A silent, barely perceptible, undercurrent of a fiscal crisis runs through the current budget.
For various reasons, which are not at all clear, the finance minister has chosen to gloss it over. But the telltale signs of the crisis are visible from two aspects in the budget that should be noted. The first is a credit entry for Rs 90,000 crore expected from the RBI which presumably will go towards PSU bank recapitalisation. This raid on the central bank’s reserves shows the government’s inability to find additional sources of revenue through taxes.
You don’t raid the secret reserves of your central bank for no good reason. On the other hand, the proposal to borrow in international debt markets by issuing sovereign bonds points to paucity of demand for government paper in the domestic debt market.
The fact that both decisions have been taken together imply that the government may have finally run out of money in the domestic markets.
The root cause of this rather unwelcome development has been long in the making. What it really means is that domestic savings from households, public and private sector are barely enough to meet the total requirement of funds needed by the government to meet its fiscal deficits.
The government by itself also doesn’t save much. The corporate sector saves a bit – in some parts, like the technology companies – but on the whole it is a net borrower. So, most of the savings in the economy come from households. Since they save nearly 30% of their annual income, we cannot look to them for additional savings. If all these savings together are not enough for meeting the fiscal deficit, then the private sector, which needs funds for expansion, will be crowded out by government borrowings.
With the present budget we have reached that inflection point.
How do you then fund the investment needs of the private sector? Note that the private sector has hardly made any new net investments over the last five years, which is one of the key reasons for a slowing economy. Given the lack of domestic savings, the corporate sector is forced to go abroad for funds. In the past, the government has been rather liberal in allowing private corporates to raise funds abroad. The problem is that non-prime borrowers used this route to fund themselves and these borrowing ran into defaults, giving Indian corporate paper a bad name.
The government therefore now proposes to borrow in its own name abroad to augment domestic savings and meet the need for investible funds in the economy.
Sovereign borrowings abroad so far form a very small portion of India’s debt, standing at about 5% of GDP. However, such borrowings, on the face of it, are attractive because they carry very fine coupon rates. The principal and interest due does carry an adverse exchange risk that in theory could offset the fine rates and more. But those risks materialise at the repayment level – years into the future – and are easy to gloss over for eager borrowers.
Apart from the obvious exchange risks, why has the Indian government shied away from sovereign borrowings before? There are a slew of reasons.
Sovereign borrowings basically subject the government’s accounts to rigorous scrutiny by credit rating agencies abroad who are notoriously finicky. India has problems justifying its GDP growth rate, with the underlying statistical model having been called into question along with the validity of a few of the underlying databases. Window dressing of national accounts has been rampant, with government using public sector entities to borrow from markets to fund itself. Such concealed funding could be as much as Rs 1.5 trillion. Fiscal deficits are consequently understated.
Expenses due have been pushed forward into next year. Export growth, the ultimate source of repayment of dollar loans contracted abroad, have shown zero growth over the last five years. We have $400 billion of reserves, but these come largely from financing operations not export earnings, unlike say those China which are primarily driven by robust exports. That is a huge minus from a creditworthiness point of view and would lead to adverse comparisons with China.
All this means the quality of sovereign bonds we issue on the market may be viewed in time as sub-par, with potential for downgrades to credit ratings. So, the government needs to be cautious in exposing all these warts. It should be eager to clean up its act before venturing abroad. That hasn’t happened yet.
India also lacks a fully convertible currency. Our convertibility is only on current account and hedged in by a slew of exchange control restrictions. As such, currency markets don’t reflect accurately all the factors that determine a market-driven exchange rate. Deep markets in India sovereign bonds and liquidity would be a consequent problem.
The philosophical problems with a sovereign bond issue, where the currency is not fully convertible, are many.
But first we need to note that what the government needs to fund its fiscal deficit is not dollars but Indian rupees, whereas what is raises abroad is not INR but dollars. This means the government will borrow dollars abroad, but then convert these into INR in a swap with RBI. When it does so, the RBI has no option but to create additional INR in the system to buy the dollars.
In effect, this creation of additional INR is nothing but printing currency, which is inherently inflationary because it creates primary money. If you are going to print INR even when borrowing abroad, why not do it at zero incremental cost directly anyway? Why pay foreign bond holders for the privilege?
The argument generally made against the point above is usually about the total cost of borrowing to the government. For instance, as of now, the domestic bond issues by the Centre saturate domestic savings and can take no more supply without a substantial hike in coupon rates. In such a case, one could argue that paying a higher rate to foreign lenders on a small portion of incremental needs is justified because it enables you to cap domestic borrowings at lower overall coupon rate.
If your currency is fully convertible, this net savings in domestic borrowing costs on say 90% of your borrowing requirements while paying a higher coupon abroad on only 10%. Full convertibility means the incremental INR at swap time comes from the existing supply of money from the market, without RBI having to create more money.The debt market abroad and at home are fungible with full convertibility. Not so in its absence.
Furthermore, since this government is all about behavioural economics and nudges, it’s also useful to see why sovereign borrowings usually end up being extremely addictive to ambitious governments in a hurry. Loans taken abroad by the private corporate sector, or those taken from developmental institutions by government, are usually tied to economically viable projects which have been scrutinised for domestic & dollar viability on a standalone basis.
Furthermore, such lending is usually monitored. End-use conditions are rigorous. The money cannot be squandered away in say building monumental statues of leaders currently in fashion. There are no such safeguards to sovereign borrowings. Warning signals without full convertibility are muted. Governments are profligate by nature. And when borrowing long term money via long maturity bonds you have to look not only to this government but also future governments.
All told, sovereign borrowings are heady cocaine to governments who have already exhausted domestic savings trying to fund their gargantuan appetite for others’ money. Without full convertibility, and strong balance sheets, they are neither cost-efficient nor immune to triggering inflationary pressures. They are best avoided unless special safeguards can be put in place to regulate and monitor end-use in a rigorous fashion that is independent of the government of the day.
What could be such a workaround? The Centre could earmark all sovereign issues for funding a domestic developmental bank such as ICICI or IDBI, which were in our not so distant past. All funds raised abroad could be earmarked transparently & directly into domestic debt securities of such banks, and these banks would then use such funds for lending to the private sector for economically viable projects that also generate exports in adequate measure.
With such safeguards, we could avoid harmful government addiction (note that by having exhausted domestic savings, it is already a confirmed addict).
The inflationary impact of such funding then becomes manageable as the funds create income-generating assets and don’t disappear into civil servant salaries or ostentatious statues of ruling deities.
Sonali Ranade tweets @sonaliranade. Sheilja Sharma tweets @ArguingIndian. Views are personal.