Wednesday, July 22, 2009

The impact of rising government borrowings

The Union Budget has put the fiscal deficit for 2008-09 at 6.2%, up from 2.7% in the face of a Rs 1,86,000 Cr fiscal stimulus. Though it projects the deficit to remain at 6.8% for 2009-10, all indications are that it will go well beyond this target. However, the Government have also announced its intent to make earnest efforts to cut fiscal deficit as a percentage of GDP to 5.5% in 2010-11 and 4% in 2011-12.

In the coming year, the Central Government is estimated to borrow Rs 4.51 lakh Cr (an increase by 50%) and the state governments (in the face of borrowing limits relaxation from 3.5% of state GDP to 4%) in another Rs 1.61 lakh Cr, taking the cumulative sovereign debt issuance for dated securities to at least Rs 6.12 lakh Cr.

Apart from the fiscal stimulus, this high central borrowings is due to the larger requirement for discount on treasury bills, and interests (coupon payments) on market loans, special securities to oil marketing companies (Rs 10,511 Cr against Rs 5529 Cr in 2008-09) and fertilizer companies (Rs 1,956 Cr against Rs 609 Cr last year), state provident funds, insurance and pension funds.

Recently the Government of India decided to step up its first half year borrowing programme by nearly 25% (or Rs 58,000 Cr) to Rs 2.99 lakh crore, in order to fund "a higher-than-anticipated fiscal deficit, owing to higher social sector spending and lower revenue receipts".

By front-loading its borrowing targets, the Government hopes that it can raise the bulk of its borrowings before recovery is under way, thereby ensuring that its borrowings do not compete with the expected increase in demand for private borrowings if (and this is a big "if"!) the economy picks up full steam in the second half of the fiscal year.

Since the government have already borrowed Rs 1.89 lakh crore from the market, it will raise the balance Rs 1.10 lakh crore till September 30 in ten tranches. The government will issue papers of 5-20 years maturity. Besides, it will also roll over treasury bills worth Rs 86,500 Cr in the proposed auctions.

Encouragingly for the government, banks have been parking an average of about Rs 1.2 lakh Cr evey day (touching even Rs 1.50 lakh Cr) with the RBI through its reverse repo auction window since April, which is up from an average of Rs 46,000 Cr every day in the previous three months. Further, the demand for liquidity through the RBI’s open market operations (OMO) to purchase government securities and thereby expand credit supply, was low.

As Businessline reports, at the OMO auctions, the weighted yields accepted for the 6.05% 2019 and the 7.95% 2032 securities were 6.98% and 7.84% respectively, indicative of the comfortable liquidity position. All this are clear indications of a banking system flush with funds, but unwilling to take credit risks and therefore preferring the safety and liquidity of Government securities despite their lower returns. Though, the RBI had said in March that it would buy about Rs 80,000 Cr worth government bonds through OMOs in the April-Spetember 2009 period, it has so far been able to purchase only Rs 29,850 Cr in the three-and-half months (against the aggregate notified amount for the period for Rs 43,500 Cr).

However, given the magnitude of borrowings, the government may be fighting strong headwinds to stave off higher interest rates some time this year. It is expected that the sheer magnitude of government borrowings would drive up the benchmark interest rates on long term G-Secs. As the graphic below indicates, the yields on 10 year G-Secs have been on their way up.

By deploying such huge amount of resources in stimulating aggregate demand and preventing the economy slowing down considerably, the Government of India may have played its final hand. The success of the stimulus program depends on a series of factors developing along favorable lines

1. The stimulus spending itself will have to deliver the biggest bang for the buck, in generating spending multipliers that stimulate aggregate demand.
2. It will have to "crowd-in" private investments, especially in sectors like infrastructure construction, so that the government investments can leverage private investments to generate a higher than other-wise possible level of investments.
3. Hope that both the aforementioned revives aggregate demand by enough to ensure that growth is sustained even after the bulk of the stimulus runs out by the end of the year. If demand continues to remain weak, the government could be caught in a vicious spiral - weak economy, higher debt service burden and declining tax revenues.
4. Hope that the government borrowings do not have the effect of "crowding-out" private borrowings and thereby snuffing out the emergent buds of revival of economic growth.
5. If the economy recovers before the government borrowings end, the government will end up competing with private borrowers in thee credit markets, thereby putting upward pressure on interest rates.
6. The higher deficits causes Ricardian equivalence to set in, leading consumers to postpone their purchases and save more in the expectation of higher taxes in future.
7. Finally, even if all the aforementioned goes according to plan and recovery is well under-way, there is the very strong possibility of inflation rearing its head and creating another set of equally challenging and complex problems. Inflationary pressures can also arise from the increase in monetary base as this deluge of government spending finds its way into the economy.


Anonymous said...

You Said:
"If the economy recovers before the government borrowings end, the government will end up competing with private borrowers in thee credit markets, thereby putting upward pressure on interest rates."

Since the interest rates are regulated, most banks being PSUs and lack of an effective functioning market, it might mean reduced availablity and not higher interest rates for the private borrowers.

Anonymous said...

Is there an Index of inflation other than WPI. Why is the CPI not used? What are relative weights assigned to different components of the CPI. What set of weights are closet to the AAm admi. Is there such a set developed by any of the left thinking economists

Anonymous said...

How are you going to link the stimulus package/ high government spending to inflation. Can u expand a step by step sequence of actions and consequences leading to such an increase.

What set of government money causes inflation? Is there a point of inflexion somewhere? where does inflation set in and upto what point does it not?

gulzar said...

thanks for those comments. sorry for the long response

1. as you said, "reduced availability" of funds, sooner or (than!) latter, pushes up interest rates. as competition for the same pool of funds increases, the banks slowly start increasing their rates. the biggest and immediate impact will be felt by those other than the Tier I companies, whose cost of capital will shoot up.

though interest rates are regulated, there is considerable room for banks, including PSU banks, to vary their rates. and gone are the days when government diktats could keep a lid on rates by decree.

2. There are four inflation indices - WPI, and three CPI indices for urban non-manual employees, industrial workers, and agricultural labor.

The WPI, with its distribution of weights, is a more accurate reflection of the national economy, while the CPI is a more accurate representation of the impact of price changes on the common man. Unlike other major economies, where inflation figures are published on a monthly or quarterly periodicity and the focus is on WPI, India has weekly figures with focus on CPI.

inflation figures mean different things to different audience. the frenzied weekly debate on inflation in India is meaningless for many reasons - its accuracy is doubtful, we can draw limited conclusions from such variations over a short period etc. academically and for policy makers, the most meaningful set of inflation indices are those (core inflation) stripped off items which can vary sharply over time - foodgrains, energy prices etc. ironically, those are the same things of relevance to common man.

i have discussed this earlier in detail, including aam admi indices and the proposal for changing it.

3. this is not an easy question to answer. inflation is of two types - cost push (one arising from supply side constraints that causes scarcity of the product in demand) and demand pull (arising from excessive money supply in the system). the inflation we experienced last year was contributed more by cost push factors, whereas any inflation now is more likely to be the result of increase in money supply.

the actions of the RBI, by way of monetary (lower rates and eased credit policy by lowering CRR and SLR) and credit policy (multiple liquidity auctions), and by government through fiscal policy (loan waivers, Pay Commission grants, infrastructure spending, tax-direct and indirect-cuts etc)actions to combat the recession have had the effect of pumping large quantities of money/liquidity/credit into the banking system and the economy. The RBIs actions injected money primarily into the banks, whereas the government's actions have been aimed more at directly pumping money into the hands of consumers and firms.

Once the banks' reserves expand,
they generally increase their lending. but unfortunately, despite the higher reserves and lower interest rates, and being flush with liquidity, thanks to the weak economy and the increased risk perception, both banks have been reluctant to lend to borrowers and demand for credit off-take among businesses too have been weak. the result has been - banks flush with liquidity, but both unable and unwilling to lend.

your last two questions do not have easy answers (nor any satisfactory answers at all!). it is almost impossible to accurately predict when inflation is setting in or when those pressures are getting out of control. and even when we belatedly know, though there are a number of options open, it is not possible to say with any degeree of certainty which specific policy or what set of specific policies can be applied to the specific context.