Government bonds fell and swap rates surged on Monday on concerns the central bank would delay interest rate cuts after the budget set a higher-than-expected fiscal deficit target.
Presenting by the budget on Saturday, Finance Minister Arun Jaitley set a fiscal deficit target of 3.9 per cent of gross domestic product for the fiscal year starting in April. Markets had expected a target of 3.6 per cent.
The government also said it would cut the deficit to 3 per cent of GDP by the 2017/18 fiscal year, one year later than previously projected.
Although Mr Jaitley also pledged the government would be fiscally responsible, traders said the looser fiscal deficit targets could persuade the Reserve Bank of India (RBI) to be more cautious lowering interest rates despite easing inflation.
After unexpectedly cutting interest rates in January, the RBI has made future rate cuts contingent on government action to shore up its finances. Its next policy review is in early April.
An agreement between India's government and the RBI over inflation targeting, in the biggest change to monetary policy since India's economy was opened up more than two decades ago, did not have much impact since it had been broadly expected.
"I am in the camp which believes that the fiscal deficit is more realistic and RBI will keep on easing monetary policy. However some in market believe that a rate cut may be postponed due to the higher fiscal deficit number," said Harish Agarwal, a fixed income trader with First Rand Bank.
The benchmark 10-year bond yield rose 4 basis points to 7.76 percent, the highest since Jan 14, while the one-year swap rate surged 4 basis points to 7.71 per cent.
Credit rating agencies also issued a cautionary note on Monday, saying the budget was unlikely to impact the country's ratings given the absence of meaningful fiscal reforms.
Although analysts broadly lauded the budget for seeking to spark an investment-led boom, they said said it fell short on structural reforms, with the government leaving major welfare schemes untouched and only cutting fuel subsidies thanks to a collapse in international oil prices.
The partially convertible rupee weakened slightly to 61.96 per dollar compared to its 61.83/84 close on Friday, tracking weaker emerging Asian currencies after China cut interest rates at the weekend.
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