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So Much Interest - Outside View by Nitin Gregory

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So Much Interest
Mar 28, 2017

Our discussion on the Balance Sheet of Nations offered an alternate view of the country's finances. The assets of a nation can be difficult to quantify. Liabilities, on the other hand, are easy to estimate. The key components of the balance sheet are households, corporates, and the government. Today, we focus on the government.

Low Debt and High Interest?

Like it or not, the government is a key player in our economy. Around 20% of India's GDP comes from government expenditure (the number is even higher in the US and other OECD countries - circa 35%). In other words, the government is responsible for a large chunk of the goods and services of the nation - e.g. infrastructure, public healthcare, subsidies, education, defense, and the list goes on...

Government expenditure in India has two broad categories - revenue and capital. Revenue expenditure runs the machinery of the government (think administrative services or debt interest payments). Capital expenditure results in an 'asset' (think infrastructure or equity investments).

Tax revenue alone can't fund all of this. The government must borrow. The Indian government's debt is currently around 69% of GDP. This is pretty tame compared to Japan (circa 220%), US (112%), and other OECD countries.

Oddly, interest payments on debt show an inverse pattern. Yearly Interest payments are about 5% of GDP in India versus 2-3% in OECD countries. What is the key driver for such large interest payments? More specifically, what is driving the high interest rates on government borrowing for India?

Lender's Choice

The short answer is demand. When demand for government debt is high, bond prices rise and yields fall. A classic case is the 2009 Greek crisis. Lenders to the government of Greece lost faith in the country's ability to repay. This resulted in a sharp decline in bond prices and a rise in interest rates. Any future borrowing will be at these prohibitive rates.

'Perceived' stability - political and regulatory - is a key driver of demand for government debt. Investors don't like civil unrest as it can affect the value of their bonds. They also don't want a government that will set retrospective regulations. This creates uncertainty in the business environment, affecting corporate profits and in turn tax revenue.

Inflation and economic growth are another set of key factors. A strong outlook on growth implies burgeoning tax revenues. This boosts demand for the country's bonds. Inflation, on the other hand, has the opposite effect. High inflation erodes the capital invested in bonds. For example, if a bond coupon rate is 3% and inflation is 5%, the investor loses 2% of his capital (in purchasing power). Inflation drives money away from bonds, increasing yields until they match the rate of inflation.

India is considered a high growth country. However, we still have work to do on inflation and perceived risk. A more transparent regulatory structure and further reduction in inflation will reduce the interest rate. This can significantly reduce the portion of tax revenue going to interest payments (currently about 25%).

Reducing the debt load is another way to reduce interest payments. This requires a larger revenue base. The government revenue for India is about 20% of the GDP versus about 35% in OECD countries. What are the key reasons for a low revenue base in India? Are higher revenues necessarily good?

More on this later...

This column is authored by Nitin Gregory. Nitin, who graduated from IIM-Calcutta, is currently pursuing a finance role with an automotive major. He has a deep interest in Macroeconomics and pens a blog at Gregonomics.

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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