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Pranav Thakur

India has seen a bout of downgrades by the international credit rating agencies in the last year and all on account of its deteriorating fiscal situation. In the circumstances, the Finance Minister has to at least look as if he is doing something about it.

AFTER flirting with the 7.20 level for a week or so, the 10-year sovereign yield saw a sharp retracement. It touched 7.50 for a brief while on the back of some profit-booking, followed by traders tripping over each other. There was a reasonable amount of investor support at that level, and it quickly bounced back. The 10-year yield should again stabilise around the 7.25 levels ahead of the Budget.

Most of the market players I speak to say that they personally have few expectations from the Budget. Most of them do not expect Mr Sinha to take any unpopular measures, such as an aggressive cut in the small savings rate, given that the BJP is set to lose the UP polls. They also expect next year's borrowing number to be on the higher side.

There seems to be a clear dichotomy between the market's individual expectations and the perceived popular expectation. While most people say that they personally do not expect any further measures on the interest rate reduction front, the market seems to have already discounted one. I, therefore, expect traders to go into the Budget with medium to light positions.

The recent bout of profit-booking has already led to some amount of portfolio pruning. So, one may not see sharp reversals even if Mr Sinha decides to postpone his decision on the small savings front. On the contrary, if he cuts aggressively and makes the right kind of noises, you could see a sharp rally, given that traders will be sitting light.

Post-Budget, clearly, there are two scenarios likely to emerge, depending on what the Finance Minister says and does in the Budget. One is where he postpones any kind of small savings cut, continues with the relief bond scheme, does not even talk about the Fiscal Responsibility Act, and projects a gross market borrowing number of around Rs 140,000 crore.

The other is where he either makes the small savings rate a floating rate or cuts it by a 100 basis points or so, scraps the relief bonds scheme or cuts its rate of interest, implements the Fiscal Responsibility Bill, and somehow projects a borrowing number close to Rs 125,000 crore.

The first scenario is too pessimistic, whereas the second one is clearly optimistic. The reality will most probably veer somewhere to the middle. I personally do not expect a move of more than 25 basis points on either side, depending on which way the Finance Minister goes. So, the broad range for the 10-year yield post-Budget should be 7-7.50 per cent.

In my opinion, the UP election results should not cause any last-moment changes in the Budget on the small savings front. One, because I do not think the UP election results will throw up any surprises for the BJP to take any remedial action. No one, including the BJP itself, expects the party to sweep the polls. Moreover, a change in the structure of the small savings rate is too important a decision to be included at the last moment.

Talking about the two broad scenarios, I would personally lean towards the more optimistic side of things. I think Mr Sinha will accept the Reddy Commission's report and make the small savings rate floating, which will impart a good degree of flexibility to the interest rate structure of the economy.

Politically too, it will be tenable, as the first fixing of the PF rate will not be much lesser than the current 9.5 per cent. The Reddy Commission had recommended linking the PF rate to the average 10-year G-Sec rate in the last year with a spread.

Mr Sinha will most probably use a maximum spread of 50 basis points as recommended by the Commission.

I also expect him to implement the Fiscal Responsibility Act in some form or the other. Even a watered down version of the original Bill will comfort the market, given that nobody even seems to be talking about it at this point in time.

India has seen a bout of downgrades by the international credit rating agencies in the last year and all on account of its deteriorating fiscal situation. In the circumstances, the Finance Minister has to at least look as if he is doing something about it.

Although the Reddy Committee had recommended scrapping the relief bond scheme altogether, Mr Sinha may just cut the rate of interest currently being offered by the scheme, as it has already collected tonnes of money for the Centre this year. Cutting the relief bond rate, I think, will be more positive for the market than actually scrapping it.

The Finance Minister displayed some political will in the last part of this year in pushing through some big-ticket divestment. He may just cash in upon it and show a large divestment number for next year, and actually keep the gross borrowing number close to Rs 125,000 crore.

(The author is Senior Trader, Interest Rates, at HSBC Mumbai. The views expressed here are his own and not necessarily those of his employer.)

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