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Will states pay more to borrow?

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MUMBAI: State governments may have to pay more for future capital-market borrowings as large provinces, including Uttar Pradesh and Tamil Nadu, are expected to sell bonds to plug deficits, adding to the glut of debt paper and pointing to likely higher yields.

West Bengal, Andhra Pradesh, Telangana and Madhya Pradesh are the other governments likely joining the countrys most populous state and peninsular Indias economic powerhouse in tapping the capital markets, where the spread between the benchmark central bond and state debt offerings may almost double to 120 basis points from 65 bps now.

Indias banking regulator has already underscored its concerns over the weakening financial health of state governments.

"If the deficits of state governments were to widen, they may have to increase their market borrowings to fund the gaps," said Naveen Singh, ICICI Securities Primary Dealers. "Going by the current market dynamics, states will need to borrow more in the second half since they deferred their borrowing by not sticking to the calendar, which could lead to a rise in yields.”

State government securities are now valued using the yield to maturity method. Bankers add a uniform mark-up of 25 basis points above the benchmark central government bond yield of equivalent maturity. Still, the market yields of state securities differ from the values in bankers books, and are typically higher than the book value. The Reserve Bank of India has, therefore, suggested market-linked pricing in its June policy, although the modalities are yet to be finalised.

"The spread between the benchmark yield and similar maturity state bonds will expand further once new valuation norms kicks in," Singh said.

The RBI study suggests that states had budgeted a gross fiscal deficit to gross domestic product ratio of 2.7% in 2017-18; the revised estimates place it at 3.1%, essentially due to shortfalls in tax revenues and higher revenue expenditure.

According to market estimates, the net supply of state government bonds, known as State Development Loans (SDLs) in market parlance, would be at about Rs 2.27 lakh crore. States have been sluggish in tapping the debt market in the first four months of FY19.

“Supplies on spread assets, SDL, and corporate bonds have been muted so far in the financial year,” said Suyash Choudhary, head of fixed income at IDFC Mutual Fund. “This will likely change going forward as both state and corporate bond issuances pick up. We also expect corporate and SDL spreads to widen from here, especially over the second half.”

Between April and June, companies have sold bonds, which is about 50-60% less than the quantum issued in the corresponding period last year.

Moreover, the RBI has also spoken about obtaining credit rating of state government bonds. This has kept the market guessing if such a move could either lead to lower rating or on a par with the central governments sovereign grade.

“The yield spread (between the benchmark and state government bonds) could well expand to historic highs if the supply of papers in SDL increases,” said Ajay Manglunia, executive vice president – fixed income markets, Edelweiss Financial Services. “Also, once markets start assigning differential credit gradation, borrowing costs of a few of them may vary.”

The spreads were as high as 100 basis points more than a year ago, which contracted to 30-40 basis points some months ago.

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