Will higher govt borrowing increase interest rates?

Government data shows the Union government’s fiscal deficit has increased to 164% of the full-year target. Revenues have fallen well short of estimates, while expenditure has increased. Concerns about increased government borrowing have already led to higher bond yields, with the yield on the benchmark 10-year government bond rising from a closing low of 5.2% at the beginning of January to 6.25% at the end of last month, before going down once again to around 5.8% by 4 February.

Similarly, the yield on AAA-rated corporate bonds has increased from a closing low of 8.1% at the end of December to 8.8%, with the spread between the AAA-rated corporate yield and the yield on 10-year government securities rising a bit.

At the short end of the yield curve, the rise has been even more marked and the yield on three-month treasury bills has increased steadily from a closing low of 4.22% on 6 January to 4.725% on 4 February. But there’s a difference here—the yield on three-month commercial paper has continued to fall, from 10.5% on 6 January to 9.51% on 4 February.

Dealers say the supply of treasury bills has been high and that is why yields have gone up recently. They also point to the fact that mutual funds have started to reinvest in commercial paper. The fall in the spread between the yield on the three-month commercial paper and the three-month treasury bill is an indication of increased risk appetite and of improving conditions in the money market. At least in respect of short-term funds, businesses are able to access money at cheaper rates. During the period 5 December to 2 January, for instance, bank investments in commercial paper increased from Rs16,275 crore to Rs1,80,051 crore. That’s not a huge amount, but at least it is much better than the fall in bank investments in commercial paper by around Rs369 crore during the period 7 November to 5 December.

Unfortunately, however, the costs of long-term funding to firms have gone up, as seen from the rise in 10-year corporate bond yields.

Citigroup Inc. economist Rohini Malkani estimates the Union government will miss its revenue targets by 5.3% in FY09, while expenditure targets will be exceeded by 22.4%. That will mean a fiscal deficit of 6.3% instead of the originally planned 2.5%. “The combined picture which takes into account the budgeted state deficit of 2.1% and the ‘below-the-line’ items would likely come in at ~11% of GDP,” says Malkani.

Is additional liquidity needed to push down interest rates further? A. Prasanna, an economist with ICICI Securities Ltd, is not so sure liquidity will do the trick and says there is talk in the market about allowing the Reserve Bank of India to buy government bonds, thereby monetizing the deficit.

Note that yields on government bonds are rising in other countries as well. For instance, the yield on the 10-year Japanese government bond has risen to a one-and-a-half month high. Yields on 10-year US treasurys, too, have been going up and there is hope that the Federal Reserve will start buying long-term bonds.

The silver lining is that India’s fiscal deficit may be lower in FY10, because a large part of the expenditure this year was one-off.

Says Malkani, “Of the Rs1,448 billion net cash outgo, expenditure close to Rs700 billion is largely one-off (food/fertilizer subsidies, etc.) which provides a buffer for higher election-related expenditure as well as lower revenues.” She estimates that the Centre’s fiscal deficit in FY10 will be as low as 4.3%. That should ease the upward pressure on bond yields.

Mark To Market | Manas Chakravarty and Mobis Philipose  -Livemint