Budget 2013: Interest rates will fall only slowly

The finance minister delivered a fiscal deficit of 4.8% of GDP as expected by the markets. What does it mean for the economy? Will interest rates come down and government bond yields fall?

A fiscal deficit of 4.8% of GDP translates into an absolute amount of Rs542,000 crore. The government will go to the bond market to finance 89% of the fiscal deficit or Rs484,000 crore.

The absorption of this government borrowing will determine the direction of interest rates in the economy.
Banks, insurance companies, pension and provident funds, FIIs, mutual funds and other institutional investors absorb the government borrowing.

Banks are the single-largest category of buyers of government bonds and are expected to take up 41% of the government borrowing assuming a 13% deposit growth in 2013-14 and 23% of those incremental deposits being deployed in government bonds.

Higher deposit growth will help banks absorb more of the government borrowing.
The rest of the government borrowing will be taken up by others.

RBI has been buying government bonds for the last four years to add liquidity into the system and could well buy more government bonds in the coming fiscal.
RBI buying around Rs1 lakh crore of government bonds will help the government borrowing go through smoothly.

Apart from the government borrowing, the lower trajectory of inflation that is estimated at around 6.5% levels will help RBI reduce the repo rate from current levels of 7.75%. Lower repo rates should translate into lower deposit and lower lending rates assuming liquidity with the banks are comfortable.

The bond market’s immediate reaction to the Budget was negative as the market was expecting a lower government borrowing amount.

However as the market goes into fiscal 2013-14 it will gauge the demand for government bonds, prospects of rate cuts and liquidity to determine direction of bond yields.

Interest rates should look to trend down in fiscal 2013-14 but the fall will not be immediate and will be slow and steady.

The writer is editor, www.investorsareidiots.com,