Yield Premium Nearing Record Spurs Subsidy Review: India Credit

Indian Finance Minister Pranab Mukherjee
Indian Finance Minister Pranab Mukherjee. Photographer: Pankaj Nangia/Bloomberg

India’s government, forced to scrap plans to reduce subsidies after a popular backlash, is being compelled by investors to cut spending after the premium on sovereign debt approached a record and the rupee slumped.

The finance ministry is paying 679 basis points over U.S. Treasuries to raise funds for 10 years, approaching an all-time high of 696 basis points reached in November. The rupee has slumped 6.8 percent this quarter, the worst performance among Asia’s 11 most-traded currencies, after Standard & Poor’s said there is a one-in-three chance that the nation will lose its investment-grade rating.

Finance Minister Pranab Mukherjee told parliament last week he wouldn’t hesitate to “bite the bullet” on rolling back subsidies to trim the deficit as the rupee dropped to a record low and the benchmark Sensitive Index of shares headed for a third monthly drop. The shortfall in finances, including states, will be the equivalent of 8.8 percent of gross domestic product in 2012, compared with 2.3 percent for Brazil and 0.8 percent for Russia, according to the International Monetary Fund.

“They are worried about the drop in the rupee, and it is clear that the markets are forcing the government’s hand on mending its finances,” Upasna Bhardwaj, a Mumbai-based economist at ING Vysya Bank Ltd., the local unit of the biggest Dutch financial services company, said in an interview on May 17. “Cutting the subsidy bill significantly will restore investor confidence to a certain extent.”

Handouts in the year ended March overshot the government’s estimate by 51 percent to 2.16 trillion rupees ($39.6 billion) as oil prices rose. Mukherjee plans to curb expenditure on subsidies to 1.9 trillion rupees, or 2 percent of GDP, in the year that started April 1, according to budget documents. The government will aim to restrict the proportion to 1.75 percent in the next three years, Mukherjee told lawmakers on May 18.

Oil Imports

The government may raise energy prices this quarter as it can’t afford higher payouts, a finance ministry official said on April 23, asking not to be identified because the person isn’t authorized to speak on the matter. Gasoline prices were last raised in November, and those of diesel, kerosene and cooking gas in June. Refiners sell fuels below cost as policy makers seek to curb price increases for 30 percent of the population that lives below the poverty line set at 50 U.S. cents a day.

The rupee’s drop is making oil imports more expensive in a nation that relies on overseas markets for about 80 percent of its requirements. The currency slumped 0.5 percent today to 54.6865 per dollar, taking its drop this month to 3.6 percent.

‘No Option’

“The government has no option but to raise fuel prices as with the depreciating rupee it could end up paying a whole lot more than estimated on oil subsidies alone,” Sujan Hajra, the Mumbai-based chief economist at Anand Rathi Financial Services Ltd. “The fiscal situation could deteriorate and it could impact the credit rating. A hike in fuel prices, particularly diesel, is a fait accompli.”

Government bonds reversed a four-month rally through February after Mukherjee said the government missed its goal of curbing the fiscal deficit to 4.6 percent of GDP by 1.3 percentage points and set the target for the current fiscal year at 5.1 percent. The yield on the benchmark 8.79 percent notes due November 2021 rose one basis point, or 0.01 percentage point, to 8.53 percent today.

Rupee-denominated securities returned 0.27 percent this quarter after earning 1.8 percent in the first three months of the year, according to indexes compiled by Bank of America Corp.

‘Slow’ Progress

The cost of protecting the debt of State Bank of India has more than doubled in the past year. Credit-default swaps on the state-run lender, which some investors consider a proxy for the nation, cost 372 basis points on May 18, compared with 177 basis points a year ago, according to data provider CMA, which is owned by CME Group Inc. and compiles prices quoted in privately negotiated markets.

The revision to the outlook on India’s credit rating reflects “slow” progress on fiscal reforms “in a weakened political setting,” S&P said in a statement on April 25.

Former Rail Minister Dinesh Trivedi said he was raising subsidized passenger fares by as much as 0.30 rupee a kilometer when he presented his annual budget for the state-run network on March 14. Trinamool Congress, his party and an ally of the ruling Congress party, opposed his decision and forced him to resign.

Trinamool’s leader Mamata Banerjee has been a source of opposition to the government in the past, stalling his plans to bring foreign supermarket chains into the nation, as well as blocking passage of an anti-corruption law and proposals for a nationwide counter-terrorism center. Singh shelved proposals to allow foreign direct investment in pensions in December after Trinamool refused to support the move.

‘Coalition Compulsions’

“The government may not be able to roll back subsidies by a whole lot or even raise fuel prices,” Amol Agrawal, a Mumbai-based economist at STCI Primary Dealer Ltd., said in an interview on May 18. “Coalition compulsions have been there for a long time and the government’s hands are tied because of it.”

Shares of Indian companies fell 0.9 percent last week, taking the drop for May to 6.4 percent, the biggest monthly decline since November.

Global funds have pared holdings of India’s bonds by $416 million since the end of March to $29.6 billion, set for the first quarterly reduction since 2009.

The rupee’s three-month implied volatility rose to this year’s highest level today, signaling greater potential for losses. The gauge, which traders quote as part of options prices, climbed nine basis points to 13.1 percent.

Prices of crude oil traded in New York will increase 15 percent to end the year at $106 a barrel, according to the median forecast of strategists in a Bloomberg survey.

“Some prudence by the government is overdue and a fuel-price increase in inevitable,” Killol Pandya, the Mumbai-based head of fixed-income investment at the local unit of Daiwa Asset Management Co. that oversees about $200 million, said in an interview on May 18. “Overall, such a move will be good for the economy.”

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