With global finances at risk, can India avoid a repeat of the 1991 crisis?

India may have done well by keeping commercial bank lending to the government within manageable limits, but RBI has been lending more to the government, which means it has been printing more notes

The International Monetary Fund (IMF) is very worried that the huge borrowing by governments all over the world is going to have the most deleterious effects on all countries individually and collectively. 

According to a blog by Andrea Deghi, Fabio Natalucci, and Mahvash Qureshi on its website, “The average ratio of public debt to gross domestic product — a key measure of a country’s fiscal health — rose to a record 67 per cent last year in emerging market countries, according to Chapter 2 of the IMF’s April 2022 Global Financial Stability Report.”

The blog goes on to say that “Emerging-market banks have provided most of that credit, driving holdings of government debt as a percentage of their assets to a record 17 per cent in 2021. In some economies, the government debt amounts to a quarter of bank assets.”

The result is that an unhealthy relationship has emerged, which is exactly like the one in the 1980s in India. “…governments rely heavily on their banks for credit, and these banks rely heavily on government bonds as an investment that they can use as collateral for securing funding from the central bank.”

When the Rajiv Gandhi and V P Singh governments had done this between 1986 and 1989, India ended up with the 1991 balance of payments crisis. The only difference between India then and the emerging markets now is that whereas the Indian banks were state-owned, the emerging markets now are mostly privately-owned. 

This is a situation where both the borrowers and the lenders can suffer. “Large holdings of sovereign debt expose banks to losses if government finances come under pressure and the market value of government debt declines. That could force banks — especially those with less capital — to curtail lending to companies and households, weighing on economic activity.”

There is even a name for this: the doom loop. If a country gets into this, it can default as we have seen a few countries do in the last 20 years. 

How does India measure up on this scale? Quite well, actually, because whereas commercial banks held 39.1 per cent of government securities in March 2019, that level reduced to 37.3 per cent by March 2021. 

Since the latest annual report is not out yet, so we don’t know the current position. Things are unlikely to have changed very much. 

Thus, according to the RBI, commercial banks “remained the largest holders of government securities (including T-Bills and SDLs) accounting for 37.3 per cent as at end March 2021, followed by insurance companies (25.7 per cent), the Reserve Bank (10.4 per cent) and provident funds (9.8 pe rcent). 

In the end, it all boils down to risk of which, says the Global Financial Stability Report, there can be two types.

One is government programs intended to support banks. If government finances become weak, as they could, these guarantees could become worthless. 

So the IMF blog notes: “Troubled lenders would then have to turn to government bailouts, further straining public-sector finances.”

The second way is via higher interest rates. These are now on the way and will hurt all economic agents. That’s why everyone is predicting a major recession.

India may have done well till now by keeping commercial bank lending to the government within manageable limits, but this has a negative aspect too: the RBI has been lending more to the government which means it has been printing more notes.

This, as we saw in 1991 — and almost saw again in 2013 — always leads to either inflation or to a balance of payments crisis — or both. There is no third outcome. 

The first is already upon us whether measured by the WPI or the CPI. 

To avoid the second, India will have to opt for slower growth.