Explained: Why The Union Budget May Have Spooked The Bond Markets In India

The Union Budget has received praise from several quarters for the focus on capital expenditure to boost the economy, while introducing longer-term measures to restructure the economy.

However, despite a positive response from the stock markets, the 10-year bond yield jumped up by 2.17 per cent. The change in yields has been quite sharp as compared to previous trading sessions.

Since bond yields have an inverse relationship with bond prices, a higher bond yield implies that investors have been exiting their bond positions.

Bond investors are spooked by the government’s focus on increasing spending without any significant additions to its revenue. The difference between government revenues and government expenditures could either be a deficit or a surplus.

With the government ramping up its expenses to bring back growth, but its revenues not increasing proportionately, the fiscal deficit is expected to widen.

Fiscal deficit targets for financial year 2022 (FY22) have been increased to 6.9 per cent, whereas the target for FY23 was set at 6.4 per cent. However, analysts expected the targets to be set at much lower at around 5.8 per cent of the Gross Domestic Product (GDP).

A higher fiscal deficit would imply higher borrowing from the government to cover its expenses. For the next financial year, the government expects to borrow around Rs 15 lakh crore from the bond markets. In contrast, analysts had pegged the figure at around Rs 12-12.5 lakh crore.

An explanation for the increase in interest rates is that the government must borrow from a limited pool of capital. Therefore, when the demand for capital from the government’s side moves up, interest rates tend to rise in tandem.

Traders expect the bond markets to reach an oversupply situation if foreign investors or the RBI do not intervene. In addition, the government’s focus on stimulating the economy by spending more could potentially stoke inflation — a scenario that the bond markets are probably discounting today.

If interest rates do continue rising, the expected “crowding-in effect” might be replaced by the private sector being crowded-out due to higher borrowing costs.

The bond markets were expecting an announcement about the inclusion of Indian bonds in a global bond index. The issue has been on hold due to certain tax issues that needed to be ironed out.

Though previous announcements did talk about the inclusion in global bond markets, the issue was not discussed during the Union Budget. As a result, bond traders were disappointed on the index inclusion front as well.

Traders had been betting on significantly lower borrowings, and a lower fiscal deficit target — both of which have not worked out the way traders expected.

A Moody’s report highlighted the government’s focus on growth to drive fiscal consolidation. It highlighted the government’s dependence on capital expenditure to jumpstart the economy, while not highlighting a tangible road to increasing revenues.

However, the revenue estimates are widely seen as conservative. Hence, if growth does return, the fiscal deficit and borrowings could be lower than anticipated by the government.

On the other hand, uncertainty related to the pandemic and supply chain issues still remain, and the assumptions made for the fiscal could possibly turn out to be incorrect — leading to higher borrowings than expected.