Bond prices and rupee fall as fuel tax cut sparks fiscal slippage worries

Representative image

Representative image

The 10 year bond yield rose six basis points as prices fell and rupee weakened 0.2 percent against the dollar after the government cut tax on fuel to curb inflation raising fiscal slippage pressure.

A report suggesting the government plans to borrow Rs 1 trillion (lakh crore) extra to offset the fiscal impact from the fuel tax cut also weakened sentiment.

At 9.13am, the 10 year bond yield was at 7.42 percent, up from its previous close of 7.359 percent. Bond yields and prices move in opposite directions. Home currency was trading at 77.66 a dollar, down 0.15 percent from its previous close.

According to Barclays, tax cuts on motor fuels, cooking gas subsidies and duty cuts on imports could curb price rises but the fiscal deficit will widen to 6.9 percent of GDP, significantly overshooting the budgetary estimates of 6.4 percent.

On 21 May, the government announced a slew of fiscal measures to assuage price concerns. Steps include Rs 8 and Rs 6 per litre tax cuts on gasoline and diesel respectively, a Rs 200 subsidy on cooking gas for poor households, and reduction of import duties on raw materials and intermediaries of plastics, iron and steel. The measures mean the overall fiscal deficit will likely exceed budgetary estimates by at least Rs 2 trillion.

Nomura Research said: “We expect these measures to have a 0.2pp direct impact on CPI (consumer price index) inflation (full impact to be visible in June CPI data) and an additional impact of 0.1-0.2pp from second-round effects. However, we are leaving our CPI inflation projection for FY23 unchanged at 7.2 percent year on year due to a spate of other upside risks.”

Despite this excise duty cut on fuel, analysts still see significant upside inflation risks from other drivers. Higher food inflation, a pending rise in electricity tariffs, continued passage of higher input costs from firms to consumers and other second-round effects (house rents, wages) are likely to drive inflation.

“The significant fiscal slippage is likely to make liquidity normalisation particularly tricky for the Reserve Bank of India this year. The demand-supply gap in bonds remains a challenge this year. While the RBI has committed to a multi-year withdrawal of excess liquidity, the risk of higher government borrowing suggests increased market scrutiny over the potential of open market operations to absorb government bonds, which runs antithetical to the RBI’s liquidity tightening stance,” Nomura added.

Overall analysts expect another 100 basis point hike in the cash reserve ratio in the second half of 2022, which would take the CRR to 5.50 percent by 2022-end.

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