The somewhat sudden rise in local bond yields to a 14-month-high of 7.06% suggests the interest rate cycle may be turning. The reasons for this include the hike in crude oil prices to levels of around $62 per barrel, the spike in US treasury yields as the Fed proceeds on its tightening cycle, the pick-up in local inflation and a real chance the FY18 fiscal deficit target of 3.2% might be breached. Even though the current hike in inflation is more related to tomatoes, given the hawkish stance RBI took even when CPI was low, chances are the central bank will cite this and fiscal deficit pressures as more reasons for putting off a rate cut in December, even if a tightening of rates could be some time away. That would be a pity since it might keep banks from cutting lending rates at a time when they were beginning to come off for new loans. Despite the central bank having trimmed the repo by about 200 basis points since January 2015, transmission has been slow and, more critically, the base rate to which the bulk of loans are pegged has hardly moved. The bond market’s concerns on the deficit are probably justified since the government, last week, gave up a potential `20,000 crore of tax collections by lowering GST rates for a host of goods from the peak rate of 28%. As finance minister Arun Jaitley observed in Guwahati after the GST Council’s meeting, it is possible better compliance and more spending will combine to boost tax collections, but the bond markets are not betting on that.
Also, while collections from GST averaged a reasonably good Rs 93,000 crore for July-October, it would be premature to assess these before the IGST and transitional credit are taken care of. Any shortage in GST collections would make it hard for the government to meet the 3.2% fiscal deficit target, given shortages are likely on other fronts too—receipts from spectrum charges, for instance. To be sure, these are early days, but unless some expenditure is pruned, some slippage seems likely. From the bond market’s perspective, any additional supply of paper would leave yields elevated. There is also concern that a few of the state governments that have announced loan waivers may end up borrowing more than budgeted for. The government overshooting the budget deficit target can be justified at a time when the economy is sluggish and growth needs to be kick-started, especially in the absence of private sector investment recovery.
However, a bigger deficit comes with its own share of problems—apart from what it signals to rating agencies, rising yields increase the cost of paper for the corporate sector and further dampen investment potential. Things could improve if oil prices stabilise or even fall—US shale output is rising steadily and the IEA has just said global demand would be less buoyant than it had projected earlier—and it will help if the government surpassed its divestment target or if GST collections end up on the positive side. And if RBI is less hawkish in December, that too could soften rates since the market has priced in an anti-inflationary stance. The government, of course, is between a rock and a hard place when it comes to whether it should breach the deficit in an attempt to keep growth up.