GST rejig from bond market's lens

Long term government bonds were the primary beneficiaries with yields on the 15 years+ maturity Indian government bonds (IGBs) easing 15 basis points over the three trading sessions following the announcement.

This seems paradoxical given long term government bonds are highly sensitive to government’s fiscal position and the GST rate cuts are widely expected to put pressure on government finances.

So, what led to the rally in the bond market? How would GST rate rationalisation affect the fixed income markets going ahead?

Perhaps the long-term bonds had sold off excessively in anticipation of GST cuts last month. Perhaps, the market was expecting a larger fiscal burden than what is estimated now. The actual impact seems to be lower than market expectations and thus, a relief rally after the actual announcement. Or maybe the probable disinflationary impact has led to expectation of rate cuts from the RBI. It can be attributed or any or all the factors mentioned herein.

However, the market outlook going ahead will be contingent on the interplay of the fiscal and monetary policy and growth impulse produced by the GST rate rationalisation.

Nevertheless, fixed income market will be sensitive to fiscal estimates.

The government has pegged the fiscal cost of the GST rate rationalisation at Rs. 480 billion (0.16% of GDP) based on the consumption data of FY 2023-24.

GST revenues are divided equally between the centre and states. Furthermore, state also get 41% of the centre’s taxes. Thus, the fiscal burden will fall in proportion of 30:70 for centre and states respectively.

From market’s perspective, the estimated fiscal impact seems manageable for FY26. However, the fiscal position of both the centre and states may become incrementally challenging—making fiscal consolidation harder.

The fiscal impact is appropriately captured by the bond market by adding fiscal risk premium on the long-term bonds leading to a much steeper yield curve than few months back.

During the initial GST rollout and follow on reduction in rates between 2017 to 2019, the passthrough was slow, partial and asymmetric. The average effective GST rate was brought down from 14.4% in May 2017 to near 11.6% by September 2019 (Source -RBI State Finances Report 2019-20). But the core CPI inflation which broadly captures the prices of household goods and services, didn’t show any notable decline. Corporations were reluctant to pass on the tax cuts on goods while tax increase on services were passed on immediately.

Assuming a conservative 50% passthrough, we see around 50 bps downside to CPI inflation with much of that coming in the second half of FY26.

In the monetary policy review early next month, the monetary policy committee (MPC) might revise down its inflation forecast. However, we expect the RBI to remain on hold and preserve the available policy room to deal with any contingency given the heightened external uncertainty and pending passthrough of earlier monetary policy easing and tax cuts.

Given the stable outlook on inflation. the monetary policy might remain on hold with lower for longer rate setup and easy liquidity environment.

For the bond market, the balance of risk is still favourable.

While tighter fiscal position and limited monetary easing room may limit downside on bond yields, easy liquidity environment and deteriorating global growth outlook may keep the yield upside under check. All in all, bond yields should remain in a narrow range unless there is any material shock to growth/inflation expectations.

Pankaj Pathak is fund manager, fixed income.

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