16th March 2012

With regards to the budget, the following points are important from the bond market perspective:

• Fiscal Deficit for FY2012-13 is likely to be at 5.1% against the revised fiscal deficit of 5.9% in FY2011-12 (original budget target at 4.6%)

• Total budget expenditure will be Rs. 14.9 trillion as against Rs. 13 trillion this year

• Net borrowing for FY2012-13 will be Rs. 4.79 trillion

• Gross borrowing will be Rs. 5.69 trillion

• In addition, there will be a net T-Bill issuance of Rs. 0.9 trillion

• Further, a net state loan auction of Rs. 1 trillion

• That will result in a total supply of Rs. 7.59 trillion, a sizeable increase as compared to this year's total supply of Rs. 7 trillion

• Total subsidies bill will be around Rs. 1.8 trillion, more or less in line with market expectations

• Disinvestment target is set at Rs. 300 billion

• Provision to issue tax-free infrastructure bonds of Rs. 600 billion. This may reduce the supply of taxable corporate bonds and may result in tighter spreads for some of these issuers.

• Total subsidies bill will be capped at 2% of the GDP

• Projected revenue targets appear to be achievable

Clearly, the bond market was not happy with the borrowing program.

The benchmark 10Y yield increased from 8.35% to 8.42% pa immediately after the news.

Market participants will be keen to understand how an average weekly supply of around Rs. 150 billion will be absorbed. Moreover, the bond supply is expected to be front-loaded in the first-half of FY13 (65% of total supply).

From the demand side, we believe that the following demand is visible:

• Rs. 3 trillion from the banking system assuming 18% growth in deposits and 28% SLR maintenance level

• Rs. 2 trillion from the insurance companies and pension funds

• Rs. 500 billion from Foreign investors and other investors

That may leave a gap of around Rs. 2 trillion between supply and potential demand, which maybe met through Open Market Operations.

Please remember that this year, the RBI has purchased bonds worth Rs.1.24 trillion this year so far. If one takes into account permanent liquidity injection of Rs. 800 billion via CRR cut, then the total support by the RBI has already reached Rs. 2 trillion this year.

Market participants are likely to be cautious and may begin to scale back their expectations of the extent of interest rate cuts by the RBI in the next fiscal year.

There is also a concern that this borrowing number may rise due to a number of factors such as a lower-than-expected growth in tax collections and disinvestment target being not achieved.

Based on these variables, we believe that the benchmark 10Y yield may revisit 8.55% level (50% rebound from the current fall from 8.97% pa in the near-term. Current level @ 8.45% pa). We also expect the 10Y to trade between 8.33% to 8.55% pa with an upward bias from the technical perspective in the near-term.

We also expect more supply at the long-end of the curve (10Y+) next year. This may help the government increase the average maturity of their borrowings. This will result in a steeper yield curve from the current inverted shape. We believe that short-term rates may ease in response to RBI's interest rate cuts in the first-half of FY2012-13 while long-term yields may inch up due to higher supply in the first-half.

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