The Hindu Business Line : Interest rate signals unlikely in Budget

Today one would know if the dream team has delivered. From an interest rate perspective, the Budget should, however, be a non-event. There should be no interest rate signals coming out of it.

The Finance Minister is unlikely to tinker with the small savings rate and the EPF rate hike announcement has already been made.

A new inflation-linked bond scheme might be announced in lieu of the 6.50 per cent tax-free bond that was discontinued in the last Budget.

The new inflation-linked bond will most likely give a fixed return over and above the average inflation for the year. With the indexation benefit, the post-tax return under the scheme should be quite attractive.

I think the proposal to link the return on various small savings schemes to the yield on government securities of similar maturities is unlikely to see the light of the day.

Apart from the possible addition of this new inflation-linked bond scheme, we should not see any fresh changes in the existing ones.

After the proposal to hike the EPF rate from 8.50 per cent to 9.50 per cent, government employees, sooner or later, are bound to make noises about a commensurate re-alignment of the GPF rate.

The Finance Ministry till now has maintained that the EPF trustees will have to generate the higher return from their internal resources and shall not get any budgetary support.

With more than 80 per cent of their corpus invested in special deposits yielding only 8 per cent, they are unlikely to meet the revised rate of return and shall have to depend on Government support. The moment the Government has to step in to bridge the resource gap, it will have to hike the GPF rate as well.

So, the Finance Minister might choose to keep the GPF rate unchanged in the Budget, but he will not be able to do so for long.

The Twelfth Finance Commission has made a set of recommendations regarding resource sharing between the States and the Centre, which has been fully accepted by the Government.

The new formula of devolution of taxes on the States and restructuring of their loans is slated to put additional strain on the Central Government finances to the tune of almost Rs 13,000 crore.

Also under the FRBM Act, for 2005-06 the Central Government has to show a 0.3 per cent fall in the fiscal deficit and 0.5 per cent fall in the revenue deficit as a percentage of GDP over this year.

The Government will have to cut down its expenditure growth to accommodate the increase in resource transfer to States.

It will have to maintain its fiscal deficit target at around Rs 1,40,000 crore for 2005-06 as well; the projected nominal GDP increase of 12 per cent will then cause the desired fall in fiscal deficit as a percentage of GDP.

For 2004-05, the Government had projected a net borrowing of Rs 90,000 crore to fund its fiscal deficit of Rs 1,37,000 crore. Thanks to a sharp jump in small saving collections, the ongoing debt swap and a large cash surplus from last year, the Government ended up borrowing a much smaller amount.

With no more debt swaps likely next year, we are back to a net borrowing number of Rs 90,000-1,00,000 crore expected in the Budget to fund a fiscal deficit of Rs 1,40,000-odd crore.

The borrowing number can drastically fall if the Finance Minister decides to go ahead with the Montek plan of using RBI reserves for infrastructure financing.

The Planning Commission had recommended that the Government should use a part of the huge foreign exchange reserves for financing large infrastructure projects.

It seemed that the idea did not gain currency with the central bank then, but things might have changed since. The probability of such a step is small; but if the Finance Minister does decide to go ahead with it, then it could be done in two ways.

Either the Government creates an SPV (special purpose vehicle) with an irrevocable Central Government guarantee, which gets the RBI dollars for funding the infrastructure projects or the Government directly borrows the dollars from the central bank.

Technically, the first option does not push up the Government's fiscal deficit; it only increases its outstanding guarantees.

But in both cases, the market borrowing of the Government does come down sharply.

Lately, we have seen the central bank buy dollars quite aggressively in the market. Some are of the opinion that it is doing so to realign the currency in REER terms, which has moved higher to almost 102.70.

But who knows, may be it is mopping up these dollars to monetise the Central Government deficit, one way or the other.

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

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