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What does RBI’s bonanza to the government mean for interest rates, equity markets?

All the stars are aligned for lower interest rates in India even as uncertainty looms over timing of US Fed’s rate cut decision.

India’s 10-year government bond (Gsec) yield fell to a near one-year low after the Reserve Bank of India (RBI) approved a record surplus transfer to the government. The yield on the new benchmark (7.10 percent coupon rate) fell 4 basis points to 6.99 percent and the yield on the older benchmark (7.18 percent  coupon rate) softened to 7.04  percent on May 22.

Bumper transfer from RBI

The RBI announced the highest-ever dividend of Rs 2.11 lakh crore to the Government of India for FY24 against Rs 87,416 crore transferred in FY23, an increase of 141 percent.

The RBI’s surplus transfer to the government for FY24 is based on the Economic Capital Framework (ECF) adopted in 2019 as per the recommendations of the Bimal Jalan committee. As per the framework, the RBI needs to hold 5.5-6.5 percent of its balance sheet in the form of tangible equity as risk buffers (contingency risk buffer or CRB). Hence, the dividend payout is not only a function of RBI’s profits but also of capital provisions.

It is worth noting that the RBI decided to increase the CRB to 6.5 percent in FY24, citing the resilience of economic growth. The dividend could have been potentially larger than Rs 2.1 lakh crore, if the RBI had provisioned for the minimum requirement (5.5 percent).

A fiscal windfall for the Government

The dividend/surplus transfer of the RBI is a significant source for the government’s non-tax receipts. In FY23, the RBI transferred Rs 87,416 crore, which was 23 percent of revised non-tax revenue of Rs 3.8 lakh crore.

The transfer amount of Rs 2.11 lakh crore (to be accounted for in FY25 fiscal accounts) is more than double of Rs 1.02 lakh crore factored into the interim budget for FY25 as dividend from the RBI and is 53 percent of the non-tax revenue of Rs 4 lakh crore budgeted for FY25.

The additional amount of around Rs 1 lakh crore over the budged estimates is a considerable fiscal boost and translates to around 0.4 percent of the GDP.

This bumper transfer provides the government with the choice of either a faster pace of fiscal consolidation and/or higher spending.

As per the glide path to attain a fiscal deficit of 4.5 percent by FY26,  fiscal deficit is pegged at 5.1 percent of GDP for FY25, the path to which looks relatively easier now.

With the Government well placed on the fiscal front, the probability of upward revision in Government’s borrowing gets ruled out even in the case of a shortfall in telecom receipts, which are part of non-tax revenues. No wonder, the Gsec yield softened.

While yields are a function of demand and supply of bonds, the RBI’s policy action sets a broader direction for interest rates. In that regard, inflation and policy stance become important variables in addition to fiscal deficit and Government borrowing.

Benign inflation and comfortable real rates

The RBI’s target for CPI inflation is 4 percent within a band of +/- 2 percent. The CPI inflation was 4.83 percent YoY in April and has largely remained steady, moderating marginally from 4.85 percent in March. The core inflation persisted at a benign rate of 3.2 percent, largely maintaining the same level as the previous month. While core inflation has consistently stayed below the 4 percent threshold for five consecutive months, food inflation inched up to 7.9 percent and can’t be overlooked.

However, the outlook for food inflation has brightened due to the anticipation of a normal monsoon, which is expected to bolster agricultural production even as the temporal and spatial distribution of monsoon will be critical factors to monitor.

Apart from elevated food inflation, incremental risk to inflation stems from the uptick in global commodity prices, especially industrial metals which are up by around 20 percent in the past three months. Moreover, geopolitical tensions can pose risk to inflation by disrupting supply chains.

Despite all the potential upward risks to inflation, the RBI’s inflation projection for FY25 is at 4.5 percent.

The MPC members have often expressed comfort around a real rate of around 1.5 percent. The real rate, which is the Repo rate (6.5 percent) minus the one-year ahead CPI inflation (4.5 percent) is now 2 percent against the RBI’s comfort level of 1.5 percent. Hence, there is room for rate cut for 50 bps which the RBI is likely to deliver, provided the US Fed also starts to cut rates by then. It is likely to be a shallow rate cutting cycle from the RBI with 50 bps rate cut estimated against the rate hike cycle of 250 bps from May’22.

Inclusion in bond index bodes well for bonds

Among the important technical factors, the inclusion of Indian Gsecs in the JP Morgan Government Bond Index is very positive. Indian bonds will have a maximum weight of 10 percent on the index and the inclusion will be staggered over 10 months, starting June 2024 till March 2025 with around 1 percent weight per month. While April saw net debt outflows after seven months of inflows amid geopolitical tensions (Iran-Israel conflict) and apprehensions around the timing of rate cuts in the US, the inclusion will bring estimated inflows of over $20 billion in the next one year.

RBI’s dividend can give wing to equity rally

RBI’s dividend bonanza will provide the next Government enough dry powder for the final budget of FY25, likely to be announced in July. The interim budget allotted capital expenditure of Rs 11.11 lakh crore for FY25, which is estimated at 3.4 percent of the GDP.

Thanks to the fiscal windfall, the government can continue with its capex thrust post the election by increasing allocations to roads, railways, and defence, which in effect will boost earnings and can justify equity valuations.

The central bank’s pause on interest rates is a real damper for equity markets.  The RBI has unleashed the “long bond” trade with bumper surplus transfer, which, along with the potential rate cuts in the second half of FY25, can give wings to “long equity” trade too