Market borrowings of the government do not always squeeze credit for the private sector in India
The so-called “crowding out" effect refers to how increased government spending, for which it must borrow more money, tends to reduce private spending. This happens because when the government takes up the lion’s share of funds available in the banking system, less of it is left for private borrowers. This also impacts interest rates in the economy.
In 2003, India introduced the Fiscal Responsibility and Budget Management (FRBM) Act. The aim of this law on fiscal prudence was to institutionalize financial discipline, reduce India’s fiscal deficit to 3% of gross domestic product (GDP), and improve macroeconomic management and the overall management of public funds by moving towards a balanced budget. We are not sure what data analysis went into fixing 3% as the limit. The Centre has found it hard to meet that target. Its fiscal deficit for 2019-20 is expected at 3.7%-plus, and if state deficits are added, it could be in excess of 6%.
Typically, the government funds its fiscal deficit by borrowing from the domestic bond market. Its expenditure is also local in nature. The Reserve Bank of India (RBI) is the official banker to the government, which spends money by first taking an overdraft from the central bank. This overdraft gets repaid through bond market borrowings. The understanding is that any such government spending should ideally not affect the availability of funds to other borrowers in the market. However, excessive government borrowing from the bond market, many caution, could lead to a rise in interest rates for the government itself and consequently for everyone else in the economy.
We considered a weekly data set of RBI from April 2012 to September 2019, comprising government borrowings (both central and state), bank deposits, bank lending to corporations, the 10-year government security yield, inflation, RBI’s repo rates, and foreign exchange reserves. We also considered annual GDP data from the World Bank since 1980 and compared the impact of government borrowing on GDP. The above exhaustive data of about 7.5 years, or about 393 weekly data points on all the above parameters, plus India’s GDP data over 39 years, offered us insights on how government borrowing impacts corporate borrowing or the availability and cost of funds.
We used bivariate regression statistics to check the relationships between various variables. Our research shows that local borrowing and spending by the Indian government does not impact any other macroeconomic variable, be it the availability and cost of funds for other participants in the economy, inflation or deposit growth, at the current deficit level—that is, with the state and central combined figure above 6% of GDP.
The two most important variables that impacted interest rates were inflation and the repo rate, which tend to move together. This clearly indicates that RBI is extremely proactive in the way it manages interest rates. We also did not see any relationship between government borrowing and inflation. While such borrowings that are funded by the central bank through devolvement could lead to inflation, the same is true for large external inflows to domestic money markets. These inflows are largely foreign direct investment plus funds brought in by foreign institutional investors, and not so much on account of trade, given India’s perennial trade deficit. These finally get reflected in the country’s foreign exchange reserves, which we found have a very strong relationship with inflation. Technically, any large inflow of a foreign currency sterilized by RBI does have the potential to move the inflation needle up, thus placing upward pressure on interest rates.
An examination of the World Bank’s GDP data from 1980 to 2019 revealed that government borrowing had a strong relationship with the size of India’s economy. It is clear that government borrowing and spending actually drives GDP growth. While we intuitively knew that government borrowing should not impact bank lending to companies, as the sums borrowed return to the market almost immediately—because all government spending passes through the banking system—we were surprised to find that it did not impact interest rates.
Bond investors would, of course, demand a higher return, as they have their own return-on-investment aspirations. However, RBI ensures that bond yields don’t shoot up because of the excessive borrowing, by taking bonds onto its books to be released back into the market in good times.
We find that we have a unique money market, different from the rest of the world, since we have investors who are explicitly required to invest in government debt. Banks, non-banking financial companies, insurers, provident funds, and pension funds are all forced to invest in government debt as a condition for their licence to operate in India. This has worked for us very effectively all these years. We also find that RBI works towards aiding the government borrowing programme rather effectively, ensuring that interest rates do not change too adversely.
We, therefore, should not be excessively worried about the government living beyond its means at this juncture. Government spending being the main driver for the country’s GDP growth, it could be a good way to put the economy on a higher growth trajectory. Perhaps it is time to revisit the entire FRBM framework.
Sandesh Kirkire & Sharang Dehadrai are, respectively, IMC PVG Chair and management student at JBIMS