The first budget of the Modi government to be presented to the parliament on the 10th of July 2014 will have to address the issue of financing the fiscal deficit.
India’s fiscal deficit has increased from levels of Rs 1269 billion seen in 2007-08 to levels of Rs 5246 billion in 2013-14. The deficit was projected at Rs 5286 billion in the Vote-on-Account for fiscal 2014-15 in February 2014. The sharp accelerating in fiscal deficit post 2007-08 was due to the fiscal stimulus provided by the UPA government post the financial crisis that engulfed the world in 2008.
The financing of India’s fiscal deficit has largely been through the bond market. Government bond issuances finance around 90% of the fiscal deficit with a variance of 3% to 5%. Fiscal 2013-14 saw government bond issuances finance 89% of fiscal deficit, with net borrowing of Rs 4680 billion. Vote on Account has projected a borrowing of Rs 4570 billion to finance 86% of budgeted deficit.
The sharp rise is fiscal deficit has taken up outstanding stock of government bonds from Rs 11,045 billion to Rs 34,723 billion over the 2007-08 to 2013-14 period. The ownership pattern of government bonds reveal that banks own around 55% of government bonds, Insurance companies own 19%, RBI own 13% and provident funds own 4%. Government predominantly depends on banks for funding its fiscal deficit.
Banks have to statutorily (SLR) invest 22.5% of their deposits into government bonds (includes state development loans or SDLs). RBI has lowered the SLR ratio by 2.75% over the last few years from 25% to 22.5%. Banks investments in government bonds amount to around Rs 17,000 billion, which is around 21% of deposits of Rs 79,000 billion as of June 2014.
Government borrowing as a percentage of deposits has gone up from 4% of deposits to 7% of deposits over the last six years. However, banks SLR ratio has dropped and RBI wants to lower the SLR ratio further from levels of 22.5%.
The Modi government will have to find investors who can offset lower demand from the banking system for government bonds to fund its fiscal deficit. FIIs can fill in part of the gap given that a reformist India with a stable government taking the right policy decisions offers a good investment avenue for their funds.
FII limit in government bonds is USD 30 billion of which almost all are exhausted. Total limit for FII in INR bonds across government and corporate bonds is USD 81 billion. Increasing the FII limit in government bonds would enable the government to free the banking system from compulsorily off taking its debt and also enable it to keep down borrowing costs.
The price the government will have to pay for FIIs to invest in government bonds is stability in the macros of fiscal and current account deficit and inflation. It is a good price to pay as the country as a whole will benefit. However any deviation from strong policies will be felt in the INR as well as government bond yields, which will see heavy volatility as seen in the June-September 2013 period when the INR fell to record lows and bond yields rose by over 200bps.