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Photo: Mint

Stealth attacks will not be able to fund our fiscal deficit

Anonymous bond-buying by RBI can’t go too far but India can explore options like a big loan against equity

A severe Siberian winter in 1972 destroyed much of the wheat crop in the Soviet Union. The Soviets were keenly looking at foreign sources to meet their large food deficit. Early that summer, they had signed a large grains-for-peace deal with America, agreeing to buy wheat from the US over multiple years. This was a prized deal for the Richard Nixon administration, much wearied by the Vietnam War and in need of re-election. It was expected to bring some cheer and fetch fat profits for American farmers. The Soviets had been “arm twisted" into an assured purchase of at least $200 million worth of wheat per year over three years, with a cumulative total of no less than $750 million. For this, they were also given access to private grain traders in the US. Unknown to the Americans, the Soviets secretly split up their buying teams, each working on a need-to-know basis. Through tough negotiations at covert meetings with large private traders held in New York, Washington and Chicago hotel rooms, Soviet buyers bought one fourth of 1972-73’s US wheat output in forward deals. They bought a billion dollars worth of grain in just one month. By the time the Americans woke up, it was too late.

Thanks to this great “grain robbery", it was the US instead that faced a wheat shortage and high food inflation (especially beef as cattle feed ran short). Mark Penn has called the 1972 US-Soviet grain deal the “economic Bay of Pigs" for the Nixon administration. It’s a separate matter that Nixon won the White House by a landslide.

Faced with a daunting shortage of food, the Soviets had planned a stealth attack on world grain markets and secured adequate supplies to meet their deficit at a very low price. Is it possible for the Indian government, or its banker, the Reserve Bank of India (RBI), to do something similar? Can India also launch a stealth attack and quickly garner enough funds to feed its monstrous fiscal deficit next year? The analogy with the wheat heist may sound far-fetched, but a recent headline gave it plausibility. Business Standard has reported that RBI had “anonymously" scooped 26,000 crore of bonds in a single day. It seems that RBI wants to secure a very large quantity very cheaply, reminiscent of the Soviets. Alas, we are not in 1972 anymore, and markets are far more vigilant and omniscient today. They know what’s up and won’t be caught off guard.

So, stealth options are out, and there is no assurance available on the quantity and price of the country’s deficit funding. There are, however, still some unexplored and unorthodox options. The first is a loan against shares.

India’s gross borrowing requirement for next fiscal year, including that of state governments, is about 23.3 trillion. Of this, the Centre alone will account for 12.05 trillion. A “forward deal" a la the Soviets to secure cheap funding, which will meet a big part of this deficit, would be a bilateral loan-against-shares deal between RBI and the Centre. It can bypass the debt market, be priced at a reasonably low rate of 4%, and be in the nature of a five-year repo. The pledged shares would have to be returned or sold in dribbles over the same period. In any case, the Centre is planning large-scale privatization of public sector entities. So, this loan-against-shares would simply advance future sale proceeds for today’s use. (See ‘An out-of-the-box solution for India’s stimulus problem’, Mint, 5 May 2020). Given a euphoric stock market, the estimated value of the government’s holdings in public sector companies is close to 20 trillion. Slow-dribble sales, or periodic haircuts of the shares pledged, might be easier to implement as a privatization strategy.

RBI’s anonymous buying of government bonds is like wanting to have one’s cake and eat it too. But you can’t have both adequate funds and low costs to bear on a massive borrowing programme. This has been especially so since 1997, when the government opted to respect market discipline on debt pricing. If there is a shortage of funds, then interest rates must go up. With next year’s gross domestic product (GDP) growth anticipated in double digits, demand for non-government credit will be at least 12% of GDP, which is about 25 trillion, in addition to credit demand from the government. How can such large demand sustain low prices, i.e. low yields on government securities? Even in America, where government borrowing even at its most bloated is a much smaller fraction of its overall credit demand, yields have spiked quite a bit in recent weeks. Hence, the second option is for RBI to let yields climb to ensure smooth bond auctions, so that it does not need to resort to anonymous raids on the bond market.

A third option is for RBI to pay member banks interest on cash reserves. The cash reserve ratio will soon be at 4%. Thus, RBI will be locking up nearly 6 trillion of banks’ money. Why not pay them interest on these funds at, say, 3%? This will give banks an additional income of 18,000 crore, which would bolster their capital base. This would be like earmarking a part of RBI’s balance sheet for the health of the banking sector, rather than turning it over to the central exchequer as a general dividend.

The fourth option would be to tap foreign markets. Sell either ‘masala’ or a dollar-denominated bonds through a proxy for the sovereign, like State Bank of India.

The Centre’s large fiscal deficit will be tackled neither by stealth nor by cleverness. It needs old-fashioned market discipline, and a slow and steady chipping away of it.

Ajit Ranade is chief economist at Aditya Birla Group.

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