The bond rout is a warning as the Centre looks at ramping up spending ahead of elections

ore people are losing their love for Indian bonds. Foreign investors have been net sellers of over $1 billion in Indian debt this month, almost cancelling out inflows since the beginning of the year. Domestic investors were already spooked by a widening fiscal deficit, so foreign selling now has managed to add pressure on the market. The deserting of the Indian market by foreign investors comes at a time when the Centre is looking at tapping the bond market aggressively to finance its election-year spending. The yield on the benchmark 10-year bond has risen by almost 100 basis points since late-July amid lacklustre investor demand. The rise in yields is due to a variety of reasons that have pushed both foreign and domestic investors to re-price Indian sovereign bonds. For one, the government is expected to step up borrowing ahead of elections; in fact, the fiscal deficit targets for the current as well as the coming fiscal year were revised upwards in the Budget. This has fuelled market fears about a rise in inflation. Further, the public sector banks, typically the biggest lenders to the government, have turned wary of lending. As the losses on their bond portfolios mount, they have turned net sellers of sovereign bonds in 2018. Another tailwind affecting bonds is the prospect of higher interest rates in the West, which has made Indian bonds look a lot less lucrative in the eyes of foreign investors. The weakening rupee, probably a reflection of higher domestic inflation and fund outflows in search of yields, has added to selling pressure.

Given these pressing concerns, it is no surprise that Indian sovereign bondshave witnessed a relief rally since news broke on March 26 that the Centre will trim its market borrowing during the first half of the coming fiscal year. The yield on the 10-year Indian sovereign bond has dropped by more than 20 basis points since that day. The Centre’s borrowing target for April-September was cut to ₹2.88 lakh crore, which is about 48% of the total budgeted borrowing for the year, in contrast to ₹3.72 lakh crore in the first half of this year. Interestingly, first-half borrowing was more than 60% of the annual borrowing target in each of the last two years. The government also announced a cut of ₹50,000 crore in the total amount of market borrowings for the year, opting instead to dip into the National Small Savings Fund to meet its funding needs. Cutting down on market borrowing is a decision linked to the market’s ‘decision’ to punish the government for profligacy. The bond rout should thus serve as a timely warning as it looks to ramp up spending ahead of elections. Lastly, with the vacuum created by the state-run banks, it may be time for the Reserve Bank of India to re-examine the rule limiting the role of foreign investors in the bond market.a