The Hindu Business Line : Fiscal deficit set to go higher

THE table on public finance gives a brief insight into the fiscal thrust that the new Government is trying to give to the economy to push it into a further expansionary path.

For the convenience of comparison, I have kept the impact of debt swaps out of the calculations. We undoubtedly had a great 2003-04 in terms of economic activity; our GDP grew by 8.2 per cent in real terms. No wonder, tax revenues jumped by a whopping 17.3 per cent over last year. With the exception of 2002-03 and 2003-04, tax revenues have been very sticky in the last five years.

Growth in tax revenues

In this background, a 25 per cent growth in tax revenues that has been budgeted for 2004-05 is at best optimistic. If the fear of drought turns into reality, GDP estimates for 2004-05 will have to be revised downwards which will push the revenue targets further away from reality.

Clearly, the Finance Minister is trying to push up investment, which is clearly getting reflected in much larger allocations to capital expenditure, both under the plan as well as the non-plan heads. There is no denying the fact that a country like India needs huge investments, more so in infrastructure. But given our fiscal situation, any large public investment will make the Government's task of achieving the goals laid under the Fiscal Responsibility Bill extremely difficult.

Debt swap scheme

The budgeted fiscal deficit of Rs 1,37,407 crore by itself is misleading. Under the debt swap scheme, the State Governments raise cheap money from the market to pre-pay their historical high-cost debt from the Centre. The Centre in turn uses this money to prepay its liabilities to the NSSF (National Small Saving Fund). As a result, the debt swap scheme is fiscal deficit neutral, although it helps both the Centre and the States to extinguish high cost liabilities. The prepayment of debt by the States to the Centre appears on the receipt side of the Central Government Budget as recovery of loans. Similarly, prepayment of NNSF debt pushes up the Central Government's non-plan capital expenditure, thereby inflating its balance sheet on both sides. But for the first time this year, the Finance Minister intends to not prepay the NSSF and use Rs 13,000 crore raised through the debt swaps to fund its capital expenditure or in other words, its fiscal deficit.

Real fiscal deficit

The real fiscal deficit to start with is Rs 1,50,000 crore and not the Rs 1,37,000-odd crore mentioned in the Budget numbers. Add to this the extremely optimistic tax revenue projections, a fear of drought, and we are looking at a number close to Rs 1,65,000 crore if not more. A higher fiscal deficit coupled with the removal of the 6.5 per cent tax free bonds is surely going to put pressure on the Central Government's market borrowing, which in the current interest rate environment is far from encouraging.

The bond market has continued with its fall over the last week. All the positive data out of the US has not been able to soothe sentiment, which has only worsened on account of mounting losses.

Apathy towards bonds

More and more number of market participants have started showing complete apathy to bonds because they are scared of further losses. The scheduled August borrowing is just round the corner, a floating rate issuance should improve market sentiment considerably. But a fixed rate issuance will drive up yields further by another fifteen-twenty basis points.

Given what is happening around us, I personally do not expect the central bank to hike rates in the October monetary policy, which should cause the 10-year yield to top out in the 6.25-6.50 per cent range. The 5-year OIS should also not go above 6.55-6.60 per cent, even if we have a fixed rate issuance. The only risk to this view is a spate of strong data out of the US, which we have not seen for some time.

Things here can go out of hand only if the market starts believing that the Fed is going to give up its `measured rate hike stance' and is going to hike rates faster.

(The author is senior trader, Interest Rates at HSBC, Mumbai. The views expressed herein are his own and not necessarily those of his employer.)