It’s not just advanced economies that have embarked on a deficit-financed fiscal stimulus adventure in the global crisis. Take the case of India. The budget deficit has jumped from 3.3% in the 2007-08 fiscal year to a 16 year high of 6.8% in the year to March 2010.
This makes India’s fiscal burden one of the largest in the emerging world. This is down to a counter-cyclical fiscal stimulus and the five-year old administration’s mission to grow India’s underdeveloped rural areas.
As a result, the country now faces an 80% public debt burden — while China entered the crisis with a low level of public debt at 40%. Consequently, ratings agencies have sounded the alarm and say without timely consolidation of the public finances India’s BBB- rating is in jeopardy.
To fund its record deficit the government has borrowed a record Rp4.51tr ($96.4bn) during the current fiscal year. As the public finances sunk deeper in the red, India has treaded carefully by front-loading issuance and crucially relying purely on the domestic market.
This has served to barricade India from global deleveraging and removed the familiar risk that dogged emerging market borrowers in the bad old days: currency mismatches. Instead, the country’s healthy banks and budding asset management industry have snapped up government paper. This is thanks to the largely state-owned financial system that has dodged the global credit crunch due to tough regulations on capital outflows.
What’s more, Indian states are legally barred from overseas bond market issuance and only issue fixed rate domestic bonds. This has insulated state governments from exchange rate risks and interest rate volatility. In addition, governments have eased refinancing risks as state bonds have a 10 year maturity — the sweet spot for domestic institutional investors.
But India’s sky-high federal and state fiscal deficit comes at the cost of crowding out the private sector and complicating the Reserve Bank of India’s (RBI) mission to keep market rates low. Faced with heavy supply of government paper, market interest rates have been edging higher despite low policy rates. Benchmark 10 year bond yields have jumped 2% this year, the biggest rise since 1999, to yield between 7.3% and 7.5% in the fourth quarter of 2009.
In addition, fears are growing that losses on government bonds will undermine bank balance sheet strength and deter unbridled consumption of sovereign paper. This is because many banks are close to their 25% limit for government bond purchases — which are guaranteed under the held-to-maturity category — as a percentage of their net demand and time liabilities. As a result, if banks buy paper above this limit, they have to be marked-to-market and will, thus, expose them to potential losses if yields widen.
Tightening the belt
This risk will emerge from the shadows if the government chokes the market with an oversupply of sovereign paper and reneges on its plan to bring down the deficit to 5.5% of GDP in 2010-11, and to 4% in 2011-12. In any case, India’s trials and tribulations over the fiscal deficit are likely to trigger other consequences. The government is now mulling the creation of an independent debt management office to shed the RBI of its role as banker to the government.
This would reconcile the central bank’s conflicting mandate to keep borrowing costs low partly to finance the deficit while at the same time killing off inflation.
But the central bank has shot back and argued any debt management office needs to be truly independent and not parked at the finance ministry to ensure the government does not apply pressure on state-owned banks to snap up sovereign paper. "There is a conflict of interest if the RBI manages government debt and there is also a conflict of interest if the finance ministry manages the debt," says RBI governor Duvvuri Subbarao.
India’s domestic funding programme has been remarkably smooth in the crisis. But the government will need to lay out a clear roadmap for fiscal tightening sooner rather than later — and crucially not rely on cosmetic measures like regulatory reform in the short term. As Subbarao warns: "To believe that setting up a separate debt management office by itself will suddenly ease the fiscal burden is to delude ourselves."