Despite cautionary pronouncements out of the Reserve Bank of India (RBI) when bond yields on 10-year treasury touched 6.4 per cent, last Thursday yields dipped towards 6.3 per cent. The soft-interest rate stance of the RBI has overwhelmed. Over the past three years, yields on 10-year treasury fell in 2000, from 11 per cent by 50 basis points (bps). In 2001, yields fell by a huge 280 bps to 7.7 per cent while in 2002, till date they have dropped another 130 bps to 6.4 per cent. Inflation has been quiescent in this period, but not so the government?s fiscal deficit.
The larger public sector deficit (including state electricity boards) is much over 11 per cent, higher than in the years prior to 2000. The financial savings of households (gross of liabilities) and the incorporated private sector total 16.5 per cent of gross domestic product (GDP). Which basically means that government sucks out some 65 per cent of the available pool of private financing savings. By contrast in 1995-96, the financing of the government deficit removed less than 40 per cent of the available pool of private financial savings.
Then again, in 1993-94, as much as 14 per cent of household financial savings was deployed in stocks, debentures, mutual funds and company deposits, while 23 per cent went to small savings, provident funds and other claims on government. In 2000-01, the first category declined to 3 per cent while the second rose to 34 per cent. Thus, in addition to intermediation by banks and insurance companies, direct financing of government from households rose steeply. One would argue that the major factor behind the householders? preference for claims on government was the loss of confidence in the stock market and collapse of many non-bank financial companies. The fact that deposits continue today to pour into small savings and provident funds, despite reductions in interest rates and dilution of tax incentives, bears out this contention.
One-third of assets of commercial banks are deployed in treasuries and debentures/advances of quasi-fiscal nature, such as food credit. Indians seem increasingly to be saving so as to lend to government, and the latter is more than willing to oblige. The financial system is becoming centred on claims on government ? like a pyramid set on its head. The recent upsurge in retail lending ? housing and automobile finance ? is expression of the desire to open a window in this hothouse.
In days of old, kings used to exact a charge for setting bullion to coin, termed seignorage in the jargon. Financing government deficit by printing notes was the modern equivalent, abandoned for fear of runaway inflation. Selective capital controls that restrict the choice of savings assets available to resident Indians are proving a far more potent and less disruptive method of (cheaply) financing government deficits. US interest rates today are lower than they are in Europe. And the yield on Indian 10-year treasury in nominal terms is the same as for US Aaa corporate bonds, and after adjusting for the higher rate of inflation in India, is the same as that of US 10-year treasury.
Whoever would have thought that, provided inflation could be kept in check, interest rates could be brought down so rapidly to superpower levels despite a burgeoning fiscal deficit and large inefficiencies in the financial sector? It has been a great show, but trickier still will be holding the ship steady ? for the prospect of the other imbalances being brought in line is far from immediate.
The author is economic advisor to ICRA (Investment Information and Credit Rating Agency)
