India's public finances and private sector at taper tantrum risk

India is the third most indebted country among major emerging markets, behind Argentina and Brazil.

India’s macroeconomic variables such as foreign exchange reserves and current account deficit are much better than in 2013 when the economy was hit by taper tantrum, but the country’s public finances are in a worse shape than what they were eight years ago. 

Similarly, the household sector and corporates are also sitting on much higher debt than eight years ago. At 89.3 per cent of India’s nominal gross domestic product at the end of March this year, India’s public debt is at an all-time high. This makes India the third most indebted country among major emerging markets, behind Argentina and Brazil.

A steady rise in India’s public debt in recent years has led to a situation where a larger portion of tax revenues is used to service interest on public debt than in the past despite a fall in interest rates in recent years. The borrowing cost for the government is down nearly 220 basis points (bps) since 2013.

According to the latest Union Budget, interest payments will consume more than half (51.5 per cent) of the Centre’s tax revenues in FY21 and the ratio is expected to rise further to 52.4 per cent in FY22. In comparison, the interest to tax revenues ratio was 42.2 per cent in FY13. This makes India vulnerable to a spike in global interest rate and a risk aversion in the financial market following a rise in bond yields in the US and dollar appreciation.

“There is a tendency for interest rates in India to go up whenever bond yields and interest rates rise in the US. The exact quantum of transmission depends on India’s policy response, but interest rates tend to move in the same direction,” says Madan Sabnavis, chief economist Care Ratings.

A rise in bond yield would raise the borrowings across the board in the economy, including government ones. The Centre plans to borrow nearly Rs 12 trillion in FY22.

Higher borrowing costs would further raise the cost of debt servicing, forcing the government to either raise taxes or cut public spending, which could adversely affect the pace of economic growth going forward.

“India’s public debt is on a higher side, which is a little risky at a time when the interest rate trajectory is on the up,” says Madan.

The yield on 10-year US government bonds is up nearly 120 bps from the record lows in July 2020. The US bond yield is now up to 1.73 per cent from 0.53 per cent in July last year. In the same period, bond yields in India are up nearly 35 bps from 5.84 per cent to 6.19 per cent currently. One basis point is one-hundredth of a per cent.

“Any policy normalisation this year will lead to adjustment in market rates, including bond yields and rupee-dollar exchange rate in view of changing fundamentals. There could be a 25-50 bps upside risk to our FY22 India 10-year bond yield forecast of 6.5 per cent,” write Tanvee Gupta Jain and Sunil Tirumalai of UBS Securities India in their recent report on Indian economy.

Higher bond yields could translate into higher borrowing cost for the corporate sector and the households. The corporate sector benefited from a decline in interest rate post the pandemic as it held to reduce the interest burden on their finances. Similarly, households saw a decline in EMIs on home loans and other personal loans as banks cut the interest rates. A big part of these gains could go away if bond yields in India rise in tandem with the rates in the US.

The pain from higher interest could be huge as India Inc balance sheet is more leveraged than in 2013. The top-listed firms, excluding banks & finances, reported net debt to equity of 0.67x in FY20 against 0.61x in FY13. And the firm’s interest coverage ratio was 4.4x during 9MFY21 against 2.9x in FY13.

The household sector has even more debt than in the past. Total retail loans outstanding are expected to rise to 23.1 per cent of GDP by the end of FY21 against 14.3 per cent of GDP in FY13. Higher interest rate could eat away a larger portion of household income, hitting the overall demand in the economy.