Whalesbook
State Deficits Grow, Pushing Up Yields
The combined fiscal deficit for Indian states is expected to reach 3.4% of GDP in fiscal 2025-26, up from 2.8% in FY23. This contrasts with the central government's efforts to cut its deficit. Increased populist spending and a larger supply of State Development Loans (SDLs) are competing for available funds, leading to higher borrowing costs. There are concerns that newly elected state governments might increase borrowing further and expand cash transfer programs.
Balance of Payments Faces Increasing Pressure
India's balance of payments is expected to show a growing deficit, projected at 2.3% of GDP in FY27, up from 0.9% in FY26. The deficit is estimated to widen to $65 billion this fiscal year, from $35 billion last year. Higher crude oil prices, forecast at an average of $95 per barrel, and a global trend towards protectionism are key factors. The Middle East crisis has worsened these deficits, with FY27 marking the third consecutive year of shortfalls. This situation challenges economic stability and requires careful management of monetary and exchange rate policies.
Geopolitical Risks Fuel Inflation and Weaken Rupee
Tensions in the Middle East have disrupted global energy and fertilizer prices. India, heavily reliant on Gulf countries for energy, is particularly vulnerable, leading to a weaker Indian Rupee against the US Dollar. If these geopolitical issues continue, they will likely increase inflation, pressure economic growth, and widen the fiscal deficit. Globally, 10-year sovereign yields have risen significantly since the West Asia crisis began, reflecting increased geopolitical and inflation risks.
Global Monetary Policy Outlook Shifts
Market expectations for Federal Reserve rate cuts have decreased, with some now predicting a possible rate hike in 2027. Options pricing suggests a roughly 30% chance of a hike by early 2027. This change in the global monetary policy cycle could affect interest rates and removes a factor that the Indian bond market had anticipated. The combination of higher borrowing needs, balance of payments concerns, and geopolitical risks points to a potential rise in India's 10-year government security yield to the 7.25-7.50% range.
Policy Actions to Support Markets
To calm market sentiment, policymakers are advised to offer clear guidance and provide liquidity and regulatory support, alongside structural reforms. Recommendations include accelerating bond index inclusion, offering tax breaks for foreign portfolio investors in debt, and creating special deposit schemes for Non-Resident Indians (NRIs). The Reserve Bank of India (RBI) is injecting liquidity into the bond market and has arranged a $5 billion dollar-rupee buy-sell swap to manage liquidity and support the Indian currency. Enhancing fiscal credibility through rule-based fiscal and debt management is also considered crucial.
Fiscal Slippage and External Weakness Pose Risks
Widening state fiscal deficits are a major risk to India's overall fiscal health. The estimated consolidated deficit of 3.4% of GDP for FY25-26, partly due to populist measures, increases the supply of SDLs and drives up yields. Unlike some developed nations that focus on fiscal consolidation, India faces potential further slippage. The projected current account deficit widening to 2.3% of GDP in FY27, alongside a weaker rupee and higher global energy prices from geopolitical tensions, exposes India to external vulnerabilities. Dependence on imports for energy and other essentials means global supply chain disruptions and price shocks can significantly impact inflation and growth. Reduced expectations of Fed rate cuts also remove a supportive element for the Indian bond market, potentially leading to higher borrowing costs.