The Indian bond market, which has been languishing over the last several years, is expecting a shot in the arm in the forthcoming Union Budget.

Austerity measures, including strict fiscal discipline, are crucial at a time when the economy is facing a challenging environment. The government has announced a medium-term fiscal plan, under which fiscal deficit is expected to decline to 3 per cent of GDP by 2016-17. It has also made it clear that it would strive to achieve a 5.3 per cent of GDP budget deficit in 2012-13 and would be improved further to 4.8 per cent in 2013-14.

“One of the major impediments to growth of corporate bond market is the huge overhang of the government bond market, which, in turn, is because of the high fiscal deficit,” said Ajit Ranade, Chief Economist, Aditya Birla Group.

“The government bond market will cheer every effort to reduce the fiscal deficit, and if the Finance Minister is able to pull down the fiscal deficit to GDP ratio to 4.8 per cent in 2013-14, then the supply side pressures on the bond market will be lower,” said Samiran Chakraborty, Head, Research, India at Standard Chartered Bank.

Worldwide, bond financing is more popular than bank financing for firms, but in India it is the reverse. There are several other factors which also impede progress. Firstly, there is very little liquidity or trading in the secondary market. Secondly, issues such as tax deductibility and stamp duty are factors too. Thirdly, bankruptcy laws too need to be streamlined to enable growth of the corporate bond market. Lastly, bond ratings also deter the development, although this requirement cannot be dispensed with.

Despite the best intentions of policy-makers, development of the corporate bond market has been rather tepid in the past.

Two steps in the budget, according to Mr. Chakraborty, that could give some immediate relief are reducing the withholding tax on FII investment in corporate debt and increasing the investment limits for insurers in AA rated paper.

Some analysts believe that the demand-supply balance for government securities to be tilted marginally against the bond markets even with an optimistic 4.8 per cent fiscal deficit.

Upasna Bhardwaj, Economist, ING Vysya Bank, expects the government to finally deliver around 5.2 per cent of GDP as fiscal deficit, thereby putting additional pressure on bond supply towards the later part of year. However, the rate cut cycle and open market operations (OMO) purchases would continue to support the bonds. “We expect RBI to cut repo rate cautiously by 50-75bps, trending the 10-year yields towards 7.20-7.40 per cent towards the second half of 2013-14.”

However, the budget announcements may bode well for bond markets, according to Ashish Agrawal, Asia local rates strategist of Credit Suisse.

The government’s ability to stick to this year’s fiscal deficit target is a significant positive, while progress on the fiscal front with subsidy reduction is one of the pre-requisites for the RBI to ease policy rates. “Targeting a lower fiscal deficit for 2013-14 will be another positive,” he said. In the near term, completion of this fiscal’s borrowing programme coupled with potential foreign institutional investor purchases of bonds will likely fuel the on-going rally.

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