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Monday, Feb 25, 2002

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Budget poses no problem for bond bulls

T.B. Kapali

We in India are facing a certain abnormal economic scenario, quite like in Japan. In this abnormal scenario, the size of the public sector deficit and, therefore, the borrowing requirement does not seem like it would ever have an adverse effect on the soft interest rates environment prevailing for quite some time now.

IT is Budget time again and the attention of the financial markets — particularly the bond market — is riveted towards what the Government's borrowing requirement is going to be for 2002-03. It is quite likely that the ensuing Budget indicates a borrowing requirement of much more than Rs 1,18,000 crore — the 2001-02 requirement.

The rupee interest rates could still remain stable, nay even soften and partying in the bond market could continue. The market's focus on the borrowing figure stems from the fact that the sovereign, even in the advanced countries, has been the biggest borrower in the financial markets.

The public sector borrowing requirement, in conjunction with the private sector's financing needs, is expected to exert a powerful influence on the course of interest rates. The foregoing would represent a normal economic situation where both the public and private sectors have their respective financing needs.

But, it has to be realised that we in India are facing a certain abnormal economic scenario, quite like in Japan. In this abnormal scenario, the size of the public sector deficit and, therefore, the borrowing requirement does not seem like it would ever have an adverse effect on the soft interest rates environment prevailing for quite some time now. (Ten-year sovereign yields at around 7.30 per cent have fallen by 350/400 bps in the past three years and have almost halved if one goes back another three years, even as Government borrowing has risen inexorably over the years.)

The size of the public sector deficit/borrowing requirement can be taken as being inversely related to the size of the private sector borrowing requirement. The private sector borrowing requirement, in turn, can be taken as being directly related to the level and momentum of economic activity. This can be taken as the normal scenario.

It has to be noted here that political considerations — such as the Cold War till the early part of the last decade — can have an independent influence on the level of Government spending/borrowing, even where private sector demand is high.

The American experience of the past decade more clearly testifies to the above state of affairs. With the end of the Cold War, the US defence budget was scaled down quite substantially during the Clinton years. At the same time, the unprecedented economic expansion right through the 1990s meant that in the last two or three years of the decade, the US Federal Government's borrowing declined quite sharply.

Where the private sector borrowing requirement and, more critically, other parameters such as rate of growth of industrial output and revenue generation from the industrial sector are all on a long-term declining trend, it is inevitable that public sector borrowing is high and increasing. That has been the case in India.

There seem to be deep structural impediments to the growth of industrial output, capacity utilisation and revenue generation from the industrial sector. The following statistics attest to this.

Industrial output growth has stagnated around 5.5 per cent on average in the past five years. Relative to say the years 1994-95 or 1995-96, when the IIP growth was around 11/12 per cent, this is a big fall. The weakness on the industrial front has been reflected in the revenue flows from the sector. After averaging a growth of around 14 per cent in the 1990-95 period, indirect tax revenues have grown only around 11 per cent in the 1995-2000 period. One can quite clearly note the contrast between the Indian and US situations here. And, the similarity with the Japanese situation also cannot be missed.

The public sector deficit has easily been in excess of 10 per cent of the GDP in Japan for the past many years. The overall debt stock is also around 1.5 times the GDP and increasing. And Japan is yet to emerge out of the economic quagmire it got mired in around the turn of the 1990s.

What about yen interest rates? At 1.50 per cent for 10 years, borrowing for the long-term is virtually free in Japan. For Japanese corporations which have a major export orientation — such as Toyota, Honda or Nissan — and which still have some flexibility as regards their debt/equity ratios, the yen interest rate scenario of the past few years could have provided enormous support in boosting their net margins. (Also, consider the fact here that the Bush administration also seems to be well endorsing the strong dollar policy of the previous administration).

Metamorphic changes in the global macro-economic environment — WTO, surplus capacity in almost everything, the information technology revolution — are all impacting on the industrial performance, fiscal balances, general level of prices and interest rates structure of individual economies such as India.

Combine that with the fact that aggregate demand in countries with sharp inequalities in income and wealth distribution, such as India, is bound to be weak and stagnant. You have the perfect recipe for stable and soft interest rates.

One has not even considered here the huge expansion in the central bank's balance sheet in the past five or six years, and the beneficial impact this has on the domestic liquidity environment.

The reference here is to the quantum jump in the Reserve Bank of India's foreign exchange reserves — a 100 per cent jump from around $25 billion in 1996-97 to almost $50 billion now. And, if the latest pronouncements from the RBI are any indication, this only seems like increasing.

The bottomline: An increase in the Government's borrowing for 2002-03 is inevitable. But bond bulls need not be overly concerned about that.

(The author is Senior Dealer in Vysya Bank. These are his personal views which do not necessarily reflect those of his employer.)

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