Budget 2018: The introduction of 10% long-term capital gains (LTCG) tax on equities on a prospective basis is a very prudent measure. Mutual fund assets under management across equity and balanced schemes have grown by 45% annually in the past three years, and have crossed Rs 8.5 trillion. At this level of maturity, and given the need to ensure that investors prudently weigh risk factors appropriately across different asset classes, equity markets should not have the same degree of relative tax advantage as before. As a next step towards eventual tax convergence, direct investments in debt securities and bank term deposits should perhaps get the same indexation and long-term tax treatment as investments through debt mutual funds.
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While the attention was on equities, the actual action was in bond markets. The new 10-year benchmark government bond yield moved up sharply by 17 bps to 7.60%. A few factors contributed to this. First, while the government’s focus on our rural sector and farmer remuneration is welcome, this could impact consumer price inflation (CPI) both through higher food prices and increased rural consumption. Second, from reading the budget 2018, some players feared there might be more bond duration supply than was expected, adding to the bond demand/supply mismatch. Third, the market anyway faces the possibility of fiscal slippage and higher CPI, if global oil prices were to rise.
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The bond market has been buffeted by a series of shocks in the past five weeks — confusion over the government’s extra borrowing programme in the current fiscal, RBI’s admonition to banks on risk management, our hitherto dovish chief economic advisor throwing in the towel, and now the budget. With all this, yields have gone up by a staggering 60 bps during this period, adding to the treasury losses of banks, and raising the cost of funds all around. The bond and swap markets are factoring in rate hikes at this stage, given the prospects of bond supply and hawkish monetary policy committee (MPC) stance. As risks to oil prices, current account deficit, fiscal deficit, and inflation emerge, RBI and MPC have little choice but to remain vigilant from a financial stability perspective.
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However, the run-up in bond yields does seem to be too much, too fast. Some relief might eventually come in the form of increased investor interest in debt mutual funds, given attractive yields, and convergence between bond fund and equity tax treatment. Perhaps FPI debt limits will eventually be increased, though in the current context, there are implications of this for currency markets and overall financial stability. In the short run, participation levels of some large banks in the bond market appear to have visibly dropped, adding to the volatility. Banks, primary dealers, regulators and the government may need to take a deep breath, sit down, and resolve any immediate issues that impede market sentiment and participation.
– Ananth Narayan Professor-Finance, SPJIMR