Rising oil to pressure inflation, fiscal deficit

Oil prices at over $90 a barrel is at two-year highs and will put pressure on inflation as well as the fiscal deficit.

The government is scheduled to raise diesel prices at the end of this month on the back of rising losses for oil marketing companies, which stand at Rs65,000 crore on the back of under recoveries in selling diesel.

The government is now in a situation where it necessarily has to raise diesel prices to bring down the subsidy bill as well as pay for the losses already incurred by the oil companies.

Petrol prices, which are decontrolled have been raised by Rs3 per litre in line with the rise in oil prices.

The bond market is now looking at rising inflation expectations, rising fiscal deficit and the spectre of the Reserve Bank of India (RBI) raising policy rates in their policy review in late January.

The fuel price rise comes at a time when food prices are moving up.

Primary article inflation which had trended down to 12.5% levels from 18% levels over a two month period has started to move up again.

Primary article inflation for the week ended December 11, 2010, came in at 15.35% against a 13.25% rise seen in the week ended December 4, 2010. Food price inflation is starting to print higher with the index for week ended December 11 rising by 10.74% against a level of 8.6% seen a few weeks ago.

Global commodity prices are also trending higher with the Reuters Jefferies CRB price index of 19 commodities closing last week at one-and-half-year highs.

Global oil and commodity prices are moving up on consumption demand in China and on better global economic prospects. Domestic inflation will be hit from all three factors oil, food and other commodities.

The government has unspent surplus of Rs1,00,000 crore parked with the RBI. The money is already accounted for with the oil subsidy bill moving up on a daily basis. Till the government compensates the oil companies, the money will remain unspent.
If the government instead starts to resume oil bond issuances for meeting the subsidy, the money lying with the RBI will take a longer time coming back into the system.

The government’s fiscal deficit will not go down despite one time revenue gains from auction of 3G spectrum.

The unspent surplus of the government is straining liquidity with the system borrowing an average of Rs150,000 crore from the RBI on a daily basis. The RBI is looking to ease the liquidity strain by purchasing government bonds. The RBI in its mid quarter policy review in mid December announced bond purchase auctions worth Rs48,000 crore over the next one month. The first auction was held on December 22.

Bond yields have been kept on hold by bond purchases by the RBI as well as by the reduction in the size of government bond auctions.

The last auction size was reduced by Rs5,000 crore from Rs11,000 crore to Rs6,000 crore.

The next auction is scheduled for the first week of January 2011.
Bond yields will remain stable till the January auction and will start trending higher thereon.

The OIS (overnight index swaps) curve moved up by 28 basis points (bps) last week with the one-year and five-year OIS yields moving up 28 bps each.

The upward movement in the swap curve reflects the market expectations of interest rates moving higher in the coming days. Swaps will continue to move higher on fears of inflation and liquidity.

Government bond auction
The government auctioned Rs6,000 crore of bonds last week. The papers under the hammer were the 7.17% 2015 for Rs2,000 crore, the 8.08% 2022 for Rs2,000 crore and the 8.30% 2040 for Rs2,000 crore. The cut-offs came in at 7.87%, 8.04% and 8.44%, respectively.

RBI bond purchase
The RBI purchased Rs8,056 crore of bonds last week. These were the 6.49% 2015  for Rs934 crore at a yield of 7.81%, the 7.46% 2017 for Rs2,279 crore at a yield of 7.85% and the 7.80% 2020 for Rs4,843 crore at a yield of 7.91.