Budget needs better projection of crude oil, borrowing

The good news is that there is a de-escalation of tension between the US and Iran after the killing of Tehran’s top General Qasem Soleimani.

On the flip side, it is necessary not to underestimate the risk of another escalation. India needs to be wary of any such developments more than other emerging market economies because oil imports are now rising above 80% mark. The International Energy Agency (IEA) had late last week warned that the country’s oil demand growth would overtake that of China’s by mid-2020s. This is quite contrary to Prime Minister Narendra Modi’s commitment to bring down India’s oil import by 10% by 2022 when the country celebrates the 75th year of independence.

Be that as it may, the Union Budget for 2020-21, to be presented on February 1, will have to take into account the caution by IEA and the fact that the risk-off sentiment has yet not ebbed even after the de-escalation of US-Iran tensions. Any further disturbance in West Asia and damage to oil facilities could send crude soaring to $100 per barrel. Last year, the budget projections were made keeping in mind crude oil prices would remain under $70 per barrel. It has already topped $70 on a couple of occasions this year. The next year appears riskier.

Importance of crude oil

If oil prices rebound, any attempt by the government or the Reserve Bank of India (RBI) to boost the economy by making loans less expensive, would not work. That is exactly what we have been witnessing at the moment. After cutting the interest rates for five consecutive times, the RBI used an extraordinary instrument in its tool kit – the special OMOs to bring down the long tenure borrowing cost or flatten the yield curve on 10-year government bonds. But, to no avail.

India’s sovereign bonds yields are refusing to come even as the RBI has tried hard and they are posing a problem just ahead of the budget. The RBI has since December 19 conducted three special open market operations of Rs 10,000 crore each buying long-dated securities and selling the short-term ones to bring down the long tenure interest rates but it has got only a temporary reprieve.

The moment oil prices rebounded, the yield on 10-year G-Sec paper started elevating. They have now reached almost at the pre-December 2019 levels. And, also forced the RBI to suspend its next special OMO. That is the importance of oil on India’s economy.

But why are the government (sovereign) bonds and yields on them so important?They depict the strength or weakness in the government credit profile and the overall economy.

The sovereign bond yield is the interest at which a national government borrows. These bonds are sold to investors to raise capital for public spending.

When the yields on them rise, borrowings become costly for the government. That, in turn, causes interest rates in the market to rise, too. But this defeats the RBI’s efforts to lower interest rates through its monetary policy easing. This is when we say the transmission is not happening as much as the cut in the key interest rate.

Since January 2019, the RBI has cut its repo rate by 135 bps but the 10-year G-sec yield has rebounded after falling about 100 bps.

The sovereign never wants the yields on its bonds to rise. Higher the yield, higher is the borrowing cost. On the contrary, lower government bond yields would mean stronger sovereign credit profile.

But rising oil prices, government borrowings, RBI’s inflation outlook and worsening deficits often put pressure on bond yields. And, therefore, any artificial management of yields does not work. The RBI’s recent management has yielded no results because yields are intricately tied to the macro-economic condition of a country.

Challenges before Budget

The Centre is also staring at an enhanced borrowing programme in the coming financial year (2020-21) because the budget deficit is expected to be large. The number would be announced in the Budget to be presented on February 1.

The fiscal slippage this year may have been to the tune of 3.8% and markets appear to have sensed that. The benchmark yields are only reflecting the sentiment.

The RBI has so far been extra-supportive in the government’s efforts to pump prime the economy. It has expanded its balance sheet faster than the growth in the economy. It has conducted unprecedented bond sales this year. But that can not happen every year.

Hence, the Union Budget will also have to take into account that its projection of deficits are realistic. And, its borrowings do not exceed to the extent to crowd out the private investment. After all, the government has unveiled a Rs 105 lakh crore infrastructure pipeline in the next five years and expects a fourth to be funded by the private sector.

The Centre’s gross market borrowing has surged 24% this fiscal.

According to Crisil estimates, the total 10-year issuances are also 1.5 times the value borrowed last fiscal. In addition to that, up to 90% of the fiscal deficit of states are now financed by market borrowings.

Until 5 years ago, only about 60% was being financed through borrowings. If sovereign borrowings are at such elevated levels, the rate of interest cannot come down even if the RBI expands its monetary tool kit. Finance Minister Nirmala Sitharaman will have to fix a large number of things internally in order to absorb external shocks in a better way.