Budget 2018: What Equities And Bond Markets Tell Us

While the equity markets seem to have comprehensively disapproved of Jaitley’s last full budget, the response of bond prices indicate the likelihood of hardening interest rates in the future

Two needles moved decisively after Union finance minister Arun Jaitley announced his budget for 2018-19. Both movements provide some clues on how to read the budget.

The first needle—indicating stock market health—oscillated wildly during Jaitley’s speech and continued to fluctuate thereafter. The BSE Sensex started floating downwards soon after the finance minister began reading his budget speech on Thursday morning, disheartened by the heavy overload of social sector announcements. It then dropped further on news of a new long-term capital gains (LTCG) tax, recovered slightly and ended the day marginally below opening levels. But, on Friday, it capsized as the full weight of the budget sank in. By the time markets closed on Friday, Sensex had lost almost 900 points, or close to 2.5%, over its Wednesday closing.

This sell-off can be read in multiple ways. The charitable justification is that the stock market was over-valued and investors needed an excuse to make a correction. The moderate explanation is that investors are unhappy with the budget maths, the expenditure programme, the lack of visible funding sources, lack of clarity over the generous spending programme and the red light flashing over the fiscal deficit levels. The extreme view is that the sell-off revealed a marked distaste for the new LTCG levy, an inexplicable 42% jump in the securities transaction tax collection next year (raising fears that the tax rate might be increased in the interim) and the inclusion of equity mutual funds in the dividend distribution tax net.

The Sensex started floating downwards soon after Jaitley began reading his budget speech, disheartened by the heavy overload of social sector announcements. Photo courtesy: AFP and Mint.

In short, whatever the reason, it does seem that the equity markets have comprehensively disapproved of Jaitley’s last full budget. It’s perhaps also an expression of the market’s scepticism with the numbers.

For example, there is no accounting for many of the grandiose spending schemes. Analysts are clueless how either the minimum support price programme for farmers, or the ambitious health coverage scheme, will be financed. There are doubts even about some of the capital expenditure schemes. Many of these are likely to be launched in conjunction with states, giving rise to a fresh wave of cynicism about their viability.

In most cases, the policy architecture is yet to be worked out. Making announcements before finalizing the policy contours is a curious practice, somewhat like a nervous sentry shooting first and asking questions later.

Some disingenuous measures on the personal tax front might have also left a bad taste. For example, a standard deduction of Rs 40,000 that was announced as relief for the salaried taxpayers was negated the next moment by an increase in cess from 3% to 4%. In fact, the budget relies heavily on cess collection, a revenue source which the centre does not have to share with states, betraying signs of nervousness not only about revenue collection but also about the impending political battles that lie ahead.

The second needle—bond markets—is providing a far more layered story of what lies ahead. Reacting to budget arithmetic, especially the government’s spending and planned borrowing programme for 2018-19, 10-year government bond prices fell and yields rose, indicating the likelihood of hardening interest rates in the future. The Reserve Bank of India (RBI) announces its sixth bi-monthly monetary policy on 7 February and it will be interesting to see what emerges.

One thing is certain though: the prospect of a rate cut now seems to have receded. On the contrary, RBI is likely to adopt a tightening stance, with oil prices rising globally, bank credit picking up, money supply growth clocking 10.7%, the government’s borrowing programme looking unrealistic and poised to breach the budgeted target (just like the current year) and general uncertainty over how the government’s proposals will impact the price line.

For example, there are questions over whether the 50% increase in kharif minimum support price will impact the consumer price line or whether it has already been priced in.

Pressure on yields will emerge from another front if Jaitley’s plans for the corporate bond markets take off. Jaitley’s speech stated that securities markets regulator Securities and Exchanges Board of India will soon come out with rules that will compel large corporates to source 25% of borrowings from the corporate bond market. In addition, he said many sectoral regulators will be asked to relax investment rules in their respective industries; for example, the insurance regulator might henceforth allow insurance companies to invest in A-rated bonds when the current rules draw the line at AA-rating. To facilitate growth of the corporate bond market, Jaitley also promised to reform the stamp duty regime in consultation with states.

Even if we leave aside the oddity of telling corporates where to borrow, the development has the potential to affect government bond yields and, subsequently, interest rates. While the government has kept its FY19 borrowing programme largely the same as FY18 (Rs6.06 trillion against Rs6.05 trillion), any additional borrowings over the budget target is likely to have consequences for interest rates.

And as the ruling Bharatiya Janata Party gets into election mode—as was evident from the budget speech’s tone and tenor—and spending gets subjected to realpolitik, the likelihood of a bloated borrowing programme and deviation from the fiscal deficit glide path cannot be ruled out. It’s election season after all.

The above article was written for Mint newspaper. It can also be read here

Time To Go To FRDI Bill’s Roots

Controversy around the bail-in clause aside, FRDI Bill’s clauses 58 and 62(1) regarding governance of a firm declared critical are inherently conflicting

Much has been said and written about the Financial Resolution and Deposit Insurance Bill, 2017. The FRDI Bill was scheduled for discussion in Parliament this winter session but will now have to yield to more immediate concerns such as the Gujarat election results and the Central Bureau of Investigation special court’s verdict on 2G spectrum allocation. In addition, the joint committee of both Houses is yet to submit its report on the bill.

Public discussions on the FRDI Bill have focused on the formation of a resolution corporation and its bail-in powers in the event of a financial company going bust. The said corporation will monitor financial services companies, in coordination with regulators, and resolve them in case of failure. Bail-in implies using the company’s various existing liabilities—different debt categories or deposits not covered by deposit insurance (all deposits over Rs1 lakh)—to resolve impending failure. This is different from bailout, which implies external help, such as government using taxpayer money.

There may be some merit in constructing a resolution regime, given the financial system’s broader linkages. But there are other equally larger issues that also need highlighting, especially because they explain how we got here.

First, there is a need to discuss the relevance of an imported idea, a palliative designed for a different disease in a different body. Soul-searching after the 2008 financial crisis and its broader systemic impact through economic linkages led to the idea of a resolution corporation. It was felt necessary to design shock absorbers to insulate the economy and other financial sector institutions in the event of one single organization going bust, à la Lehman Brothers. The idea was discussed in various global governance institutions and rules were framed.

Some of the global credit rating agencies have been following up assiduously on the progress of implementation. Eyebrows are raised at jurisdictions, especially emerging economies, continuing to defer a resolution regime or designing a custom-built framework suited to their economy. In the meantime, the US, the epicentre of the crisis—which used taxpayer money to bail out all banks, including ensuring hefty bonus payouts to bankers—continues to enjoy the highest credit rating. Irony has, of course, been missing from the global credit rating lexicon.

In India, the idea of a resolution corporation was advocated in 2013 by the Financial Sector Legislative Reforms Commission. This was followed up in 2014 with a Reserve Bank of India (RBI) working group report on crafting a resolution regime for financial institutions. Finally, in 2016, a Union finance ministry committee submitted a draft code on the resolution of financial firms.

Speaking in Parliament on 21 December, Union finance minister Arun Jaitley defended the FRDI Bill, claimed that depositors’ money in public sector banks would be protected and said that the bill was the outcome of a commitment made by the previous government to G20. Jaitley is right. The resolution framework was part of the G20 leadership’s final declaration at the 2011 Cannes summit. Ironically, there’s also a segment in the same communique that’s titled ‘Avoiding Protectionism and Reinforcing the Multilateral Trading System’; see where that’s got us.

This goes to the heart of the issue. The Indian government’s willingness to accept a cut-and-paste formula is curious, coming as it does on the back of similar decisions in the past which seemed alien to the peculiar complexion of India’s financial services—salary cap for financial sector chief executive officers and tightening regulation of “shadow banks”, leading to a squeeze on non-banking financial corporations which provide a unique last-mile solution to the Indian banking system, among others. In a system where banks (with an overwhelming public sector presence) dominate the financial system and are extensively regulated by RBI, there should be some discussion about whether importing regulatory frameworks, in universum, makes sense. More pertinently, whether the bail-in provisions recommended in the Financial Stability Board’s October 2014 guidelines are applicable to India.

By the way, all those fond of citing Singapore’s examples of good governance should look at the city-state’s proposed resolution regime, which excludes all deposits and senior debt from bail-in.

Secondly, there’s the issue of democracy and fundamental rights. In its current form, the FRDI Bill disallows the proposed corporation’s resolution process from being challenged in courts. This might be necessary to avoid undue delays in the resolution process and to avoid failure of wobbly financial companies. But it’s also like a slippery slope: the overwhelming presence of government representatives on the corporation’s board (including regulators’ representatives) can convert the corporation into a blunt tool of vengeful political action. It also disregards the RBI working group’s recommendation that a grievance mechanism be built into the process.

The larger, moral question is: Why does the FRDI Bill have to start off by being ham-fisted and draconian? Add poor drafting to that list; think tank PRS Legislative Research demonstrates how clauses 58 and 62(1) regarding governance of a firm declared critical are inherently conflicting. There are other similarly inconsistent clauses.

Finally, there’s the spectre of new regulators chipping away at the powers of old regulators, such as RBI. It raises the question: Does it really remedy anything?

The above article was originally published in Mint newspaper and can also be read here