A view normally held is that higher government borrowing tends to put pressure on interest rates—which, in turn, affects the private sector’s ability to invest, and, hence, probably growth. The rationale is that there are fixed sums of money available with banks which have to be deployed as credit or investments. When the government borrows more, then there are fewer funds available for the private sector and there is a crowding out phenomenon. Further—even if funds are available—the cost goes up as yields on bonds rise, which sets the pitch for the deposit and credit rates as they indicate the risk-free rates that have to be adjusted with the premium to be charged. Intuitively, when more government paper floods the market, the price of government bonds decline due to oversupply conditions which, in turn, push up yields.
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The fiscal deficit for the year is around Rs4 trillion and the borrowing level in net terms is around the same level. Government officials have maintained that there is not going to be any significant crowding out because there are surplus funds in the system to the tune of Rs1-1.5 trillion presently that are being invested by banks in the reverse repo auctions. Therefore, while interest rates are not expected to come down, they would also not move up significantly to cause disturbances. What, then, is the true picture?
The accompanying table provides a peep into the past to show how these numbers have tallied when borrowings were high. The first column provides information on the difference between incremental deposits and credit every year, which is the unadjusted surplus (before accounting for the cash reserve ratio, or CRR) that banks could invest in government paper. The difference between these surpluses/deficits and the net government borrowing programme is seen in the next column as the “system’s deficit”. This gives the deficit that was created on account of the government’s borrowing programme after considering the surpluses that were available with banks from their incremental deposits. Different interest rates, such as the prime lending rate, deposits rate for one year, reverse repo and repo rates and the 10-year bond rate, have then been juxtaposed to discern the reaction of interest rates to this situation.
Now, the deficit in funds has been present in eight of the 10 years, with the deficit being very high in fiscal 2005 and fiscal 2006, which has now peaked in fiscal 2010. However, interest rates have shown a continuous decline up to fiscal 2004 and fiscal 2005 and then increased subsequently before declining in fiscal 2010. The rate of increase or decline in interest rates has not been related to the quantum of the system’s deficit increasing or decreasing, and appears to be more a part of a trend. In fact, it would not be incorrect to say that interest rates have been influenced more by policy rates than existing liquidity. Government securities (G-Sec) rates were relatively marginally more related with liquidity when the deficit was high.
There is evidently a conundrum here, where we are witnessing large borrowings that are not being financed by the banks, leading to a deficit. Yet, there are surplus funds in the banking system as evidenced in the reverse repo auctions. And interest rates are not in sync with the liquidity trends. How does all this add up?
To begin with, it must be pointed out that banks are one set of entities that purchase government paper. Reserve Bank of India (RBI) data for March shows that banks hold around 40% of government paper, followed by insurance companies with 23%, RBI with 10% and primary dealers and provident funds with around 10% each. Therefore, while banks are the most important supplier of funds, the same flows from other entities too.
Two, the market stabilization scheme (MSS) of RBI helped to absorb surplus funds a couple of years ago, and these funds have been used astutely to finance the government borrowing programme in the form of unwinding of the same.
Three, RBI has been reducing CRR at regular intervals to provide more funds. Since September, for example, a reduction of 400 basis points in CRR meant a supply of at least Rs1.5 trillion.
Lastly, key bank interest rates have been guided, though not dictated, more by policy rates than implied liquidity. In fact, even the G-Sec rates which should be most affected by liquidity have a countervailing force that works in the government’s favour. When deposits growth is tardy, savings get channelled into other avenues such as insurance or provident funds which, in turn, invest in government paper. Hence, as long as the gross domestic product is growing and the marginal propensity to save is increasing, there will always be funds for the government—unless there is a major shift to the capital markets. Besides, bank deposits are rarely substituted with equity, as the class of investors is different, as is the risk profile.
All this means that we really may not have to despair of the large government borrowing programme for the year, and the system may just be able to tide over this hurdle with minimum pain.
Table by Ahmed Raza Khan / Mint
Madan Sabnavis is chief economist, NCDEX Ltd. These are his personal views. Comments are welcome at email@example.com