How Rising Bond Yields Can Derail Government’s Fiscal Deficit Target

The impact of the Reserve Bank of India (RBI) hiking the repo rate last Friday was reflected in the rising of the bond yields and the narrowing of the spread between the five- and 10-year yields. While the five-year bond yield closed at 7.05 per cent on Monday, the 10-year one ended at 7.34 per cent. The spread between the two shrank to 29 basis points from 30 basis points last week.

The commotion in the bond market is the result of participants expecting more rate hikes from the RBI. Experts were anticipating a rate hike by 25 to 35 basis points this time.

The RBI’s Monetary Policy Committee (MPC) had raised the key repo rates by 40 basis points and 50 basis points in May and June, respectively. 

The RBI’s latest repo rate hike of 50 basis points to 5.4 per cent was carried out to tame inflation, following which the benchmark lending rate crossed the pre-pandemic level of 5.15 per cent. 

The rising yields, however, mean something else for the central government.

Impact Of Rising Bond Yields 

With bond yields rising, the borrowing cost for the central government is set to go up. That might negatively impact the fiscal deficit at a time when the government has set a target of maintaining a fiscal deficit at 6.4 per cent of the GDP for the current financial year.

Anubhuti Sahay, senior economist, Standard Chartered Bank, says that the cost of government borrowings could go up and the narrowing of fiscal deficit can happen on higher revenues in terms of tax collection but it will take time. “It is possible that if revenues are higher than additional expenditure, we might see some compression but, as of now, we expect the government to stick to a 6.4 per cent fiscal deficit number,” she says. 

“Right now, the economy is doing well and revenue is higher but, at the same time, there is pressure on the expenditure front,” Sahay adds. 

In March, the government had finalised its borrowing programme for the first half of the current financial year. Out of the gross market borrowing of Rs 14.31 lakh crore estimated for the current fiscal, Rs 8.45 lakh crore was to be borrowed in the first half.

The borrowing was scheduled to be completed in 26 weekly tranches of Rs 32,000-33,000 crore and was spread under 2, 5, 7, 10, 14, 30 and 40-year securities and floating rate bonds of various tenors, said a government press release.

Sahay says that the bond yield curve is set to flatten as more rate hikes by the RBI are expected. 

"From the bond yield perspective, we expect the 10-year bond yield to go up to 7.75 per cent as government borrowing supply is pretty large and we expect the repo rate to go up to 6 per cent," she says.