Government finances seem to be headed for a mess and the bond market is already sending out early warning signals. Higher spending and weaker tax revenues are likely to send the consolidated fiscal deficit of the Union and state governments into double digits, at which point a strike by local and foreign bond investors could push India close to a macroeconomic crisis.
There is nothing wrong in using a fiscal stimulus to counter an economic slowdown, but a lot depends on the circumstances. The ability of the Indian government to boost economic activity through higher fiscal deficits is constrained by two factors. One, the ability to actually complete the public projects that are announced, or the lack of state capacity. Two, the fiscal deficit is already too high for comfort and further public spending may be a threat to economic stability, or the lack of fiscal space.
Illustration by Jayachandran / Mint
The domestic money market is already worried that higher government borrowing to finance a growing deficit will push up interest rates. A new report by investment bank Goldman Sachs points out that the yields on government securities of all maturities have climbed in the past week because of plans by the government to borrow extra money for its growing deficit. This is in sharp contrast to the drop in yields to at least 10-year lows when interest rates were cut earlier this month. What’s more, the yield curve has become steeper: the difference in the yields on short-term three-month securities and long-term 10-year securities widened.
As domestic money market rates rise, there will be further pressure on the Reserve Bank of India (RBI) to cut its policy interest rates and help banks lend more by reducing the amount of cash that they have to keep with the central bank. The overnight index swap market—a good indicator of monetary policy action— seems to be pricing in further monetary easing.
The race will then be between growing demands by the government on local bond markets (which will push up interest rates) and pressure on RBI to ease monetary policy (which will push down rates). That will entail a balancing act between sustaining growth and maintaining economic stability.
Fiscal stimulus is based on a simple premise—do not have money but will spend. The success of that strategy depends on the readiness of lenders in the bond market to finance this deficit.
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