It is ironical that the resignation of a key ally of the UPA is spurring a surge in the Sensex, Nifty, rupee (INR) and ten-year government bond prices. The withdrawal of the support by Mamata Banerjee's Trinamool Congress to the government has the potential to throw the country into a political uncertainty with mid-term elections looming ahead. The markets do not like political uncertainty, and ideally, should have fallen. On the contrary, there is an uptrend. Looking at the way the events are unfolding now, the government is likely to stick to the reforms-reducing oil subsidies and opening up various sectors to foreign investors, the steps that resulted in the UPA's break-up with Mamata.
It is true that to a certain extent the rise of the Sensex and Nifty by over 5.5% this month so far and the 2% plus appreciation of the INR against the dollar have been helped by the bond purchase announcements of the ECB, US Fed and Bank of Japan. With each of these central banks pledging to pump in liquidity to shore up their respective markets and economy, sentiment in Indian markets have improved. However, all the gains could have been negated by a single stroke of reform rollback by the government as allies threatened to withdraw support.
The fact that the government is choosing to hold its ground and also go ahead with more reforms is a clear sign of its resolve to face the consequence-a mid-term election. The markets will not be too concerned with mid-term polls as it sees that any party that comes to power at the Centre will have no option but to carry out the much-required reforms. Whatever the Opposition may say or any new alliance say, the fact remains that if subsidies are not reduced, taxes not rationalised and more FDI not allowed, the economy will go into a tailspin. The markets know this and will sustain the higher levels.
If the UPA manages to remain in power, despite the TMC withdrawing support, it will gain in confidence to carry out more reforms. A fiscal consolidation roadmap is on the cards. The FM is expected to announce these measures by the end of October. The states too need support from the Centre in restructuring loans of their beleaguered electricity boards (SEBs). If this is not done soon, the people will have to suffer more electricity cuts. Fiscal reforms will encourage the RBI to cut its key policy rates, which in turn should result in a rally in government bonds.
The government has indicated that it will stick to its scheduled borrowing for the second half of 2012-13 and not increase the size. Bond markets were worried the government may have to borrow more than the budgeted net borrowing of Rs 479,000 crore, on the back of weakening economy and rising subsidy bill. The government sticking to its borrowing is positive for the bond markets. State governments must also realise that stable government bond yields will lower their borrowing costs. State development loans (SDL), raised through securities issued by state governments, are sold at spreads over the government bond yield. Many states have extremely poor finances due to their government's fiscal profligacy. Their finances would have worsened if the borrowing costs go up.
The Centre is banking on this weak footing of the state governments to carry out tough economic measures. However, many of the UPA's allies opposed to tough economic measures know that such measures directly affect their own constituencies. It is all nice to cry out against fiscal consolidation, but at the end of the day the states will actually be more in trouble than the Centre if the government's fiscal position deteriorates.
West Bengal is bankrupt and Mamata has to go to the Centre for funds. If the Centre does not have money to bail out West Bengal, where will Mamata go? The government knows this and markets too are sensing it. Expect more rallies going forward.
Arjun Parthasarathy is the Editor of www.investorsareidiots.com, a web site for investors.