The bond market has not yet come out in open rebellion, but there are now growing signs that banks are less eager to buy government bonds and the interest rates on these bonds are climbing. The yield on the benchmark 10-year Indian government bond on Tuesday touched its highest level since the panic after the collapse of Lehman Brothers subsided.
Illustration: Jayachandran / Mint
The reason for this unease is well known. The fiscal deficit has soared, partly because of higher spending to support domestic demand in an economic slowdown and partly because of the huge increase in money poured into politically attractive social sector schemes.
The government will have to borrow a record Rs4.51 trillion this year to fund a deficit that is estimated at 6.8% of national output. The finance ministry has tried to reassure investors that this massive claim on national savings will not harm the chances of the private sector to borrow at reasonable interest rates once the economy recovers. But that seems an increasingly hollow assurance.
Reserve Bank of India governor D. Subbarao has used almost every public occasion available to him in these past few weeks to say that the sheer size of the government’s borrowing programme makes it difficult to bring down market interest rates.
There are no quick fixes. We do not think that the two most obvious choices—increasing money supply or allowing more foreign money into the government securities market—are worth pursuing right now. More money flooding the economy will fan inflation. More foreign investment in government securities is risky, given the high fiscal deficit.
The only sustainable way out of this awkward corner is to have a credible plan to cut the fiscal deficit as soon as the economy stabilizes. The first Manmohan Singh government squandered a brilliant opportunity during the economic boom, when it could have used record tax collections to set public finances in order.
The 11th Finance Commission will hopefully put in place a new set of fiscal rules to constrain government profligacy. The recent experience suggests that the fiscal deficit should be defined in terms of total public sector borrowing requirement, so that the off-balance sheet fudging that took place in the last two years of the previous government is avoided.
But till we return to fiscal sanity, the bond market and international credit rating agencies will continue to be worried.
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