YV Reddy is right: The govt borrowing on its own won't work

Mar 13, 2015

- By Vivek Kaul

Vivek Kaul
In the budget speech he made on February 28, 2015, the finance minister Arun Jaitley had said: "I intend to begin this process this year by setting up a Public Debt Management Agency (PDMA) which will bring both India's external borrowings and domestic debt under one roof."

The government of India, like most governments spends more than it earns. The difference it makes up through borrowing. This borrowing is currently managed by the Reserve Bank of India (RBI). Jaitley now wants to take away this responsibility from the RBI and set up an independent public debt management agency.

On the face of it this sounds like a simple move-one institution was taking care of the government borrowings needs, now the government wants to takeover the responsibility. But it is not as simple as that.

Before I explain why, it is important to understand something known as the statutory liquidity ratio (SLR), which currently stands at 21.5%. What this means is that for every Rs 100 that banks raise as a deposit, Rs 21.5 needs to be invested in government bonds.

This number was at higher levels earlier and has constantly been brought down by the RBI over the years. This provision helps the government raise money at lower interest rates than it would otherwise be able to.

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This is something that the Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework (better known as the Urjit Patel committee) released in January 2014 pointed out: "Large government market borrowing has been supported by regulatory prescriptions under which most financial institutions in India, including banks, are statutorily required to invest a certain portion of their specified liabilities in government securities and/or maintain a statutory liquidity ratio (SLR)."

This statutory requirement essentially ensures that there is a constant demand for government bonds. This helps the government get away by offering a lower rate of interest on its bonds.

"The SLR prescription provides a captive market for government securities and helps to artificially suppress the cost of borrowing for the Government, dampening the transmission of interest rate changes across the term structure," the Expert Committee report points out.

Take a look at the following chart. Between 2007-2008 and 2013-2014, the government was able to borrow money at a much lower rate of interest than the prevailing inflation. The red line which represent the estimated average cost of public debt (i.e. Interest paid on government borrowings) has been below the green line which represents the consumer price inflation, since around 2007-2008.

The major reason for the same is the fact that there is an inbuilt demand for government securities. The Economic Survey of 2014-2015 has some interesting data which buttresses the point that I am trying to make. The total internal liabilities of the government of India have gone up by 1.9 times between 2009-10 and 2014-2015. Nevertheless, the average cost of borrowing has gone up only from 7.5% to 8.41%.

This financial repression of forcing banks, insurance companies as well as provident funds to buy government bonds, allows the government to raise money at low interest rates, than they would be able to do if they allowed the market to operate.

Now the government wants to take away the debt management function from the RBI and raise money independently. In this scenario the question is can the SLR continue? Dr YV Reddy, former governor of the RBI, made this point in an interview to the The Economic Times. As he said: "If the government is having an independent debt office then how can the statutory liquidity ratio of a high order continue. Once it is an independent debt office, basically, it should independently be able to raise money."

Fair point, I guess. "So, if the government want to raise money then indirectly the regulator cannot go on supporting through a cell. So the pre-condition will be SLR has to be removed. Because it would be inappropriate to say that you are independent but I will help you do something. So, in all probability the RBI will have no choice except to reduce SLR to zero as a precondition for an independent debt office," Reddy told The Economic Times.

The question that crops up here is whether the government is ready to take on this risk given that it is likely to lead to higher interest rates. With banks no longer having to compulsorily buy government bonds, they may not buy government bonds all the time, like is the case currently. This will lead to a situation where the government will have to offer a higher interest rate to get the banks interested. While this sounds good on the face of it, given that if the government offers higher interest rates on its bonds, that higher interest rate will become the benchmark.

Given this, banks will have to offer higher interest rates on their fixed deposits. This means that the chances of savers getting a higher rate of interest (which is greater than the rate of inflation) also goes up.

But if banks offer a higher rate of interest on fixed deposits, they will also have to charge a higher rate of interest on their loans. And this is something that the government won't like, given that it is currently trying to push down interest rates in the hope of getting the investment cycle and the consumption cycle going all over again. It needs to be pointed out that savers are not the ones either governments or politicians are really bothered about.

Nevertheless, the government might force the RBI to keep the SLR at its current level. But then there would be no independent public debt office. It would be a farce. As Reddy put it: "If the government is pressurising the RBI to not reduce the SLR that is inappropriate. That is not an independent debt office. And it would be inappropriate for RBI even to appear to support the government debt programme. It cannot appear to be."

Long story short-we haven't heard the last of this issue. There will be more to come in the time to come. Stay tuned.

Vivek Kaul is the Editor of the Diary and The Vivek Kaul Letter. Vivek is a writer who has worked at senior positions with the Daily News and Analysis (DNA) and The Economic Times, in the past. He is the author of the Easy Money trilogy. The latest book in the trilogy Easy Money: The Greatest Ponzi Scheme Ever and How It Is Set to Destroy the Global Financial System was published in March 2015. The books were bestsellers on Amazon. His writing has also appeared in The Times of India, The Hindu, The Hindu Business Line, Business World, Business Today, India Today, Business Standard, Forbes India, Deccan Chronicle, The Asian Age, Mutual Fund Insight, Wealth Insight, Swarajya, Bangalore Mirror among others.

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3 Responses to "YV Reddy is right: The govt borrowing on its own won't work"


May 1, 2015

Hi Vivek,
Well researched artilce as always.
Have just one disagreement with the hypothesis:
If there is no SLR, govt. won't like it because in a political economy, govts. can service debt only be increasing revenue and if the government is not particularly bright, it can do so only by increasing tax burden on existing tax payers or slashing spending (which costs votes).
I think the hypothesis of banks offering higher interest on deposits and thereby charging higher on loans, because of higher interest recd. from govt. is a bit of a stretch.
what banks charge and what banks offer is pretty much a play on : what their competitors are doing and what is the cost of raising funds for the banks and the returns offered to them elsewhere.

If anything, freeing up of the 21% cash from low yielding govt. debt will give banks extra cash to loan out... something that would drive the interests down (extra supply pushing the price down etc).

However, in a political economy, a govt. would not want to compete with private sector for funds...
I think this will happen only when we have reached more maturity..as a polity.


Like (1)


Mar 14, 2015

We are enlightend by your article Sir
YV Reddy's opinion is right but why the new batch of economists brought in by Modi Sarkar are silent on repurcussions and possible reversal of this policy prescrition Can we presume that FM has done this to please some external agencies to appear to be reformist buy as it is usual in India later blame non-execution on some legal excuse

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Raghuveer Singh Rathore

Mar 13, 2015

If any country’s Govt forms any independent & separate agency without involvement of Central Bank, that would adversely affect the economy of any nation, for then in our country RBI will be left with no option other than to zero the SLR, because of their non-interference in the instance, which does not sound pleasing at all. YV Reddy has rightly said - "The Govt borrowing on its own won't work".

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