New Delhi: Record borrowing needed to fund India’s plans to ramp up spending this fiscal year threatens to backfire and choke off a nascent economic recovery.
While governments around the world are trying to spend their way out of recession, India’s case is special: its economy has remained relatively robust, inflation risks are higher than elsewhere and credit is growing scarce.
With global oil and commodities prices rising in recent months and adding inflationary pressure, India’s central bank could even be forced into raising interest rates before Asia’s third-largest economy has recovered fully.
The Budget unveiled by the newly re-elected Congress party-led government on Monday poses upside risks to rates in terms of higher yields, as well as to inflation, due to its expansionary stance, said DBS economist Ramya Suryanarayanan.
“The Budget has definitely increased those chances, and at a time when the economy needs more spending towards infrastructure for a sustainable recovery. More supplies (of government debt) will crowd that out,” she said.
The record $93 billion in borrowing planned to fund a 36% spending hike in the 2009/10 budget also risks stifling the flow of credit to businesses and gives banks even more reason to keep lending rates high unless the central bank buys large chunks of the debt, analysts said.
Finance minister Pranab Mukherjee said this year’s fiscal deficit will rise to 6.8% of GDP. With state-level deficits added in, Suryanarayanan expects India’s consolidated fiscal shortfall to cross 12% of GDP.
India’s yawning fiscal deficit is a problem. The government debt-to-GDP ratio is just under 80%, almost double the norm for emerging Asian markets.
Unlike other emerging economies like South Korea, India’s government sells bonds entirely to the domestic market, making it more likely that it will crowd out local corporate borrowers looking to raise funds for operations or expansion.
Then there is timing. The government will be keen to avoid a year-end credit squeeze that begins with the October harvest season and festivals like Diwali, which usually falls in October or November.
That means the government will likely hope to limit any market disruptions to a shorter period by packing in most of its extra borrowing by end-September, taking the weekly borrowing requirement to an unprecedented Rs13, 800 crore ($2.86 billion) over three months and putting upward pressure on bond yields just as the economy appears to be turning the corner.
Higher borrowing costs will spill into the broader economy at least partly because banks are required to invest 24% of their deposits in government debt.
Even before the government’s borrowing plan was announced, banks were reluctant to lower rates. The central bank has cut its main lending rate by 425 basis points since October to spur growth, but state-run banks, the dominant players, have reduced lending rates only by 150-200 basis points in that time.
Benchmark yields have already risen 184 basis points this year on expectations of heavier government borrowing.
Ten-year bond yields are hovering near three-month highs over 7% and on Monday rose 16 basis points after the budget was announced, their biggest one-day rise since late March. Yields built on their gains on Tuesday as concerns of excess government supplies pushed down bond prices.
Piyush Wadhwa, senior vice-president at ICICI Securities Primary Dealership, said with cash conditions ample, loan growth muted and bank deposits rising, policymakers would be eager to complete the bulk of the borrowing in the next few months.
A jump in the 10-year bond yield to 7.5% due to the surge of debt would erase the effect of the central bank’s easing, said Rajeev Malik, an economist at Macquarie Securities.
Bond traders said the flood of new supply will likely push 10 years above that 7.5% level in the next two to three weeks, and expect the central bank to try to stave off any further sharp spikes from those levels.
“It would mean borrowing costs remain high as a result of which the central bank would have to step in to ensure the nascent investment recovery doesn’t get choked off,” Malik said.
The flow of credit needed to lubricate India’s economy is already slowing. Loan growth fell to around 16% in late June from 27% in November.,”
In a bid to control yields, the central bank has been buying government bonds since February.
Finance secretary Ashok Chawla said on Monday the central bank would absorb about half the government’s borrowing needs.
Central banks around the world from the US Federal Reserve to the Bank of Korea have been pouring cash into their banking systems, potentially stoking inflation down the road, and will have to extricate themselves from bond markets, hoping to make only minimal disruptions.
But India’s economy needs less stimulus than most and the inflation risks are higher.
Indian GDP growth slowed to 6.7% in 2008/09 from nearly 9% in the previous five years, but has held up better than most of its more export-reliant Asian neighbours.
Prices, meanwhile, are rising from a year earlier due to domestic demand. Indian consumer price inflation was 8.6% in May, due mainly to rising food prices. Wholesale price inflation, the most closely watched price barometer, has been rising since February.
Bond markets are already expecting some kind of policy tightening by the central bank late this year, likely in the form of siphoning excess cash from money markets.