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The article highlights the failure of FRBM Act to contain India’s rising debt and suggests an alternative framework.

Issues with the FRBM Act

• Economic disruption caused by the COVID has prompted calls for a relook atthe Fiscal Responsibility and Budget Management Act (FRBM).
• The introduction of the FRBM in 2003 reflected the belief that setting strict limits on fiscal deficits, both for the centre and the states, was the solution.
• But this framework didn’t work.
• Apart from the initial period, when growth was booming, the deficit targets were largely honoured in the breach, leaving the primary balance [Revenue-Non-intrest expenditure] essentially unchanged (Figure 2, phase 2).

Debt has increased to record levels

• India’s general government debt has soared.
• It is now close to 90 per cent of GDP — the highest independent India has ever seen.
• The debt ratio will come down naturally as GDP normalises.
• Even so, on current policies, it is likely to exceed 80 per cent for the foreseeable future.

Would such a high level of debt be sustainable?

• Briefly, sustainability depends on two key factors:
• 1) The primary balance (PB), revenue less non-interest expenditures.
• 2) The difference between the cost of borrowing and the nominal growth rate (r-g).[interest-growth differential]
• Debt does not explode when the primary balance is greater than the interest-growth differential.
• In India’s case, PB has been negative as the government has run primary deficits.
• But this has been counterbalanced over the past decade by favourable differentials, as interest rates have been lower than growth.
• Hence, the broadly stable debt ratio.
• This equilibrium has now been upset by the sudden increase in debt.
• If the interest-growth differential consequently turns unfavourable, as occurred during the previous period of high debt in the early 2000s (Figure 2, phase 1), then debt sustainability could only be preserved by shifting the primary balance into surplus.
• And this would not be easy.

Why shifting primary balance intro surplus is not easy

• Primary deficit of the Centre and states combined is typically about 3 per cent of GDP. [say PB is -3% of GDP]
• So, shifting the primary balance into a modest surplus [i.e. turning PB from -ve to +ve] would require an adjustment of 4 percentage points of GDP.
• But non-interest expenditure is only roughly 20 per cent of GDP.
• If tax increases were ruled out, then a sudden adjustment would require non-interest spending to be cut by no less than 20 per cent (4 divided by 20 times 100).[20% of 20 is 4]
• Clearly, this would be politically impossible.
• But this would render India susceptible to panic and possibly even crises.
• The government needs to eliminate the tension, undertaking a pre-emptive consolidation to prevent the need for a sudden adjustment.

Strategy based on 4 principles

• The government should start by defining a clear objective, based not on arbitrary targets but on sound first principles: It should aim to ensure debt sustainability.
• To this end, the government could adopt a strategy based on four principles.

1) Abandon multiple fiscal criteria

• The current FRBM sets targets for the overall deficit, the revenue deficit and debt.
• Such multiple criteria impede the objective of ensuring sustainability since the targets can conflict with each other,
• This creates confusion about which one to follow and thereby obfuscating accountability.

2) Don’t get fixated on specific number

• Around the world, countries are realising that deficit targets of 3 per cent of GDP and debt targets of 60 per cent of GDP lack proper economic grounding.
• In India’s case, they take no account of the country’s own fiscal arithmetic or its strong political will to repay its debt.
• Any specific target, no matter how well-grounded, encouraging governments to transfer spending off-budget such as with the “oil bonds” in the mid-2000s and subsidies more recently.

3) Focus on one measure for guiding fiscal policy

• In this regard, Arvind Subramanian and Josh Felmanwe propose targeting the primary balance.
• This concept is new to India and will take time for the public to absorb and accept.
• But it is inherently simple and has the eminent virtue that it is closely linked to meeting the overall objective of ensuring debt sustainability.

4) Don’t set yearly target for the primary balance

• The Centre should not set out yearly targets for the primary balance.
• Instead, it should announce a plan to improve the primary balance gradually, by say half a percentage point of GDP per year on average.
• Doing so will make it clear that it will accelerate consolidation when times are good, moderate it when times are less buoyant, and end it when a small surplus has been achieved.
• This strategy is simple and easy to communicate; it is gradual and hence feasible.

Consider the question “Despite the FRBM framework India’s debt level have touched a historic high. In light of this, examine the reasons for the failure of FRBM in controlling the debt level and suggest the way forward to make India’s debt level sustainable.”

Conclusion

COVID has upended India’s public finances. It is time to learn from past experience and adapt. Adopting a simple new fiscal framework based on the primary balance could be the way forward.

What explains the Indian government borrowing at a higher interest rate than the interest rates for a home loan? The answer lies in the structural shortage in demand for government bonds. 

How the government’s cost of borrowing matter

• Interest on government debt is a transfer from taxpayers to savers who own government bonds.
• As the government bondholders are primarily domestic, interest paid by the government is just a transfer from one hand to the other within the economy.
• However, the government’s cost of borrowing does matter.
• The large increase in interest costs limits the government’s ability to spend elsewhere.
• But more importantly, this rate also affects the cost of borrowing for large parts of the economy.

Understanding the term premium and credit spread

• The RBI sets the repo rate, which is the short-term risk-free rate.
• That is, the loan must be repaid in a few days and there is almost no risk of default.
• The rate at which the government borrows is the long-term risk-free rate.
• But the lender wants higher returns given the longer duration of the loan.
• The difference between the repo rate and government’s borrowing cost, say on a 10-year loan, is called the term premium.
• When a private firm takes a 10-year loan, it would have some credit risk too, which means a credit spread is added to the 10-year risk-free rate.

Challenge posed by term premium

• From an average rate of 73 basis points since 2011 (one basis point is one-hundredth of a per cent), and 120 basis points in 2018 and 2019, the 10-year term premium is currently 215 basis points.
• In other words, the interest rate for a 10-year period borrowing is 2.15 per cent higher than the current repo rate.

How this is related to dysfunction in bond market in India

• Financial markets are forward-looking, and as the collective expression of the views of thousands of participants, efficient ones can occasionally “predict” what comes next.
• But the Indian bond market is not one such: The view some hold, that the rise in term premium reflects future rate hikes by the monetary policy committee (MPC), is mistaken.
• The Indian bond market is still too illiquid and not diverse enough to predict future trends.
• Even though some pandemic-driven measures are being withdrawn, the MPC continues to be accommodative, and for several months at least, headline inflation is unlikely to force an abrupt change.
• In any case, the spurt in yields after the budget points to the causality being fiscal instead of inflation-related.
• But even the fiscal rationale seems weak.
• The Centre’s tax collection for FY2020-21 has been substantially ahead of target, and state governments have also borrowed Rs 60,000 crore less than expected.
•  Also, the14 states, accounting for three-fourths of all state deficits, have budgeted FY2021-22 deficits at 3.3 per cent, far lower than the 4 per cent average expected earlier.
• Just these factors suggest that total bonds issued by the central and state governments should be lower than what the market had feared before the union budget was presented.
• And yet, government borrowing costs have not returned to pre-budget levels.
• This reflects dysfunction in the market.
• Why else would a government be borrowing at a higher cost than a mortgage on a house?

What is the reason for dysfunction in bond market

• Dysfunction can be traced to residential mortgages being among the most competitive of loan categories.
• On the other hand, there is a structural shortage in demand for government bonds.
• In such a market where there is a structural shortage in demand the marginal buyer holds all the cards, and as any buyer would, demands higher returns.
• Over 15 years,  the share of banks in the ownership of outstanding central government bonds has fallen from 53 per cent to 40 per cent now.
• But no alternative buyer of size has emerged to fill the space vacated.
• The RBI sometimes buys bonds to inject money into the economy, but of late this space has been used to buy dollars to save the rupee from appreciation.

Solutions

• The solution to the problem of bond market may lie in getting new types of buyers.
• The RBI opening up direct purchases by retail investors is a step in this direction, though it may not become meaningful for a few years.
• That leaves us with tapping foreign savings.
• The limit on share of government bonds that foreign portfolio investors (FPIs) can buy has been raised steadily.
• But without Indian bonds being included in global bond indices, these flows may not be meaningful, and would be volatile, as they have been over the past year.
• To enable inclusion in bond indices, the RBI and the government have earmarked special-category bonds which are fully accessible (FAR) by foreign investors.
• The FTSE putting India on a watch-list for “potential future inclusion” in the Emerging Markets Government Bonds Index is a step forward, and, one hopes, triggers similar actions by other index providers.

Consider the question “How the lack of retailness in the bond market affects the cost of borrowing of the government as well as the private borrowers? Suggest the measures to deal with the issues.”

Conclusion

The issues with bond markets in India highlights the urgency to find new buyers for government bond as it has implications not just for the government’s own fiscal space, but also for the cost of borrowing in the economy.