Mumbai: The Reserve Bank of India (RBI) has been able to push down the yields on Central government papers by rejecting higher bids at bond auctions but the yields on state government papers have been on the rise.
To bridge widening fiscal deficits, state governments are offering 10-year paper at rates as high as 8.9% at a time when the yield on the 10-year Central government security is 6.6%. The difference, or the spread, between Union and state government papers is now about 230 basis points, at least three times than what is seen even in a bullish market. One basis point is one-hundredth of a percentage point.
Banks and provident funds have been buying these bonds even though there is practically no secondary market for them. The investors hold on to them as a high-return, government-backed, long-term investment.
On 17 March, at least 11 state governments raised Rs12,114.920 crore from the market in a fully subscribed auction in which Andhra Pradesh raised Rs1,925 crore at a yield of 8.59%. On 9 March, 10 state governments raised Rs14,095.345 crore, with Assam offering an 8.89% yield.
RBI rejected all bids in its Central government bond auction last week as dealers were asking for a high yield.
Total borrowings by state governments, including Tuesday’s auction, have crossed Rs1 trillion against a target of Rs59,000 crore.
Given the glut of of government paper, investors are demanding higher coupons on state government bonds. “These bonds are very illiquid, so they have to have a high coupon,” said N.S. Venkatesh, managing director of IDBI Gilts Ltd, a primary dealership firm that buys and sells government securities.
According to him, banks use these bonds to boost their investment income, as well as meet the mandatory investment in government securities, currently 24% of deposits.
While they have other sources of funding, the main financier for the states remains the Union government. But as Central government revenues contract due to the slowdown in the economy, state governments are taking a hit. The Central government in February also cut its service tax and excise duty, a loss of Rs30,000 crore to the exchequer.
All these translate into less money for the states and force them to raise money from the market to fund their deficits. The combined gross fiscal deficits of Indian states is expected to go up to Rs1,12,653 crore in fiscal 2009 from Rs1,07,958 crore a year ago and Rs77,509 crore a year before that, according to RBI’s annual publication State Finances: A Study of Budgets.
One of the main reasons for this high deficit was the fall in investments in small savings certificates, or SSCs, such as National Savings Certificate and Kisan Vikas Patra, which offer an interest rate of 8.5%.
Funds from these schemes, collected by state governments, go into a cental bucket from which it is disbursed to states, but at a 100 basis points premium. Of late, though, SSCs have fallen out of favour, declining 30% from fiscal 2006 to fiscal 2008 as banks have stated offering more attractive interest rates.
“However, last year, with banks offering 10% and above interest rates on fixed deposits against small savings rates of around 8.5%, a lot of money got diverted to the banking system and collections in small savings were lower than they were in past years,” said Pradeep Madhav, managing director of STCI Primary Dealer Ltd.
To bridge the gap, state governments have hit the market like never before.
As per the 12th Finance Commission recommendations on Centre-state tax distribution for 2006-10, states are allowed to decide how much they want to borrow from the market provided the amount does not exceed 3% of their gross domestic products. In its interim budget in February 2008, the Union government allowed states to run a deficit at 3.5%, an increase of 50 basis points, in the next fiscal year. This would allow states to borrow an additional Rs30,000 crore.
“These (state government) bonds also don’t hurt banks’ profitability much if they have to provide mark to market losses on it. The spread for calculating mark to market is only 25 basis points more than the similar benchmark central government paper,” said Venkatesh of IDBI Gilts. Mark to market is an accounting practice of valuing assets by current market price and not the cost at which they are bought. But the biggest reason for investors’ rush to state government bonds is the same as in any other downturn: security. As Joydeep Sen, vice-president of the advisory desk at BNP Paribas Wealth Management, said, “The state government bonds are a safe bet for investors. They don’t default, have high coupon rates and (are) guaranteed by the government.”