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Early warning signals for debt sustainability and repayment have begun to show up, causing concern in bond markets (Photo: iStock)
Early warning signals for debt sustainability and repayment have begun to show up, causing concern in bond markets (Photo: iStock)

What India’s bond market fears

The debt-growth dynamics raises red flags on debt sustainability and puts pressure on the bond market, while making clear that fiscal stress is here to stay

Mumbai: The National Statistical Office (NSO) has pegged nominal growth rate at 7.5% for the fiscal year ending March 2020, the worst on record since 1975. A simple extrapolation of the budgeted fiscal deficit of 7 trillion on the now lower GDP number of 204 trillion, worsens the fiscal deficit ratio to 3.5% of GDP. The actual figures, to be announced in the upcoming budget, may be higher, but the fiscal arithmetic already overshoots targets set by the Fiscal Responsibility and Budget Management (FRBM) Act. While this fiscal slippage in times of slowing growth does not come as a surprise, early warning signals for debt sustainability and repayment have started to show up, causing concern in India's bond markets.

American economist Evsey D. Domar, in 1944, proposed two necessary conditions for public debt to be sustainable. One, nominal GDP should grow at a rate faster than public debt. And two, GDP growth should be higher than interest rates. The Indian economy stands in violation of both the conditions, data on debt and growth rates uptil the September-ended quarter shows.

“Even as inflation has gone up, real GDP growth is expected to improve to only around 5% in the December quarter," said Abhishek Upadhyay of ICICI Securities Primary Dealership Ltd. Judging by WPI inflation till November, nominal GDP is expected at around 7%. This reflects a very narrow interest rate-growth rate (I - G) differential and raises red flags on debt sustainability.

Massive shortfall in tax revenues mean that the only engine of growth today, government spending, is being propped up by increasing borrowing. And if growth does not recover soon, this will further worsen the debt-growth metrics.

The fiscal stress is heightened with state finances deteriorating and states demanding a rise in fiscal deficit limits to 4%. Over the past five years, there has been a 30% increase in the market borrowings of states as they moved from the national small saving funds (NSSF) to state development loans (SDLs) to raise debt, a recent note from CRISIL points out.

Last year, FM Nirmala Sitharaman in her budget speech announced overseas sovereign borrowing to ease pressure on domestic bond markets. While the bond markets cheered, it also raised concerns about insulating debt from currency risks, and the proposal was eventually dropped.

Higher borrowing at a time when growth is slow is likely to worsen the debt-GDP ratio for India. This puts immense pressure on an underdeveloped domestic bond market such as ours. Successive monetary policy rate cuts may have relaxed short term bond yields, but the long-term yields have surged, widening the term premium. Prior to RBI resorting to ‘Operation Twist’ measures in December 2019, the term premium reached 129 bps, the highest on record since the global financial crisis.

More rounds of open market operations may be done to ease the government’s borrowing costs given the impending fiscal slippage, but such moves are not costless. With higher debt comes higher interest obligation. Interest payments have gone up in recent years, and now account for more than 90 percent of the centre’s fiscal deficit.

As an alternate source of deficit financing, the central government is increasingly relying on the NSSF funds left untapped by the states. This takes off pressure from the domestic bond markets partially but it clogs up monetary transmission and raises costs of funds in the economy. The interest rates on these savings schemes are administered much above market rates.

Since banks compete with such schemes for deposits, banks remain unwilling to cut deposit rates. And to maintain their spread (difference between lending and deposit rates) at a time when their balance-sheets are under stress, they are also reluctant to cut lending rates, clogging transmission channels for monetary policy rate cuts. The efficacy of such rate cuts in boosting growth thus becomes limited.

India’s public debt also appears worrying when compared with other emerging economies. Although India’s overall debt levels are in line with peers, public debt levels are on the higher side, and fiscal deficit levels are amongst the worst, even without accounting for delayed government payments that have kept the fiscal deficit figures lower than what they would otherwise have been.

The choice for the government is stark. If it bets on significantly higher fiscal spending in an attempt to boost growth, it would push up bond yields further, and the government (and businesses) would end up bearing a heavy interest burden. And if it humours the bond markets, it won’t be easy for it to provide any growth stimulus in the upcoming budget.

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