FM’s aim to crowd-in investment at risk unless RBI goes against global central bank grain

Achieving that goal crucially hinges upon the Reserve Bank of India and to what extent the domestic central bank is willing to adopt a diametrically opposite path to that currently being trod on by major global central banks.

The private investment that the government is understandably hoping to attract faces a significant hurdle at the present juncture – a massive hardening of borrowing costs in the economy.

And while the RBI had managed to, over the past couple of years, keep borrowing costs well under its control; it is now caught between the proverbial rock and the hard place.

The Budget presented on Tuesday has made it evident that the government’s principal priority is to make sure that the economy revives sustainably from the ravages of the COVID-19 pandemic.

The 35 per cent on-year increase announced for central government capital expenditure is testament to this as is the fact that of the higher public expenditure, a significantly higher allocation has been earmarked for areas such as affordable housing.

“With economic growth showing signs of picking up, the budget should solidify the process and hopefully incentivise even greater private investment via stronger growth outlook,” Nomura’s Managing Director and Country Head, India Prabhat Awasthi said.

But in order to facilitate the growth push, the government has had to make a compromise and the casualty here is the degree of fiscal consolidation to be achieved over the next few years.

At 6.4 per cent of GDP, the fiscal deficit target for the next financial year is well above the range of 6-6.20 per cent that was predicted by a majority of economists.

Financing that fiscal deficit will require the government to borrow a gargantuan Rs 14.95 lakh crore from the domestic market through the sale of bonds – a fresh all-time high.

Sovereign debt yields shot through the roof as traders digested the sheer scale of the government’s borrowing requirement, with yield on the 10-year benchmark paper climbing 15 basis points to close at 6.83 per cent.

Yield on the benchmark paper was at 6.45 per cent at the end of December. Bond prices and yields move inversely.

The view in the market is unanimous – unless the RBI takes on the mantle of taking out a significant portion of that bond supply hitting the market, yield on the benchmark paper could head well past 7 per cent even before the borrowing programme for the next fiscal year starts in early April.

A realignment of sovereign bond yields of such a magnitude could well derail the investment story as financing options become more and more expensive. Government bond yields are the benchmarks on which the entire gamut of credit products is priced.

The knock-on effect could be felt across the board – from home loans to auto loans to corporate entities looking to hit the bond markets for financing, especially lower-rated companies.

“At present, home loans are going at 6.50 per cent; that is lower than the 10-year benchmark bond yield, there will obviously be a correction,” PNB Gilts Managing Director and Chief Executive Officer Vikas Goel said.

“There is no telling where yields are headed. The RBI will have to start buying right away; it cannot wait for the next financial year. We started the current cycle of easing yields at 8.23 per cent so that shows you how much of an upside there is. The plans to crowd-in investment will face huge challenges if borrowing costs harden to that extent,” he said.

What complicates matters for the RBI is the likelihood of aggressive rate hikes by the US Federal Reserve and the undeniable fact that domestic inflation, while currently within the 2-6 per cent range, faces significant upside risks from elevated international crude oil prices.

In post-Budget press briefings on Tuesday, government officials themselves acknowledged that the Fed’s tapering plans and crude oil prices posed risks and that the higher-than-expected fiscal deficit target for the next year had been set keeping those external exigencies in mind.

The RBI may not choose to hike benchmark policy rates anytime soon but it will likely have to embark on some degree of normalisation of ultra-loose policy in order to prevent large-scale overseas capital outflows and maintain the stability of the rupee amid wider trade deficits.

As the threat of imported inflation from oil prices grows, the first line of the policy defense may likely include targeting the massive liquidity surplus in the banking system and that is where the central bank faces a Catch-22.

In the absence of a wider pool of investors – the government did not announce any steps regarding the inclusion of Indian bonds in global indices – the only way to address the demand-supply mismatch in the market and bring down borrowing costs would be for the central bank to expand its own balance sheet for the fifth year in a row.

The central bank is estimated to net purchase government bonds worth around Rs 2.5 lakh crore in the current year.

But doing so would again pump in durable liquidity in the system. Pushing growth is no doubt of paramount importance for the central bank, but with many larger Indian companies passing on high input costs to consumers that very growth objective could be at risk if consumption demand were to falter.

Between a rock and hard place indeed!