The great Indian Ponzi scheme

It’s dangerous to finance debt repayments from new borrowings

S S Tarapore

Increasingly, in recent years, advocates of fiscal prudence have been ridiculed. Even advocates within the government of a sane fiscal policy have been subject to stultification by legislators. It is becoming fashionable to argue that the attempts to bring about fiscal correction in the nineties were a mistake. The new theology is that the ad hoc Treasury Bill was a powerful tool for financing the government and should be restored. The way to fiscal salvation is through lowering interest rates.

Having reduced interest rates to a 30-year low is just not enough. We now need to work towards the paradise of Japanese-style zero interest rates. There are respectable opinion makers who show considerable impatience at the authorities’ cautious reduction in interest rates. According to them, the economy needs a sharp reduction in interest rates. To the argument that savers would have a disincentive to save, the answer is that savers are only rentiers, they perform no useful function in society and therefore they should be punished. It is then argued that investors have deserted their posts and to entice them back, interest rates should be reduced, and our cherished dream of an eight per cent growth rate can then be achieved.

In recent years, it is also claimed, our fiscal management has been exemplary. Interest rates have been slashed while the borrowing programme has increased exponentially. As per the budget estimate, the revenue deficit for 2001-02 was put at Rs 78,821 crore while interest payments were estimated at Rs 1,12,300 crore. If only there were no interest payments, we would have a revenue surplus. What better argument could there be to reduce interest rates?

In fairness to the finance ministry, the budget estimate for 2001-02 for net market borrowing, at Rs 77,353 crore, is a shade lower than the borrowing of Rs 77,947 crore in 2000-01. The borrowing programme for 2001-02 has moved along extremely well and there would be little or no pressure while meeting the full year’s figure. The likelihood, however, is that given the larger than expected fiscal deficit, the government will need to borrow more than the budget estimate by at least an additional Rs 10,000 crore. With worldwide concerns about a deep recession, the advocates of fiscal prudence have been sent into the wilderness and any economist thriving on patronage just cannot be a roadblock to the forces working towards a fiscal expansion.

One should not be surprised if the gross fiscal deficit in 2001-02 is over Rs 1,30,000 crore (as against a budgeted figure of a little over Rs 1,16,000 crore). Even if the GFD is around 5.3 per cent of GDP in 2002-03, it would amount to Rs 1,44,000 crore and if the share of net market borrowing remains unchanged, the net borrowing could be a little less than Rs 1,00,000 crore.

Given the government’s new found ability to raise longer-term funds in a falling interest rate environment, there is a strong possibility of the government forcing the market to accept longer-term paper. Reserve Bank governor Jalan has provided a signal service by warning that “...banks and primary dealers (PDs) and other market participants must explicitly take into account that the interest rate environment can change quite dramatically within a very short period of time”. Here is a clear signal for banks, PDs, dedicated gilt funds and other participants in the gilt market. The downward joy ride of interest rates is too good to last and sensible participants must prepare for the inevitable carnage in 2002-03.

The government is well within its rights to lengthen maturities at the lowest possible interest rate but it is for market participants to decide how much to invest, at which maturity, and at what rate. It is all a matter of conjectural variation of borrowers and investors sizing each other up. PDs are the most vulnerable segment among market participants and they cannot expect to be bailed out by the RBI as they have been done in the past. While there are clear danger signals written in bold letters, in many ways it should be easier to predict the movements in the interest rate cycle in 2002-03 than in 2001-02. Investors would want to shorten maturities while the government would try to push its luck with longer-term paper.

The government must understand that if it is interested in longer maturities, in the current climate, investors would demand a higher yield. It would be best to allow market clearing rates of interest and to gradually yield to market demand for an increase in longer term rates. The government could be doing exceedingly well if it can contain the increase in interest rates in 2002-03 to say 1.5 percentage points. It would be highly desirable to accept a gentle market signal instead of jerky, large, and delayed increases. This will enable market participants to undertake a smooth adjustment without too much of bloodshed.

The difficulty with the Indian gilt market is that it moves dangerously in a unidirectional manner till it receives a jolt and then moves in the opposite direction. If the government is serious about minimising its cost of borrowing over the long run, then its fiscal policy should actively work towards the development of the retail segment; this is an issue which needs separate treatment. What is most alarming is that the government has made light of the repayment burden and has for nearly four decades financed repayments out of fresh borrowing. This is a blatant case of a fiscal Ponzi and such schemes inevitably explode. Time and time again official bodies have warned that repayment out of fresh borrowing is not sustainable and that a self-sustaining consolidated sinking fund should be setup. The centre has sanctimoniously advised states to set up such funds if they so wish but has refrained from setting up a fund to meet its own repayments. It is naive to argue that a CSF will raise the revenue deficit and that we owe nothing to posterity. In the case of government internal debt, the explosion comes suddenly without any warning. The Cassandras have been proved wrong so far. Will we learn from past mistakes or will we be punished by the future?