Bond yields have retraced after finance minister Nirmala Sitharaman reassured the markets that the government will not borrow more than what it has planned. The benchmark yield, which had hit a recent high of 6.60%, is now hovering around 6.4620%. The markets had been somewhat nervous thinking the government might need to borrow more than Rs 14.8 lakh crore (gross) due to weak direct tax collections—gross tax receipts between April and July are up only 0.8% year-on-year due to the lower personal income tax collections. Moreover, there’s the potential loss of Rs 48,000 crore revenue for the current year after the goods and services tax (GST) rate rationalisation. A financial package for exporters, which is still in the planning stages, could mean additional government spends. The high supply of state loans was also weighing on investors. The government is obviously banking on buoyant demand to minimise the loss of revenue as GST cuts would make 99% of products cheaper. Also, households now have more purchasing power thanks to the income tax cuts.
Fiscal math under pressure
The fiscal math, however, could get complicated if there is a shortfall in tax collections and the nominal GDP growth comes in lower than the assumed 10.1%—in Q1, it grew just 8.8%. The fiscal deficit for the four months to July was close to 30% of the targeted amount for the full year—higher than the 17% increase in the year-ago period—which is good for the economy but has probably worried the bond markets. However, the finance minister seems determined to stay on the path of fiscal consolidation, so the deficit is unlikely to exceed the targeted 4.4% of GDP. Since we have just won an upgrade from S&P this would be the right approach. In that case, however, the government would need to either curtail expenditure on some fronts or raise more via disinvestment and strategic sales. The total budgeted expenditure of Rs 50.63 lakh crore, therefore, might be pruned somewhat.
Ripple effect on credit markets
The FM’s reassurance should have seen bond yields soften more than they have. But the bond markets probably apprehend that the curveball that the US has thrown in the form of a 50% import tariff will see the growth momentum moderate. The robust 7.8% GDP growth in Q1 notwithstanding, the potential loss of exports and the consequent loss of jobs and incomes, bond markets fear, will slow the economy. Since the private sector is reluctant to invest meaningful sums, it fears the government would need to continue to do the heavy lifting by borrowing significantly, if not immediately, sometime later in 2026. One must concede their fears are not altogether irrational.
In this context of elevated yields, Reserve Bank of India (RBI) Governor Sanjay Malhotra’s observation that “while the banking channel is crucial, transmission through risk-free sovereign bonds is equally important, as it serves as a benchmark for pricing in other segments of the market” is instructive. The higher sovereign yields have already pushed up corporate bond yields, prompting some issuers to postpone borrowings. In fact, some banks have tweaked their marginal cost of funds-based lending rate upwards, albeit marginally. This must be disconcerting for the central bank, which is the government’s debt manager, at a time when the effort has been to bring down the cost of money. One should not be surprised to see the RBI stepping in to support the demand.