Saturday, February 21, 2009

Observations on increase in government borrowings

Faced with increasing demand for a third round of fiscal stimulus and declining tax revenues, the Government of India have decided to borrow an additional Rs 46,000 Cr between February 20 and March 20. This would take the overall borrowings of the Government for the financial year to Rs 2,71,000 Cr, as against the budget estimates of Rs 1,35,000 Cr. A few observations on this

1. The "liquidity preference" of banks, with the resultant flight to government securities, means that there will be no dearth of buyers for this debt. In the natural course, this demand for safe government securities, coupled with low and declining inflation, should have meant lower yields on them.

2. The RBI has been purchasing government securities in large quantities in recent weeks as part of its liquidity injections to un-freeze the credit markets. This too has acted to raise bond prices and lower yields.

3. However, the announcement of additional borrowings elicited an immediate response from the debt markets, driving up the yields on long term Treasuries in expectation of higher future interest rates. In recent weeks, the yields on the benchmark ten year government bonds have risen steeply from a very low 4.86% in January to 6.43%, well outside the repo rate (5.5%) and reverse repo rate(4%) band, another indication that the markets are pricing for expected higher interest rates in the future. It is being estimated that this benchmark rate could stabilize above 7% for the medium term atleast, thereby anchoring inflationary and interest rate expectations. This signal is not desirable as it would immediately generate negative expectations among businesses about borrowings and investments.

4. The higher long term yields will, at some time in future, also have the effect of crowding out private borrowings, as businesses get put-off by the higher cost of capital. This is not so much a problem now as the economy slows down, given the reluctance of private businesses to make investments. During such times, only government investments can bring the idle resources and capacity to full use.

5. There is also a self-fulfilling dimension to this. Higher yields only makes government securities even more attractive for already risk averse banks, thereby "crowding out" private borrowers even more.

6. The high level of borrowings required are yet another reason for the RBI to lower interest rates. Besides reducing the immediate debt service burden, it would also give it enough room to manouevre when it comes to rasing rates as inflationary signals invariably show up sometime later.

7. The borrowings will drive the fiscal deficit, including the states and off-balance sheet entities, well past 10% of GDP (Some predict it to be around 13%, including all off-balance sheet liabilities). This raises questions about how the government will unwind the debts it is running up. The prospects of higher interest rates in the future bodes ill for exiting from this debt burden. Further, in such uncertain economic times, such macroeconomic imbalances can be heavily penalized by the markets, with potentialy disastrous consequences on the rupee exchange rate and our external balance.

8. It is therefore necessary that these costly borrowings be spent on those measures that deliver the largest bang for the buck. And tax cuts, by way of which the government has already doled out over Rs 50,000 Cr in corporate welfare to boost the bottom-lines, are surely not the most effective way of stimulating the economy. More so developing economies like India where the price transmission belt is riddled with imperfections.

Apprehensive of driving down long term bond prices, the Government have announced that it will not raise the additional Rs 46,000 Cr by market borrowings or overseas borrowings. It has also ruled out private placement by the RBI. Therefore the only options left are to either monetize by printing money or to draw from the account created to keep the rupee funds collected by issuing bonds under the Market Stabilization Scheme (MSS) (the bonds were issued to sterilize the rupees released on forex market interventions to keep rupee from appreciating). Of the two the latter looks are more plausible alternative since it would not have any immediate "crowding out effect".

The borrowings are not likely to have any adverse immediate impact in crowding out private borrowings or raising interest rates. The credit market freeze and anemic economic expectations means that both the banks are not coming forward to lend and the businesses are not willing to make investments by borrowings. Further, the low and declining inflation means that there will be no pressure to raise interest rates. To this extent the Government is blessed with favourable macro-economic environment to sustain large borrowings. The challenge will be to unwind these positions once the economic growth picks up and inflationary pressures start showing up.

Update 1
As expected the Government have entered into an MoU with the RBI to de-sequester the MSS funds, so as to enable the Government to mop up its borrowings without having any impact on interest rates. Rs 45,000 crore will be transferred in instalments from the 'MSS cash account' to the normal cash account of the Central Government by March 31. An equivalent amount of government securities earlier issued under the MSS would now form part of the normal market borrowing of the Centre, according to the RBI.

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