Rates rise due to fiscal deficits? Economic Times 23rd Dcember 2010

A working paper brought out by the IMF titled, “Fiscal Deficits, Public debt and Sovereign bond yields” authored by Emanuele Baldacci and Manmohan S Kumar , examines the relationship between fiscal deficits and interest rates in 31 countries and concludes that higher deficits and government debt increase sovereign yields, thus imparting an upward thrust to interest rates. Does this theory hold in India ??

Ever since Fiscal Responsibility and Budget Management (FRBM) rules were enforced, the fiscal deficit has become a priority. However, since fiscal year 2005, fiscal deficits have been rising quite prodigiously. It has accelerated in the last three years, necessitating larger borrowings by the government. The financial crisis further necessitated a stimulus package, which exacerbated these imbalances. It is projected to cross Rs lakh core this year.

But, curiously, the impact on interest rates has been quite different from what was expected. The average cost of raising fresh funds for the government increased up to fiscal year 2008 when issuance of paper was `1.88 lakh crore, but then came down in the next two years even as borrowings more than doubled. The accompanying table shows that the cost of fresh borrowing has actually gone below the level of fiscal year 2006 when borrowing was less than 40% of that in fiscal year 2010. Clearly, the government has been able to borrow at a lower cost. The same trends are reflected in the secondary market, too. But, what about the private sector?

The average lending rates of banks (as denoted ex post by the return on loans outstanding) have been increasing over time, but accelerated after fiscal 2009 even when the cost of borrowing fell for the government. Simultaneously, the corporate spreads have shown an increase since fiscal 2007. In fiscal 2010, the spread between government and commercial borrowing widened to 527 basis points. The cost of deposits has also increased albeit more gradually.

Therefore, two conclusions can be drawn here. The first is that the government is able to borrow money from the market at a cheaper rate than borrowers from banks. This has also contributed to increasing the spread for corporates. The second is that deposit holders on an average get a return that is lower than what the government pays on its borrowing. This means that if the same money was put in GSecs, which have limited liquidity, the returns would be better. Banks, in fact, do make up for lower yields on GSecs by charging higher rates to borrowers.

Can the government be held responsible for this structure of interest rates? The answer is yes and no. The ratio of incremental credit to fresh GSecs issues has declined over time, which is a concern as it shows that there could have been a crowding out of the private sector. But, this comes with a caveat insofar as that higher allocation of bank funds to the government is voluntary as their investment deposit ratio is over 30%, which is higher than what is mandated. This implies that if credit has not increased commensurately, there are other reasons such as economic slowdown of the recent times or greater prudence exercised by banks in accordance with the RBI/Basel recommendations.




Also, that the credit-deposit ratio has remained high (above 70% in last five years) means that the RBI has actually paved the way for the borrowing programme without creating a funds crunch. It has used open market operations (OMOs), a process by which it buys securities for banks, to provide liquidity in times of stress.

The increase in interest rates can be partly attributed to policy changes. Banks too have been altering their rates to balance their net funds to reflect the cost. At another level, most banks have announced base rates in the range of 7-8%, allowing the government to borrow at this rate, while ensuring a minimum return on capital for themselves. But, the gap between cost of deposits and the government rate has narrowed, thus making banks recoup this difference (from 300 basis points in fiscal 2007 to 63 basis points in fiscal 2010) on commercial lending.

Therefore, there are three takeaways from this discussion. First, higher borrowings do not increase sovereign yields, which, on the contrary, show downward proclivities. Second, the RBI has ensured that there is no physical crowding out of the commercial sector from credit on account of this phenomenon through astute liquidity management through OMOs and phasing of auctions.

Lastly, commercial lending rates have certainly increased sharply due to higher cost of deposits, regulatory compliance (capital adequacy and provisioning), and maybe higher rent seeking — but less due to government borrowing .