Interest rate is among the key economic variables in any economy which influences several decisions taken by a range of economic agents. Besides savings and investment decisions, interest rates determine choice of technology by firms, and influence the economy’s production structure. Sovereign debt instruments provide the anchor for all interest rates, since they are the only financial instrument with zero default risk. Theoretically, interest rate on private debt of a particular maturity should be the interest rate on government bonds of the same maturity with a premium reflecting default risk of the private borrower. To effectively play this role, government bonds must be freely and actively traded so that their yield (effective interest rate) accurately reflects market risk and liquidity premia. The market for government bonds in India is essentially a wholesale one, with no retail participation. Participants include banks, other financial institutions, foreign portfolio investors (FPI), and some non-financial corporates. In terms of volume, although total stock of government bonds is nearly 48 per cent of GDP, “in float” volume is only 17 per cent, since statutory holdings by banks and other fiduciary institutions can’t be placed on the market. Thus, the market is limited to excess holdings of these institutions (6 per cent), holdings of non-fiduciary bodies (6 per cent), and that of the RBI (5 per cent). Therefore, the range of participants and the float are large enough for a reasonably efficient market. The market maker, to all intents and purposes, is the RBI. However, the RBI’s functioning in the market is different from that of standard private market makers: Its objective is not to maximise profits from arbitrage and trading fees, but to attain the desired interest rate level. To carry out its mandate, the RBI necessarily has to have a target rate around which it can work. Most central banks have a publicly stated base value of real interest rate, and monetary management is about deviations from this base value depending upon cyclical factors. The RBI hasn’t articulated what it considers to be the desirable real interest rate level. One way is to assume that the coupon rate on treasury bills reflects the finance ministry’s take on this. At present, the coupon rate on 10-year treasury bills is 7 per cent. ALSO READ: Part 1: How much public debt is too little? In order to judge whether voluntary holdings of government securities are too high, the actual market-determined yield should be compared to the desired rate. If yields are higher, it implies an excess of government securities in the market: If yields are lower, it means that there is an excess demand for government bonds, and any reduction in supply will lower interest rates further, thereby distorting various decisions that are contingent on interest rate. At present, yields on 10-year treasury bills are marginally below the coupon rate of 7 per cent.
Therefore, voluntary holdings of public debt amounting to 12 per cent of GDP are by no means excessive, and may even be too low.Minimum public debt: If voluntary holdings of public debt are added to the RBI’s holdings and mandated holdings, the minimum public debt stock comes to at least 58 per cent of GDP. Of the total public debt of 68 per cent of GDP, securities account for 47.5 percentage points and the rest for the remaining 20.5 However, this is only the current position. In view of the government’s push towards greater “financial inclusion” in the form of bank deposits and insurance coverage, this ratio is likely to trend upwards. Therefore, some cushion needs to be provided for contingencies. Seen in this light, the FRBM Committee’s recommendation of a target public debt ratio of 60 per cent seems eminently sensible, but as a floor and not a ceiling. Fiscal deficits and composition of public debt: The stock of public debt is only one part of the story. Consideration must also be given to fiscal deficit, which is the annual rate of public debt generation. If nominal GDP grows at 11.5 per cent annually, debt ratio will decline by 6.2 percentage points annually if there is no addition to debt stock. Therefore, to stabilise public debt ratio at the desired level fiscal deficit should be maintained as 6.2 per cent per annum. Also, the steady-state relationship between fiscal deficit and debt stock ratio assumes that the composition of the debt doesn’t matter. It does matter and any analysis which ignores this is seriously flawed. A basic distinction has to be drawn between government securities and all non-securitised public debt instruments such as provident funds, external borrowings, etc: It is the former which determine market yields and thereby the economy’s interest rate structure, while the latter has no direct role to play. As things stand, of the total public debt of 68 per cent of GDP, securities account for 47.5 percentage points and the rest for the remaining 20.5. In comparison, of the minimum public debt of 60 per cent of GDP, securities should be 48 percentage points and others 12. Therefore, supply of government securities is already below its optimal level. Although this is not an immediate problem since the gap is small, it shouldn’t be allowed to persist. This compositional inconsistency has an important implication for financing of current fiscal deficits: government securities must account for at least 5 per cent of GDP in the total financing of consolidated fiscal deficit for the immediate future. Unless this condition is met, the gap between the actual and desired stock of government securities will continue to widen to a point where fiduciary institutions will be under stress both from being unable to meet legal requirements, and reduced income flows from their holdings of public debt instruments. The finance ministry needs to assess these considerations, and perhaps so should many other countries. (Series concluded)
The author is country director, International Growth Centre (IGC) India. This is the second part of a two-part series. This article has been published with permission from Ideas for India (www.ideasforindia.in), an economics and policy portal. A version of this appeared on I4I.