In our view, funding the fiscal deficit will pose a stiffer challenge than in the past with rising M3 growth limiting Reserve Bank of India (RBI) open market operations (OMO), on the one hand, and global uncertainties stalling privatisation, on the other. In response, RBI is likely to hike banks’ held-to maturity (HTM) limits by a further 2% of the bank book to fund the high fiscal deficit without pushing up yields.
Further, mobilisation of extra budgetary resources (EBR), such as public sector undertaking (PSU) infrastructure bonds, would allow a step-up infrastructure investment in a fiscal and liquidity-neutral manner.
Mind the Gap
Our projected Centre’s fiscal deficit targets of 7.2% of GDP for FY2021 and 5% of GDP for FY2022 assumes PSU divestment of Rs 300 billion (Rs 62 billion financial year-to-date) in FY 2021 and Rs 700 billion in FY2022, respectively. We expect 1-1.5% of GDP worth of demand-side measures to offset the demand shock the economy is facing.
Key steps are likely to include: higher subvention for homebuyers to rekindle real estate demand; oil tax cuts; lower income-tax cuts funded by Covid-19 cess on higher incomes; recapitalisation of PSU banks/formation of asset reconstruction companies (ARCs)/‘bad bank’ through non-fiscal levers like recapitalisation bonds, or the use of RBI’s revaluation reserves; and PSU infrastructure bonds of Rs 1,000 billion.
We place overall FY2022 net borrowing at Rs 13.5 trillion. Conventional market demand from banks, insurers and pension funds should leave an excess supply of over Rs 5,126 billion. To contain yields, this will, in all likelihood, largely be met by a hike of 2% of book in banks’ HTM limits (about Rs 3,068 billion) (atop 2.5% so far) with RBI OMO limited by rising M3. While we expect some more liberalisation of foreign portfolio investor (FPI) debt investments, we do not expect any fresh inflows, as yields are likely to harden over the next 12 months.
We see three compelling reasons to hike banks’ HTM limits till FY2024. It contains yields/lending rates by incentivising banks to invest the $73.5 billion money market surplus in government securities (G-secs) without fear of higher yields. Paper placed in the HTM bucket need not be marked to market: a 100-basis-point (bps) hike in yields leads to 7.2% mark-to-market hit. Also, yields should rise as growth normalises.
We expect the RBI monetary policy committee (MPC) to cut 50 bps in H12021, with inflation peaking off and hikes of 100 bps in FY2023. Second, this supports recovery by enabling New Delhi to run higher fiscal deficits. Finally, it reduces the threat of future inflation at a time M3 growth, at 12.4%, is in excess supply, given average 2% FY2020-22 growth.
We reiterate our call that EBR risks are overdone. While both direct government borrowing and EBR are part of the public sector borrowing requirement (PSBR), we do not agree with the conventional wisdom of adding up the government’s issuance of G-secs and EBR, such as infrastructure bonds owned by a fully government owned special purpose vehicle (SPV), to measure crowding out, as they have very different liquidity effects.
Bond is Right
We consider PSU infrastructure bonds to be a fiscal- and liquidity-neutral way to fund public capital expenditure this year. When a bank bids in a G-sec auction, it has to carve the investment out of its loan/investment book. As the money flows to the government account with RBI, money market liquidity shrinks. This is called crowding out in the argot.
If the public breaks down their fixed deposit to buy a G-sec in a primary auction, money flows from his or her deposit account to GoI’s account with RBI. This obviously impacts the bank as well as money market liquidity. If the public buys a quasi G-sec/PSU bond — that is, part of EBR — funds flow from, say, its fixed deposit to PSU’s current account. This does not impact bank’s deposits, asset book or money market liquidity. Hence, there is no crowding out. In short, G-secs are typically funded by bank liquidity, while quasis or PSU bonds are financed by leverage on bank deposits.
Budget 2021 may announce or indicate broadening RBI’s objectives to include growth and financial stability, in addition to inflation targeting in FY2022. RBI Governor Shaktikanta Das has himself opined: ‘…the fact remains that though the focus of monetary policy is mainly on inflation and growth, the underlying theme has always been financial stability… From the perspective of the Reserve Bank, we will continue to focus on effective communication and coordination with all stakeholders to achieve broader macroeconomic objectives of price stability, growth and financial stability…’.
The writer is India economist, Bank of America Global Research. Printed by permission. Copyright © 2021Bank of America Corporation