Budget 2021: Higher general government borrowings to keep yields elevated

Accordingly, market borrowings have sprung a negative surprise. The gross Government of India securities (G-sec) issuance for FY2021 has been revised upwards by Rs. 800 billion to Rs. 12.8 trillion. While the issuance is set to ease to Rs. 12.1 trillion in FY2022, the level is nevertheless higher than our and market expectations.

Further, the glide path for the correction in the government's fiscal deficit over the medium term, targets a limited reduction to below 4.5 percent of GDP, by as late as FY2026.

What about state governments, whose bond market issuance has seen a considerable rise in recent years? The Fifteenth Finance Commission (15th FC) has recommended a net market borrowing limit of 4 percent of gross state domestic product (GSDP) for the states for FY2022, higher than the baseline anchor of 3 percent of GSDP that they were eligible for, up to FY2020.

Subsequently, their fiscal deficit is recommended to be reduced to 3.5 percent of GSDP in FY2023, before reverting to 3 percent of GSDP during FY2024-FY2026. Further, the 15th FC has recommended an additional borrowing of 0.5 percent of GSDP for FY2022-FY2025, provided that the state governments fulfil certain performance criteria related to the power sector.

At this stage, how much of the enhanced borrowing limit of the state governments get channelled toward growth-boosting capital expenditure, remains uncertain.

Taken together, the general government fiscal deficit is likely to print between 10.8 percent-11.3 percent of GDP in FY2022, and may remain as high as 7.5 percent of GDP in FY2026.

This suggests that general government market borrowings are going to remain substantial over the medium term. This will impose a hardening bias on G-sec and state development loan yields, and pressurise the structure of interest rates.

Globally, we expect interest rates to remain lower for longer. In the Indian context, we foresee that the repo rate will be left unchanged through 2021, with the CPI inflation expected to average 4.6 percent in FY2022, exceeding the mid-point of the Monetary Policy Committee’s (MPC’s) target range of 2-6 percent for the third consecutive year. Despite the unexpectedly sharp softening in the CPI inflation in December 2020, our projections suggest that inflation will dip below 4 percent only in a couple of months of FY2022. As a result, we believe that the rate cut cycle has ended, and expect an extended pause for the benchmark repo rate.

At the same time, we anticipate that the MPC will change the stance to neutral from accommodative, only once there is greater certainty that a durable economic recovery has taken hold.

Such confidence is likely to emerge only in the middle of this calendar year. The first GDP estimates for Q4 FY2021 will be available by the end of May 2021. If the pace of growth for that quarter exceeds the prevailing tepid expectations, the stance may be revised in the June 2021 MPC review.

However, we suspect that the MPC will choose to err on the side of caution. In our view, the Committee is more likely to change the stance to neutral in the August 2021 review, once there is some evidence that a strong recovery has set in during FY2022, perhaps benefitting from a swift take-off of the government planned capital spending.