Hours after Pranab Mukherjee presented his Rs10.21 trillion Union Budget on Monday, India’s central bank said it would auction Rs15,000 crore worth of bonds on Friday, almost double the amount it was originally slated to borrow from the market this week. This signals that the action now shifts from North Block on Raisina Hill in New Delhi, that houses the finance ministry, to Mint Road in Mumbai, where the Reserve Bank of India (RBI) is headquartered. The onus of making Mukherjee’s gamble on growth through the borrow-and-spend formula a success rests squarely on the shoulders of D. Subbarao, governor of the central bank.
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In the interim budget in February, Mukherjee had projected a Rs3.62 trillion market borrowing by the government in fiscal 2010, through its investment banker RBI. At that time, the fiscal deficit for the year was estimated to be 5.5% of India’s Rs54.3 trillion gross domestic product (GDP). Now it has gone up to 6.8%. And since Mukherjee has not found any other avenue to generate revenue, RBI will have to borrow an extra Rs89,000 crore from the market, taking its overall borrowing programme in the year to Rs4.51 trillion, a level never seen before. In the last fiscal, when the government had to announce a series of stimulus packages to bring the economy back on track after the collapse of Wall Street investment bank Lehman Brothers Holdings Inc. led to an unprecedented global credit crunch, the government borrowed Rs2.61 trillion from the market. In fiscal 2008, the government had borrowed Rs1.82 trillion. At Rs4.51 trillion, the government will need to raise on average Rs37,500 crore every month from the market. This is also Rs75,000 crore more than what the Indian banking system lent to corporations and individuals, and almost 70% of the deposits that the system mopped up in the year to mid-June.
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In addition, the banking system will have to take care of an additional Rs1.6 trillion worth of borrowing by the state governments during the year. Mukherjee’s Budget has empowered Indian states to borrow Rs21,000 crore more from the market this year— 0.5% of state gross domestic product—following the recommendation of the Planning Commission. After all this, the banking system will be left with very little money to lend to others. Moreover, there is no guarantee that the government will be able to stick to its estimate of fiscal deficit; in all probability it will crawl up and reach about 7%.
Yields on government bonds have been on the rise, but there is no panic as yet in the market as RBI seems to be confident of facilitating such a huge borrowing programme, with “least disruption”. Anticipating higher fiscal deficit and the need for more money to take care of that, RBI has been borrowing Rs3,000 crore extra every week in the past one-and-a-half months, already raising Rs18,000 crore from the market. It will borrow Rs15,000 crore later this week against the previously planned Rs8,000 crore. This will take the extra borrowing to Rs25,000 crore, leaving a gap of Rs64,000 crore that RBI will have to manage in rest of the year. And even for that there is a ready solution. RBI has already transferred Rs28,000 crore worth of intervention bonds to the government and plans to transfer Rs5,000 crore more, taking the total to Rs33,000 crore.
The intervention bonds were floated between 2004 and 2007 under the so-called Market Stabilization Scheme, or MSS, to soak up excess liquidity that was created because of RBI’s intervention in the foreign exchange market. The central bank was buying dollars to check the runaway appreciation of the rupee because a strong local currency hurts exporters by reducing the rupee equivalent of their foreign exchange earnings.
For every dollar that RBI bought, an equivalent amount of rupees flowed into the system and the central bank sucked out the excess money through MSS bonds and treasury bills. Under the arrangement, MSS bonds are kept with a special account of RBI, and hence do not impact the fiscal deficit of the government. However, the interest paid on it by the government adds to the fiscal deficit.
After transferring the MSS bonds to the government’s book, technically known as desequestering, RBI will still have to find ways to manage Rs31,000 crore extra borrowing from the market. So far, the government has borrowed Rs1.62 trillion this fiscal.
Bankers are not a worried lot yet as there is abundant liquidity in the system and either there are not too many takers for bank credit or banks themselves are not too keen to lend for fear of loans going bad. Since the beginning of the current fiscal year and till mid-June, there has in fact been a Rs5,334 crore decline in banks’ credit portfolio, and even on Tuesday banks parked Rs1.39 trillion with RBI’s repurchase window.
But the situation may change soon. In the second half of fiscal 2009, Indian public sector banks had sanctioned fresh loans worth Rs6.18 trillion and many corporations now plan to make fresh investments. When they actually start knocking on banks’ doors, banks will have no money to lend. So interest rates will go up and money will become more expensive. This will deal a blow to Mukherjee’s plan to ride out the slowdown through more spending and more borrowing as rising interest rates can kill growth. It’s another matter that a higher fiscal deficit may encourage global rating agencies to downgrade India’s sovereign rating to junk. And that will again push up the borrowing cost for Indian companies. From now on, what RBI does to manage the government’s borrowing is more important than what the finance minister promises Bharat. If RBI trips, Mukherjee’s gamble on growth won’t pay off.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai. Please email comments to firstname.lastname@example.org