Do the math: deficit won’t push up rates

Do the math: deficit won’t push up rates
The Financial Express, July 16, 2009, Page 6

Mahesh Vyas

The gross fiscal deficit of the central government is projected to be 6.8% of the gross domestic product in 2009-10. This is higher than most expectations. The finance minister’s speech was categorical in ruling out privatisation of PSUs and also ruling out the divestment of its ownership in banking and insurance. The minister did not announce any “reforms” as the markets understand them.

As a result, the markets were punishing. Equity valuations dropped precipitously. CMIE’s COSPI (it includes all actively traded stocks) dropped by 7.5% from 4 July, the eve of the budget, to 14 July. The Nifty dropped 7% in the same period.

The question worth considering is ,will this high fiscal deficit cause high interest rates? I have stated earlier in this column that the fiscal deficits seen in the past two decades in India bear no statistical relationship with interest rates or inflation. Now, we work out some simple arithmetic to see how 2009-10 would pan out.

The 6.8% GFD/GDP ratio is derived from the central government’s plan to borrow Rs 4.5 lakh crore from the financial markets. But Rs 1.62 lakh crore has already been borrowed. Thus, more than one-third of the total annual borrowing was actually completed in the first quarter. This did not lead to a stiffening of interest rates. On the contrary, PLRs of banks declined during this period.

Back to the arithmetic. Rs 0.5 lakh crore is to be repaid on account of maturing government securities. Thus, the government has to effectively borrow only Rs 2.4 lakh crore in the remaining nine months of the year. This is a lot less daunting than what the Rs 4.5 lakh crore figure conjures.

Further, there is ample liquidity to meet the demands of the government and the private sector. Banks have consistently parked more than Rs one lakh crore with the reverse repo window of the Reserve Bank since April 2009. As of July 3, 2009, the amount outstanding in this account was Rs 1.6 lakh crore. Banks only park their excess liquidity in this account as it offers a mere 3.25% returns.

The statutory liquidity requirements on bank deposits is another source of funding the deficit. Banks are expected to mobilise Rs 7.7 lakh crore by way of deposits during 2009-10. These are expected to yield another Rs 1.5 lakh crore to the government as SLR during the July 2009 to March 2010 period.

Thus, the SLR investments of banks in the remaining months and the reverse repo investments of banks together can comfortably meet deficit requirements in the remaining months of 2009-10.

But, will all this funding of the government deficit hurt the availability of funds to the private sector through the banking system. Again, some simple arithmetic should help. RBI expects deposits to grow by 20%. We accept this assessment and thus estimate that Rs 7.7 lakh crore of deposits would be mobilised. Of this, 24% will be appropriated for SLR and 5% towards CRR. This leaves Rs 5.4 lakh crore of deposit money to meet credit disbursement. This is much more than the projected Rs 4.4 lakh crore of credit demand in 2009-10.

Credit demand is projected to drop in 2009-10. In the first quarter of 2009-10, outstanding bank credit declined from Rs 27.8 lakh crore as of March 28 to Rs 27.7 lakh crore as of June 20. Bank credit is thus expected to grow by 16% in 2009-10 as against a growth of 17.5% in 2008-09. This lower growth of 16% implies that credit deployment will be of the order of Rs 4.4 lakh crore in 2009-10.

Thus, banks’ deposit-credit gap will widen to Rs 3.2 lakh crore in 2009-10 from Rs 2.2 lakh crore in 2008-09. Banks will thus have additional liquidity. This additional liquidity will fund government borrowing.

The various computations discussed above make it clear that the large deficit of the government can be easily funded without straining the financial markets; without raising interest rates or starving the private sector of funds during the year. This does not justify the large deficit. It merely explains its implications for interest rates without debating its larger merit or demerits.

Recent press statements by bank leaders indicate that they expect interest rates to rise in the second half of the year. Implicitly, they do not expect them to rise around now. But, the calculations made above show that they are unlikely to rise during the entire year. The excess liquidity on the contrary imply that interest rates may even decline further during the year.

The question now is: why did the markets tank after the budget? Is the deficit going to hurt growth this year? Unlikely. The concern is elsewhere—will there be a normal monsoon. We discuss that another time.

—The author heads the Centre for Monitoring Indian Economy