deficit target. In a move towards fiscal consolidation, the Finance Minister partially hiked the indirect tax partially to pre-crisis level. Further, the domestic fuel prices were hiked with immediate effect.

Although FY11 net borrowing numbers are much lower at Rs. 3.45 trn (previous year: Rs. 3.98 trn), the gross borrowing numbers are set at Rs. 4.57 trn, almost same as last year's target, on account of huge maturities lined up.
On currency front, the rupee started the year at above 50 per dollar levels and thereafter has been appreciating - driven by dollar weakness and foreign inflows on back of economic turnaround. Rupee has appreciated by 9.6% between April-February 2009-10. However, rupee depreciated marginally by 0.8% in Feb'10 over the previous month on appreciating US dollar.
G-Sec yields harden from the beginning of the month on higher than expected CRR hike announcement in the January end RBI policy meeting.The 10 year benchmark yield harden by almost 8-10 bps. G-Sec yields further hardened on the concerns about higher gross borrowings numbers, better than expected IIP data, upward revision of FY10 GDP numbers and higher inflation numbers. 10 year benchmark yield moved up from 7.63% at the beginning of month to 7.86% by end of the month. Market participants hesitated from building fresh positions prior to Budget and the volumes in general were lack-luster.

Taking cues from G-Sec market, the corporate bond yields harden ahead of Union Budget meeting, depicting the uncertainty regarding the gross borrowing numbers. 10 year AAA increased to 8.90% by month end from 8.68% in the previous month, while 5 year jumped to 8.60% from 8.30% in the previous month.

The liquidity conditions continued to be comfortable, although LAF balance has come down. LAF balances which were close to Rs. 1,00,000 cr at the beginning of the month came down to close to Rs. 50,000 cr towards the end of the month on account of implementation of 75 bps CRR hike. CD levels jumped from 4.7% for 3 months and 6.10% for 1 year at the start of month to 5.75% for 3 months and 6.70% for 1 year at the end of the month on account of CRR hike and huge issuance.

Outlook

We expect the G-Sec yields to be under pressure on higher inflation numbers (on account of domestic fuel price hike and partial roll back of indirect tax cuts) and higher gross borrowings numbers. Market participants are expected to take further cues from hi-frequency economic data like IIP, credit numbers etc. and policy-makers comments and actions. Global policy-makers actions on fiscal and monetary front will also act as a guiding factor. Corporate bond spreads may not shrink further on the shorter maturity yield curve, however, spreads on longer maturity corporate bonds are expected to become wider as the huge G Sec supply might push the yields upwards.

Common Source for Debt Market View: RBI, CMIE, Bloomberg

By: Mr. Prashant Pimple - Fund Manager, Debt.

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