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Markets Unnerved by Downgrade

The reaction of the market does not absolve the government of fiscal profligacy

A liquidity-driven market survived the double whammy of downgrades this week. Contrary to the general belief that yields would rise sharply, players had scant regard for the lowered ratings as prices continued to move up. The yield on the 2011, 11.50% sovereign bond fell to 9.26% after touching a mid-week high of 9.36% as panic offloading was seized upon as buying opportunity. The sentiment was further perked up by RBI governor's statement that the soft interest rate bias would continue. Backed by record forex reserves and ample selling from public sector banks, the rupee continued to hold its ground and closed the week at 47.11 to the dollar.

The week also saw the twin auction for Rs 6,000 crore of sovereign bonds. However, the downgrade broke the string of heavy over subscription with the first devolvement of the current fiscal. The 2013 paper for Rs 4,000 crore devolved on the RBI and primary dealers with the market expecting a higher yield on the back of S&P downgrade. On the other hand, the 18-year paper attracted heavy over subscription. Despite reporting Friday and auction outflow, call rates continued to rule steady.

Someone Must Bite the Bullet!
While the markets received a pat on their back from the finance minister for holding steady, the RBI governor also timed his statement to perfection as he dangled the candy of softer interest rates. Yet, this does not absolve the government of fiscal profligacy with low inflation, stable rupee and falling interest rates providing little fodder for argument against the downgrade. Both the rating agencies have chided the government for splurging scarce capital even as the pace of reforms has slackened. Moody's even went a step forward as it highlighted the recent problems plaguing state-controlled institutions.

Further, even though the economy continues to go from bad to worse, there has been no credible blueprint from the government on how it plans to trigger growth. While industrial growth has slumped to 2.1% for the first quarter against 6.1% for the previous year, business confidence is at a two-year low. The much-hyped dis-investment process has also failed to deliver tangible results. There is surely a genuine concern on the fiscal front with unchecked deficits. Its high time the government spent more on revenue generating avenues and act business like while putting a lid on wasteful expenditure. With fiscal imprudence being the centre of downgrade, the government could now be under pressure to table the Fiscal Responsibility Bill.

With the markets ignoring the downgrade, buying momentum is expected to continue on the back of a surfeit of liquidity. Fresh borrowing is also not likely in the near future as the government will receive an annual dividend payment from the RBI. Further, with the CRR on inter-bank term liabilities gone, more money will come into the system. The yield on the 10-year benchmark, which had dropped to a historic low of 9.2% in mid-July, could now breach the earlier level. However, profit booking could emerge at those levels. Buying, though, is expected to be concentrated at the medium-end of the segment, as markets remain watchful. Most bond funds have already scaled down their portfolio maturity with the average now under 4 years.