The Hindu Business Line : Budget of Bonds and Rates

THIS is a good Budget and has gone down a new and desirable path (if for a second you look beyond the discussion around the turnover tax). It has attempted to take reforms to the next level of the economy. The last few Budgets focussed on reforming the industrial sector and the capital market and the success of those reforms are visible. This Budget has correctly shifted focus to the neglected areas of the economy — rural and infrastructure — without sacrificing fiscal discipline. The emphasis on developing basic physical infrastructure will improve long-term competitiveness of the economy and the quality of living.

Investment in agriculture and the rural sector will broadbase the beneficial impact of reforms and in the medium term will add to disposable incomes thus generating demand. The focus on health and education will improve the quality of labour resource — a key input in the growth of the services sector. There will always be a question mark on the effective delivery of these measures and ensuring that benefits accrue to the appropriate sections of society. But that a start has been made in this direction is promising.

From a debt fund perspective, it was disappointing that the Budget left the small-savings rate unchanged. It was expected that the current rates would be retained for senior citizens and lower-income groups but reduced for all others.

Clearly, from the remarks of the Finance Minister, this was not a politically feasible option this time and will hopefully happen in the next Budget. The increase in the distribution tax rate for corporate investors will lower returns but on a relative basis debt funds still remain the best investment option.

There is some confusion if debt funds will need to pay turnover tax on bond purchases. The Budget proposal clearly looks at introducing a turnover tax to be offset by a lower capital gains tax regime. Since debt funds will not benefit from the lower capital gains tax (as units are not transacted on a stock exchange) it is logical to assume that they will also be exempt from turnover tax on purchase of bonds. Clarity on this issue is awaited. The hike in the limit of 100 per cent FII debt funds from $1 billion to $1.75 billion will create short-term demand as there still exists an arbitrage opportunity at the short end.

The Budget acknowledges the fact that declining interest rates have helped the government rein in fiscal deficit considerably and in the larger interests of the economy , we should maintain a benign interest rate regime that balances the claims of savers and borrowers. In addition, it is clearly being recognised that a significant part of consumer demand has been generated by the low interest rates available on consumer loans.

The lower revenue deficit (ignore for the moment if this is achievable), and the fiscal deficit being maintained at 4.4 per cent of GDP considerably ease pressure on interest rates.

In my view the future direction of interest rates will be determined by the following:

The direction of US interest rates. Following weak data, further rate hikes are expected to be measured. This is reflected by the pull in of long-term yields in the US and the flattening of the yield curve.

Inflationary fears driven by oil and commodities. Oil prices are being driven by supply constraints as demand remains robust (any slowdown in China will be positive).

A good monsoon should ease commodity price hike fears. The Economic Survey predicts inflation at 5 per cent and this looks achievable. Market expects inflation to come off as the base effect of steep steel price hikes in August 2003 kicks in.

Liquidity in the system. The Economic Survey expects capital flows to continue and talks of balancing export growth (while current account is in positive, India runs a significant trade deficit) with appreciation in the currency. It refers to an improved method of sterilising flows (read, medium-term market sterilisation bonds (MSBs) if capital flows continue).

In the near term expect no movement in repo or bank rate but expect long-term bond yields to remain volatile and the 10-year government yield to move in a band of 100-200 basis points over the repo rate.

The current mood in the RBI is far more acceptable to volatility unlike in the past where the Central bank would intervene even on small bouts of volatility in asset markets. If there is any adverse movement in the US interest rates or local inflation there could be a hike in the repo rate while short-term movements in liquidity will only impact the steepness of the yield curve. We still continue with our recommendation of investing in either the actively managed debt funds (Dynamic Bond and Medium Term) or accrual funds (Cash and Floater).

In the last one year yields have risen by 10-15 basis points (the 10-year yield has risen from 5.7 per cent a year back to 5.8 per cent) and on analysing one year returns of debt funds it is seen that the Dynamic and Medium Term have both outperformed Cash and Floating rate funds while income funds have not.

(The author is Managing Director, Standard Chartered Mutual Fund)

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