Macronomics: The Insane Fiscal Deficit and The Onslaught of Bond Issuance

At Capital Mind Premium we take a quick look at how the fiscal situation has panned out in this financial year. Fiscal is a term bandied about quite often, and let me clarify that I mean “of the government” when I use the term.

A housekeeping note: In order to avoid over-enthusiastic spam checkers, we request you to add “[email protected]” to your address book. (This newsletter is an opt-in and has a further email confirmation. If you should wish you unsubscribe, please click the link at the very bottom of this email)

Summary

• The Tough Fiscal Situation till November: Deficit Already at 94%

• Government Finances Broken Down

• Does December Change Anything?

• The Problem With Market Borrowings

• A Wonky Yield Curve

• 89,000 Cr. must be repaid before May!

• The Populism Fear

• Where we position our Fixed Income and Stock Portfolios

We’re At 94%!

In data released on Tuesday, it turns out that India’s Government Finances aren’t all fancy.While we are occupied by what is happening in Delhi state, which actually has the surplus to give away 7,000 liters of water if it chooses to (though it doesn’t have the water), the real story lies elsewhere.

Till November, we find out that (surprise, surprise):

• The Central Government hasn’t earned as much as it should have

• The government’s spent more than it bargained for

• The difference is now 94% of the whole year’s number and there’s still four months to go

Here’s the status:

Source: CGA.

As a caveat, we must state that tax revenue which is a huge indicator in anything the government does, would have been collected in December, so the November numbers might be a temporary low.

The Financial Situation

The problem, really, is that we’re spending it faster than we’re earning it.

Source: CGA.

Even with the slowdown in spending, government expenditure grew at 17.7% over the previous year. Revenues, meanwhile, grew just 12.5%. Remember that here, the impact of taxes is lesser – since advance taxes are in December in both financial years compared.

So Does December Change Things?

The Income Tax Deadline is December 15, and a release by the Income tax department says:

“Net direct tax collections for the current Financial Year (F.Y.) 2013-14, up to 20th December 2013, stood at Rs. 4,12,918 crore as against Rs. 3,63,338 crore in the same period last year showing a growth of 13.7%.”

This means direct taxes (Corporate and Personal taxes) are up to 4.12 trillion rupees in December, an addition of 500 billion (Rs. 50,000 cr.) This would only add another 5% to receipts, which are budgeted to be over Rs. 10 trillion.

Indirect taxes could add about 12,000 cr. (120 billion) more.

The Powergrid disinvestment was in December, but having sold about 18 crore shares at Rs. 90 (and some at a Rs. 4.5 retail discount) that’s an addition of less than 1,700 crores to the government kitty. Which in this scheme of things is a drop in the ocean.

Revenues therefore will go up by Rs. 70,000 cr.

Expenditure wise, nothing has really come down, and we expect expenditure to continue at the same pace. If that’s the case, we’ll have spent another 100,000 crore (1 trillion) in December.

That’s a deficit of Rs. 30,000 cr. in addition, and could easily push the fiscal deficit beyond the budgeted limit in subsequent months.

Why do we care?

The government bridges the gap between expenditure and earnings (and there has always been a gap) through market borrowings.

These market borrowings are in the form of bonds. The government borrows a heck of a lot of bonds. It has already borrowed over Rs. 5 trillion (5 lakh crore) this year, and while some of it was used to repay maturing debt, the vast majority is fresh borrowing. Note: this is just long term borrowing – the government also borrows short term, through T-Bills and such.

You’ll see that the government has actually borrowed more than the fiscal deficit recently – this accounts for repayments etc.

Now we’ve already borrowed 5 trillion in this year. According to the issuance calendar, the government should only borrows Rs. 55,000 crore more (550 billion) in the next quarter, most of it only in Jan and Feb.

If the Fiscal Deficit continues in this vein, we might see more borrowing. More borrowing means more bonds, and more bonds means more supply. Which means prices of longer term bonds will fall.

The Wonky Yield Curve

The yield curve, currently is wonky. The 10 year bond (8.83%, 2023 November) is trading at 8.84% but it seems to a huge anomaly, because everything else is beyond 9.15% in that range.

This is largely because the 10 year bond has only recently been issued, and we’re seeing a move from the 2023 May bond (which is at 9.16%) to the 2023 December bond as part of the move towards greater liquidity. Eventually, this is likely to settle beyond 9%.

Effectively we are seeing longer term yields at 9%+. Yet, we believe at Capital Mind that yields could go further up – and thus, prices further down. The reason: A lousy deficit and no real short term mechanism to bridge it.

The one saving grace would be if foreign investors were to return to buy debt. This doesn’t look likely, given the weak government situation.

Government Borrowing For Subsequent Years

Now, while we tend to think short term – and this government will change in May next year – the burden of the rest of us that are looking to survive beyond 2014 is: How much are we going to pay?

Debt in 2008-09 was issued at 5 year tenures, because there was this magnificent worldwide crisis. That now comes home to roost, because we have to pay it back.

Note: To give a fair comparison, the total outstanding debt for 2013-14 at the start of the year was Rs. 95,000 cr. only. This tells you how much more debt we have to repay in the coming years.

If the fiscal deficit remained at 500,000 crores (5 trillion) the government will need to borrow more than 650,000 crores in the next year and nearly 700,000 crores in 2015-16. That’s a borrowing hike of 20% to 40%!

And get this: 89,000 crores worth of Government Debt comes due in April and May 2014!

This effectively means we’ll definitely see a lot more debt issued in the next few months. Yields will go higher in expectation.

The Populism Fear

With a certain party in Delhi announcing some free water and some cheap power, the fear is that other states – not quite as financially stable as Delhi – will follow suit, no matter what the consequences.

The food security bill will be a greater expenditure from subsequent years. There may be a wage increase in the NREGA and a rise in the fuel subsidy (as Brent Crude continues to be at $110). In today’s press conference, the PM has mentioned they will hike the number of subsidized LPG cylinders per year by 33%, from 9 to 12. (The subsidy is about Rs. 500 per cylinder)

All governments like populist policies – cheap fuel, free cycles, payments to minority classes and so on. However, these cost money, and given the current fiscal situation, a further liability will be extremely dangerous.

I know some people like to think of the Government Debt as a percentage of GDP. This is sheer nonsense, because effectively we spend 50% more than we earn! The deficit is about 55% of revenue, which is a greater problem. In fact, just interest payments are more than 30% of what we earn, and with rising yields, future debt will end up being even more expensive.

Given that the current government might only last a few more months, and the rest of us have to live longer, it is likely that the powers that be take short term “look-good” decisions, which hurt the rest of us in the longer term. Until April, this fear will remain.

Where we position fixed income and stock portfolios

If the fiscal situation continues as it is, and the supply points to even more bonds being issued, would you want to stay allocated in longer term Government Bonds?

The RBI is unlikely to lower the interest rate just yet. Even if inflation were to look like it will subside, they are going to wait a few months to see it stabilize. A high fiscal deficit is, by nature inflationary and is likely to have an ‘upward pressure’ on inflation going forwards. This then firms an investment decision.

Fixed Income: Where we would invest:

• Continue to remain invested in ultra-short term and liquid mutual funds.

• Avoid FMPs longer than 91 days.

• Avoid longer term bonds until elections.

• Wait for interest rates to turn, or for rates to be substantially more attractive.

• While tax-free bonds are attractive, the yield curve steepening might give us more issuance in subsequent years at higher yields, so purchases must be staggered.

In another post, we’ll mention what funds and FMPs look attractive to us, in a fixed income portfolio we are constructing for our own parking of long term and emergency funds.

Stock Impact: If yields were to go up, then losses will be borne by banks, insurance companies and the RBI. Banks were provided a special dispensation to amortize losses in longer term bonds over the financial year (2013-14) when yields spiked in August to 9%.

Will banks be given more such opportunities if yields went to 10%? This is unlikely, because it’s a structural move, and thus, bank profits will be hit. I would avoid banks at the current time.

Higher yields is effectively a hike in interest rates for the corporate sector. This will contract corporate profits. As a short-term investor, you should ignore this, because actual on-the-ground stock performance does not impact stocks as much as momentum due to sentiment. Looking longer term, the set of stocks to seriously avoid is those that depend primarily or majorly on government expenditure, or those that have very high debt levels.

Finally, the above analysis is a big risk to the “Green Shoots” mentioned in Macronomics earlier. Stock markets are optimistic, and I have been so as well. But it might be difficult to sustain this positive sentiment if the government finances are in the toilet.