Why the Modi government’s big borrowing plan this year will hit all ordinary borrowers too

New Delhi: Narendra Modi’s government announced last week that it will borrow Rs 8.45 lakh crore from the market, in this case banks and financial institutions, in the first half of 2022-23 (until September) by issuing bonds.

This amount is 59 percent of the total gross debt target that they had announced during the presentation of the Union Budget for the current year that begins on April 1.

Borrowing for the April-September period is slightly higher than market participants (essentially government bond investors) expected. These bonds will be auctioned weekly from April 4, as is the usual practice each year.

But what’s so different about the overall lending landscape this time, and how can it affect consumer demand for home and auto loans? There is high inflation.

As inflation erodes the purchasing power of money, bond investors often seek returns that are above the rate of inflation. This means that the country’s biggest borrower, the Indian government, will also have to pay higher rates on its bond offerings when inflation rises.

Since sovereign bonds are considered risk-free, the cost of borrowing for all other entities, be they corporations or mortgage borrowers, is above the government bond rate. In the current scenario, when the government will borrow at high costs, all borrowers in the country will feel the pressure.

Retail inflation or inflation based on the Consumer Price Index (CPI) increased to an eight-month high of 6.07 percent in February, mainly due to the increase in fuel prices.

This is the second month that retail inflation has been above the 2%-6% inflation target band as prescribed by the Reserve Bank of India (RBI).

Various estimates suggest that inflation will increase further in the coming months once the increase in fuel prices is factored into the CPI, and will be in the range of 5.5-6 percent.

“Elevated commodity prices, especially crude oil, are likely to exacerbate the impact of large government borrowing in the market on bond yields,” said a report from ratings agency ICRA.

Also read: Global investors turn bearish on Indian bonds as index inclusion stalls

Why does a government go into debt?

In a given financial year, the government earns a certain revenue through various means.

Most of their income comes from taxes, direct and indirect. At the same time, the government also spends regularly on various central schemes to stimulate growth. It also spends a great deal on providing subsidies (food, oil, and fertilizers) to keep the prices of products and services low so that people can afford them, and also to encourage production and consumption.

The difference between what a government earns and what it spends is known as the fiscal deficit, where the latter is greater than the former.

To finance this gap, the government uses three routes: market loans, receipts from the National Small Savings Fund, and loans from multilateral institutions such as the World Bank and the Asian Development Bank.

In the past three years, market borrowing has typically accounted for 50-60 percent of the fiscal deficit, which is set at 6.4 percent of GDP for 2022-23.

Large market indebtedness by the Center

During the last 10 years, there has been a substantial increase in central government lending through bonds, almost three times.

In 2011, the government borrowed Rs 5.09 lakh crore from the market to finance its deficit, compared to Rs 8.45 lakh crore it plans to borrow in the first half of the current fiscal year alone. The total gross loan for 2022-23 is estimated at Rs 14.31 lakh crore.

The government market loan stood at Rs 7.1 lakh crore in 2019-20. In the 10 years ending 2019-20, the government increased its loans by only Rs 2 lakh crore or 40 per cent.

However, with the devastating impact of the Covid-19 pandemic on government revenues, the Center’s lending soared to Rs 12.6 lakh crore in 2020-21.

In three years, the government’s gross borrowing has doubled, while the balance sheets of the banks, which buy most of these bonds, have expanded by about 33 percent.

It was hoped that as the economy revived and returned to pre-pandemic levels, the government would be able to reduce its fiscal deficit and thus its borrowing. But with the increase in interest payments on loans from previous years, the overall burden of debt service has become heavier.

Also read: Why the global rally in China’s sovereign bonds may have run its course

Impact on the cost of capital

Since the start of the pandemic, the RBI’s Monetary Policy Committee (MPC) has pursued ultra-loose monetary policy, keeping the repo rate, or the rate at which banks borrow from the RBI, at 4 percent, the level lower. in two decades.

This is despite record levels of retail inflation.

Simultaneously, the central bank has maintained excess liquidity in the banking system so that the government’s weekly loans do not face any pressure.

But with market forces at play and the expectation that the US Federal Reserve will continue to press with aggressive tightening, which means raising interest rates, the RBI may finally have to change its dovish stance and reverse the flexible rate cycle.

The juxtaposition of the above with a large borrowing in the market can result in a higher cost of borrowing for the government and, therefore, for companies and individuals.

Another factor is that, in the last two years, the RBI absorbed a significant part of the government’s large lending program.

The central bank bought Rs 3 lakh crore worth of bonds under open market operations in 2020-21, and a further Rs 2.2 lakh crore worth of bonds under its government securities purchase program in 2021-22, keeping the cost in check. of the loans.

This year, however, the RBI will not be able to buy as many bonds as monetary policy will change course and the central bank would actually raise interest rates, moving away from monetary accommodation.

The 10-year government bond yield, which represents an investor’s return on interest payments on the bond, is currently 6.84 percent.

Businesses and banks often track this return when deciding interest rates on various loans they offer to consumers. When bond yields fall, borrowing costs for corporations and the government are reduced, leading to increased spending.

Market experts estimate that the 10-year bond yield will range between 7 and 7.4 percent in the first half of the current fiscal year.

With rising yields and rising RBI rates, banks can pass on rising rates to consumers, denting demand for loans.

(Edited by Sunanda Ranjan)

Also read: Ignoring inflation may fight back, but it won’t buy additional growth in India

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