The rising ten-year benchmark yield, a reference for banks to price loans, is attracting much concern. Some note that the 10-year yield is significantly higher relative to inflation than what has historically been the case. Indeed, long-yield movements across different monetary policy frameworks are not too different. Monetary policy was anchored to WPI inflation previously, inching towards CPI inflation from 2012, and formalised so in January 2014. But, ever since the flattish, above-8% yield curve of 2014 slid down the scale after monetary easing in FY16, the 10-year yield essentially settled in the 7.5% region. From mid-2017, this has risen rapidly, excluding the post-demonetisation aberration. Its June 2018 peak (7.9%) isn’t too far from its 2012 range. The spread between long and short (policy rates) rates that rarely exceeded 100 bps since January 2014—being an average 57 bps until October 2017—has been widening; it touched 182 bps this April and still ranges around 140 bps today.
Why have long-term yields remained high when retail inflation is nearly half of the pre-2014 levels? The criticism in 2012 was that monetary policy was lax. But, long-bond yields then, as now, are market-determined. Moreover, the debt market opened considerably after 2014 to foreign investors. That, combined with lower inflation and fiscal consolidation by the Central government should surely bring down 10-year yields? Lower public spending, lesser market borrowings, plus a rising tax-GDP ratio amidst slowing growth for two years would imply more financial resources available for the private sector and therefore, a lower price, or cost, of funds?
But, none of this has happened. Instead, the 10-year yield has climbed up further. The puzzle deepens when you see its deviation, from the usual global synchronisation, since November 2017. Is that a hint of domestic factors pushing up yields? That public sector banks absented from the bond market for some months in 2018 is unconvincing because it doesn’t explain the hardening of rates before or after their re-entry last month.
So, why it is that lower inflation, continuous fiscal consolidation and increased openness have not lowered long-term yields? Why the deviation from historical trends vis-a-vis inflation? What explains its sharp, steady increase since last year? If some calls for this year’s second half were to be noted, then, the 10-year benchmark may range 8-8.4%. Has the inflation premium jumped up so sharply? Or, are other factors at play?
It increasingly appears that fiscal pressures are impacting long-term yields—commonly called ‘crowding out’ in conventional economic parlance. On the face of it, the Central government has been ‘fiscally responsible’, respecting fiscal deficit/GDP commitments as per an outlined consolidation path in two of its four years. But, this has not meaningfully lowered the stock of public debt. After a modest decline, the total debt/GDP ratio rose 1.9 percentage points in FY16, stabilising at 68.6% thereafter. Public debt/GDP ratios are likely to have risen further since then: RBI’s estimates show higher aggregate states’ debt/GSDP ratios. And the vast gap in the Central government’s budgeted versus revised debt/GDP ratios tell a pessimistic story. For example, it was budgeted to decline to 44.7% in FY18, but the actual outcome, as per revised estimates, is 50.1%! In all likelihood, the FY19 target (48.8%) will be difficult to achieve given such a massive overshooting last year.
It is obvious that fiscal consolidation has not been aggressive enough. It certainly has been insufficient to bring down premiums demanded by investors to compensate for fiscal risks. The states cannot be blamed too much because, as Indira Rajaraman (bit.ly/2vp4Xsz) notes, it is the Central government (which sets fiscal policy), that approves enhancements in their borrowing limits.
Besides the rising public debt levels, the government is raising massive amounts of financial resources, off-budget, and via other public agencies while unpaid liabilities are shifted to other agencies. Some examples:
*FCI food subsidy bills accumulating for several years: Ashok Gulati estimates this was `1.34 trillion as of March 2018; the real number may be `3 trillion, including DCP states’ claims (bit.ly/2IiM4Mx). FCI is thus borrowing (on government’s behalf) more expensively outside the budget, viz. NSSF ( `1.2 trillion in 2017-18 alone), unsecured short-term loans from banks (costlier than usual CC limits) and through rolling ways and means advances during the year. Interest liabilities thus building up are anyone’s guess.
*PSU borrowings on the government’s behalf for one or more expenditures. For example, ONGC’s `250 billion borrowing to buy HPCL last year. More is to follow according to reports of the government’s stake sale of NHPC to NTPC (reported estimate of `182 billion).
*Budget FY19 already contained an intent to raise extra-budgetary resources to scale-up infrastructure, health, education and social sector spending. The railways is reported to have asked for a 40% increase in its budgeted allocation (`530.6 billion), but has been asked to raise funds from the market; if realised, this would be a Rs 212 billion market financing for the government. NHAI-SBI agreed to Rs 250 billion of unsecured loans over 10 years and a three-year moratorium on principal repayments. Apart from the increased fund flows diverted towards the government, future interest liabilities are being created.
*Bailouts/recapitalisation by LIC: Its IDBI acquisition is expected to cost Rs 100-130 billion. The reported bailout of infra major IL&FS (it holds a LIC shareholding of 25%) could be as per the company’s recent board approvals (a `Rs 45 billion rights issue and Rs 35 billion of liquidity support from lenders), while equity support for divestment has been endless. LIC would be buying bonds out in the market if it did not have bailout and stake-sale commitments to meet!
It is abundantly clear how the government is cornering significant amount of financial resources available in the economy through many routes—banks, insurance, small savings, and so on, in addition to its own debt issuance. And we are just one quarter down in FY19. Doubts are raised as to how much more funds may be raised in these manners, while concerns about non-provisioned expenditures, such as increased MSPs and Ayushman Bharat, have arisen.
Fiscal pressures are also bearing down in a period when the national savings rate has been falling—at least a percentage point each year. From last year, there has been reduced bank financing as 11 public banks are under PCA watch. Is this the perfect recipe for ‘crowding out’ pressures, to which the long-term yield is perhaps responding? Ironic, if actually so, because the whole justification of scaling-up public capex has been to offset the shortfall in private investments and stimulate these, in a process called ‘crowding-in’! But, as we know, the economy has been long recovering—in fact, for as long as the case for sustained government capex has been argued for in the public discourse. Time will tell whether that is ‘crowding-in’ or ‘crowding-out’!
The author is a New Delhi based macroeconomist