Will stimulus push up government financing costs? - Capital Economics
India Economics

Will stimulus push up government financing costs?

India Economics Update
Written by Shilan Shah

The new fiscal stimulus will substantially push up India’s already-high public debt ratio. Policymakers may have to resort to unusual steps to keep borrowing costs in check, including further financial repression and a return to partially monetising the deficit.

  • The new fiscal stimulus will substantially push up India’s already-high public debt ratio. Policymakers may have to resort to unusual steps to keep borrowing costs in check, including further financial repression and a return to partially monetising the deficit.
  • While the new fiscal stimulus announced by PM Modi isn’t as impressive as the headline figures suggest, it is still a chunky package by normal standards. The Finance Ministry has not yet given full details and has not provided a new estimate for the budget deficit this fiscal year. But we think the new measures could have a price tag of up to 4% of GDP, with the late-March fiscal package worth another 1%. This will have to be financed by issuing more government debt. That could be a concern over the medium term given that debt levels in India are already high by EM standards. (See Chart 1.) But almost all of India’s public debt is denominated in rupees and held domestically. The threat of a public debt crisis is low.
  • Concerns about debt being on an unsustainable trajectory could still push borrowing costs up and cause financial conditions to tighten. That risk can be reduced if policymakers lay out a credible plan for debt stabilisation over the long run. And policymakers can do more to keep a lid on yields. One option would be further financial repression – essentially forcing domestic savers to channel funds to the government. This could take various forms, including pressure on banks or incentives for them to hold more government bonds. The statutory liquidity ratio already requires banks to buy large volumes of government debt.
  • There are more immediate challenges. Large-scale debt issuance could be a problem if it overwhelmed private sector demand for government bonds. Such concerns probably explain why 10-year yields jumped 20bp on Monday (to 6.2%) after the Finance Ministry raised its estimate of its borrowing needs this year. Questions over the market’s ability to digest a lot of government debt have led to talk of deficit monetisation as a solution – the RBI purchasing bonds directly from the government.
  • This would not be as radical as is often made out. The practice was common in India until 1997. And the RBI already buys a lot of government bonds as a tool to manage liquidity, albeit in the secondary market. The RBI has held between 10-18% of all outstanding government debt for the past decade. (See Chart 2.) It is also hard not to view the RBI’s annual dividend to the government as deficit monetisation through the back door when, as recently, the finance ministry determines the dividend’s size (1% of GDP last year).
  • There are of course significant risks attached to deficit monetisation. It could raise further questions over the RBI’s independence – recall that former governors Raghuram Rajan and Urjit Patel both left the post in acrimonious circumstances after falling out with the government (the dividend was a key factor in the departure of Mr Patel). And fears that a constraint on government spending even in “normal” times had been removed could cause inflation expectations to skyrocket.
  • The RBI and the government would therefore need to provide plenty of assurance to the market that deficit monetisation was only a temporary measure intended to speed up debt issuance. They could, for example, set out strict guidelines with well-defined limits on how many bonds it would buy and over what period of time. If communicated clearly, deficit monetisation could prove to be a useful short-term tool for policymakers whose priority now should rightly be pulling the economy out of a catastrophic slump.

Chart 1: Gross Government Debt (% of GDP)

Chart 2: RBI Holdings of Government Bonds (% of Total)

Sources: IMF, Capital Economics

Source: RBI


Shilan Shah, Senior India Economist, shilan.shah@capitaleconomics.com
Mark Williams, Chief Asia Economist, mark.williams@capitaleconomics.com