White-knuckle moment for bond markets

Centre-state equation to be keenly watched

The bond market is keenly interested in how the Centre manages to settle the shortfall in the GST compensation and how many bonds will finally hit the market. Preliminary soundbites by finance ministry officials seem to suggest that bond issuances won’t be more than ~97,000 crore, which the government can work out through a special bond.

The bond market is keenly interested in how the Centre manages to settle the shortfall in the goods and services tax (GST) compensation and how many bonds will finally hit the market.

Preliminary soundbites by finance ministry officials seem to suggest that bond issuances won’t be more than ~97,000 crore, which the government can work out through a special bond. These bonds will be issued by states, but will be effectively guaranteed by the Centre.

Through these guarantees, the government will see if the coupon of these bonds can be kept as close to government securities as possible, Expenditure Secretary T V Somanathan told Bloombergquint.

But the market is worried that once issued, these bonds may be used again even after state Budgets are finalised and borrowing calendars are announced.

“The moot point is deficit financing will add supply in the market, whatever the nature and issuer. The duration, timing of issuances, statutory liquidity ratio status or held to maturity status will be crucial. This will be pure yield play, and banks will have the appetite, given the buoyant deposit accretion and muted credit, though some adverse effect on the corporate curve cannot be ruled out,” said Soumyajit Niyogi, associate director, India Ratings and Research.

It is left to states to decide if they will want to limit their borrowings to ~97,000 crore. If not, the bond market has reasons to feel apprehensive.

The government has placed two options before states. One, borrow ~2.35 trillion from the markets to make good on the GST shortfall, including the negative fallout of the Covid-19 pandemic. Or, borrow just ~97,000 crore, which is the core GST shortfall. If states agree to borrow only ~97,000 crore, the special scheme will be operationalised.

Some states have already rejected the ~97,000-crore proposal, albeit not formally. “If this ~97,000-crore route is taken, this won’t be much of a wrinkle for the markets. However, if states opt for the ~2.35-trillion extra borrowing route, and who knows if it ends there, then the RBI will have to step in to bear some of the burden,” said a senior bond trader.

Experts are pegging the shortfall much higher than what the Centre is estimating. That would mean that in both options, states will have to hit the market route.

Rating agency ICRA estimates there will be a shortfall of ~3.4 trillion, based on ICRA’S projection of the shortfall in GST compensation and the central tax devolution (CTD) for 202021 (FY21). Even if states meet all the prescribed reforms within the timeline, and borrow ~2.35 trillion, the revenue shortfall will be ~1 trillion.

Despite higher borrowing, states will have to still cut their expenditure. “Loss of revenue, other than GST compensation and CTD, as well as higher revenue expenditure on the aforesaid activities, could result in an even sharper contraction in the state governments’ ability to undertake capital expenditure in FY21, compared to our assessed range of ~1-3.4 trillion,” said Jayanta Roy, group head-corporate sector ratings, ICRA.

The bond market has reasons to be nervous since not many believe in the government arithmetic. The fiscal deficits of the government and states could end up being much more than what the initial estimates

suggest, and the bond market fatigue has already set in.

While estimating market borrowing for FY21 could be challenging at this point in time, Standard Chartered said its base case assumption for the Centre’s net market borrowing is ~10.9 trillion; for states, it is ~8.25 trillion. The bank said the borrowing by the Centre for the second half could turn out to be favourable “and may positively surprise markets; however, state development loan supply remains heavy”.

In the end, the RBI will have to chip in with ~3.5-4 trillion of open-market operations, or Operation Twist purchases.