States on borrowing binge bad news for Narendra Modi and Indian bonds

With an ever-rising supply of debt that offers yields higher than sovereign notes, borrowing by states threatens to overshadow that by the Centre


Narendra Modi plans to borrow a net Rs4.2 trillion in the coming year. Photo: PTI
Narendra Modi plans to borrow a net Rs4.2 trillion in the coming year. Photo: PTI

Mumbai: Prime Minister Narendra Modi’s government is finding itself pitted against an unlikely competitor as it pursues bond investors to finance the budget deficit: Indian states.

With an ever-rising supply of debt that offers yields higher than sovereign notes, borrowing by state administrations threatens to overshadow that by the federal government, according to Edelweiss Asset Management Ltd and HDFC Standard Life Insurance Co. That complicates matters for Modi, whose promise of fiscal discipline has lured foreigners to local bonds after a four-month hiatus.

Increased competition from states is also bad news for the sovereign-debt market, which saw benchmark notes in February post their biggest monthly loss since 2013, after policy makers in Asia’s third-largest economy signalled an end the monetary easing cycle. There is also a growing risk that, unless state deficits are pared, their debt levels could quickly get on to “an explosive path,” JPMorgan Chase & Co. said in a February report.

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“There’s an increasing amount of concern over the states’ bond supply and the time when it will overtake government bond supply is not far away,” said Dhawal Dalal, chief investment officer for debt at Edelweiss Asset. “Concern about the health of the states is also something that worries market participants.”

Working together, India’s 29 states combined would form a bloc that has a bigger economy than the whole of sub-Saharan Africa, more members than the European Union, and twice the population of North America. Net borrowing by states will rise 12% to Rs3.8 trillion ($58 billion) in the next financial year, after an estimated 30%-surge to 3.4 trillion in the fiscal year ending this 31 March, according to ICRA Ltd. Modi plans to borrow a net 4.2 trillion rupees in the coming year.

“The disproportionate market focus on central finances masks the fact that India’s fiscal centre-of-gravity has rapidly moved from the centre to the states,” Sajjid Chinoy and Toshi Jain, economists at JPMorgan Chase, wrote in the report. Borrowing by states is poised to overtake the centre’s by 2018-19, they said.

Financial stress

Why are the states borrowing so much? Revenue losses suffered on account of Modi’s shock currency recall in November and higher wages for staff have strained their finances, according to ICRA, the local unit of Moody’s Investors Service.

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“The consolidation of recent years seem to be coming apart,” said Aditi Nayar, principal economist at ICRA in Gurgaon. “Servicing of debt related to the power sector-restructuring” is another factor contributing to the worsening state finances.

Borrowing costs reflect the stress. States sold 10-year debt at an average cut-off yield of 7.89% at an auction Tuesday, versus 7.15% at the 10 January sale. Similar-maturity sovereign bonds paid 6.78% in Mumbai Thursday, indicating that the yield spread has widened to more than 100 basis points. The historical mean is 40-50 basis points, according to JPMorgan.

That’s an impending challenge for Modi even as he celebrates his party’s resounding victories in just-concluded state elections, including in Uttar Pradesh, India’s largest.

While higher yields and the implicit sovereign guarantee are a draw with investors, the securities are hardly a match for government bonds when it comes to liquidity. That’s partly why foreign investors, who were granted access to state debt in late 2015, have largely stayed away from the sector.

Investment by global funds stands at Rs14.8 billion, data from the National Securities Depository Ltd show. That’s just seven percent of the Rs210-billion limit available to them.

“We buy state bonds only for portfolios where liquidity risk is not a concern, because the yield offered is close to top-rate corporate bond,” said Badrish Kulhalli, Mumbai-based fixed-income manager at HDFC Standard Life. “The extra supply of state bonds means the government bond yield curve will also steepen.”Bloomberg

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