In my growing-up years, I was captivated by Aesop’s Fables, in particular by the story of The Boy Who Cried Wolf. To those who may not recall it, the story was about a shepherd boy who, to amuse himself while engaged in the monotonous task of tending to his sheep, once shouts, “Wolf! Wolf! The wolf is chasing the sheep.”
Not surprisingly, it has the entire village coming out to protect the herd of sheep grazing on the hillside. When it turns out to be a hoax, the villagers returned to their chores, mightily peeved and equally amused. Inspired, the boy does it once more and the villagers fall for it again. The third time, a wolf actually turns up, but the villagers ignore his shout, figuring the shepherd boy is just having fun.
The central message of the fable was the trust deficit that the shepherd boy encountered. Something similar to how bond markets are responding to the government’s commitment to sign onto a programme that would, over the next five years, lower the country’s fiscal deficit, or government borrowing.
Excessive government borrowings have prevented the bond markets from defining a yield curve based on pure demand-supply trade-offs; as a result, the pricing of paper is distorted. There has, therefore, been a persistent demand for reining in government debt to prop up a legitimate and market-based debt market in the country.
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Actions speak louder than words. The yield on 10-year government paper was 7.83% just prior to the Budget. A week after finance minister Pranab Mukherjee made his commitment, based on the recommendations of the 13th Finance Commission (TFC), in the Lok Sabha that the government would reduce its borrowings in line with a transparent timetable, the yield had gone up to 7.94%.
Since bond yields and prices are inversely related, it is obvious that the price of 10-year government paper has fallen. As we all know from basic microeconomics, prices fall only when there is excess supply: clearly, bond dealers believe that borrowings would be more than estimated, and, hence, supply of government paper, contrary to what the finance minister claimed, is actually going to go up.
It is a promise they have heard before from several finance ministers in the last two decades. While occasionally they have adhered to it on paper, more often than not, this has been attributed to creative accounting where legitimate government spending is shown outside the official books.
Maybe bond dealers are being unduly conservative. Or maybe they are right in suspecting that the United Progressive Alliance (UPA) will not be able to deliver on its promise of fiscal rectitude by curbing government expenditure on subsidies. A conclusion on this debate is possible only at the end of the next financial year. For the moment, we can only read the tea leaves.
There are several reasons why these circumstances may be different from what prevailed earlier. The Congress-led UPA is probably the strongest alliance to assume power since coalitions became the governance norm over a decade ago. This is because the Congress has 208 seats in the coalition and has backed it up with a string of electoral victories at the state level, emphasizing for the moment that it does not really face a serious political challenge.
It has so far exploited this advantage without actually shedding the pro-poor branding that it has so assiduously cultivated. And it has cleverly linked its anti-poverty actions to its ability to sustain growth, which, in turn, is based on its ability to pursue some long-pending economic reforms. In this Budget, it has taken it to the next level, saying that the UPA was committed to the poor, but was equally determined to realize value for every rupee that it spends on development programmes or subsidies.
In India, nothing happens overnight. And if it is being driven by the Congress party, one can safely expect a long period of attrition while it wears down the opposition. For example, while it promised a clean-up of fertilizer subsidy in the July budget for 2009-10, it was not till last month that it actually got its coalition partner, the Dravida Munnetra Kazhagam (DMK), which heads the fertilizer ministry, to sign on.
It has now, taking off from the TFC recommendations on more action on expenditure reforms with a large focus on subsidies, to reduce and then eventually eliminate the revenue deficit—the difference between revenue spending such as interest payments, and receipts such as taxes. The commitment is a remarkable departure as the UPA is promising action on some of the most politically sensitive items.
The markets believe that it can’t do so. The Congress and the finance minister are firm that it can do so in the medium term. And herein lies the trust deficit.
The response of the bond markets has only raised the stakes further. The UPA can’t afford to fail in implementation of the key Budget promise. It should remember that economic success begets political longevity.
Anil Padmanabhan is a deputy managing editor of Mint and writes every week on the intersection of politics and economics. Comment at email@example.com