For the Indian bond markets, the Union Budget 2022-23 is likely to be an interesting and important budget for several reasons. Indian bond markets are worth nearly $2.3 trillion but they fall short on liquidity and participation.
Here is what bond markets expect from Union Budget 2022-23.
1. Timetable for inclusion in Bond Indices
This is likely to be the big story of Budget 2022-23. The Indian government bonds are expected to be included in the liquid and popularly benchmarked JP Morgan Bond Index and the Bloomberg Bond Index. Both these indices have billions of dollars of passive funds and ETFs benchmarked. A report by Morgan Stanley had indicated that the first such inclusion could happen as early as March 2022, but clarity from the Finance Minister in the Budget will go a long way to boost confidence of investors.
Why is this so important. Despite a $2.3 trillion debt market stock, Indian bonds were not included in global indices, so most passive funds are unable to invest in India. There have been some concerns with respect to taxation and capital account convertibility which had stopped index providers from including Indian debt paper in global indices. It is estimated that the inclusion in the bond indices would bring in $30 billion of incremental flows into Indian government paper; or 45% of aggregate debt flows of $66 billion in the last 5 years.
2. Inflation versus growth trajectory
One can argue that inflation and interest rates are the purview of monetary policy. However, with monetary levers mostly exhausted, the government would look at fiscal levers in the coming year. That has to come out of the Union Budget. At a conceptual level, the markets would look for signals on whether the government will still persist with its growth focus. If the focus would still be on overriding growth, then rates cannot go too high. That means, even if rate hikes were to happen in India, they would be marginal at best and nothing close to what the US Fed has been contemplating.
For the bond markets, the rate outlook and the willingness to support growth at all costs will be the key drivers of sentiments. Normally bond markets look at two factors as cues in the budget; the outlook for inflation versus growth and the outlook for government borrowings. Bond markets expect a delicate balance of inflation and growth in the Budget. It has to be robust growth, without compromising on inflation risk.
3. Government borrowing program for FY23
In the last 2 years, the total government borrowings were in excess of Rs12 trillion and FY23 is likely to be the third successive year when central borrowings would exceed Rs12 trillion. For bond markets; it means fiscal deficit will still remain high and the pressure on rates would continue. During the current year, the yields offered by the G-Secs were so unattractive that in most cases there were no takers.
There will be two things of interest to bond markets in Budget 2022-23. Firstly, how much will the RBI pay as dividend transfer to the government. It is obviously going to be less than the Rs110,000cr paid in FY22, but that would be a key aspect of government revenues in the coming year. Secondly, how will the government reduce the bond devolvement on the RBI, since that is tantamount to money creation and hence inflationary.
4. Time to revisit sovereign bonds once again
The Union Budget 2019 had announced plans to raise $10 billion via offshore sovereign bonds (government debt in foreign currency). However, the plan was subsequently dropped due to the macro vulnerability that it would create. In the last 2 Union Budgets, the idea was not revisited due to pressure of COVID relief. With things relatively under control, Union Budget 2022 could revisit the issue of Offshore Sovereign Bonds once again.
There is no need to get paranoid about offshore sovereign bonds for two reasons. Firstly, with aggressive plans to borrow $160-$180 billion via government borrowings in FY23, the government will need offshore borrowings to reach the target. Secondly, with forex reserves of $650 billion and rupee largely stable, the currency risk of offshore sovereign bonds may be overstated. With Sovereign external debt to GDP at under 5%, sovereign bonds could be an idea that should be revisited in Budget 2022-23.
5. Focus on GST cuts to curb inflation
A lot of the inflation in India is caused by high levels of indirect taxes. Classic examples are the duty structures on petrol, diesel, automobiles, services etc. For instance, petrol and diesel are still outside the purview of GST so there are cascading duties by the centre and the states. Automobiles attract non-merit GST rates of 28% while most services attract 18% GST, creating a cascading effect on inflation. The inflation levels can be tamed by rationalizing indirect tax rates and that is something bond markets will really be hoping for.
The macro challenge of creating a robust debt market still remains. Last year, the RBI introduced a retail scheme to enable retail investors to directly invest in government securities online. Measures like inclusion of G-Secs in global indices will go a long way in making Indian bond markets more liquid. That is long overdue!