Why they think we are junk
Business Standard, October 02, 2002
If current trends continue, it will come as no surprise if the rupee debt is further downgraded
The reaction to the recent downgrade of India’s rupee debt by Standard and Poor to “junk” status varies from hurt national pride to mild concern. The use of the term junk, which is a technical term in the bond industry, is partly responsible. So, indeed, is the word default and the visions of bankruptcy it creates. Unfortunately, such sentiments have taken attention away from the seriousness of the matter — the unashamed use of public money for pursuing narrow political objectives that have no growth enhancing impact.
Default is commonly understood to mean not just not paying up at all. But if the term ‘default’ on public debt includes rescheduling or delays in the payment of interest or principal, the chances that the Indian government would choose to ‘default’ are much higher than it may seem at first glance. A 17 per cent probability of default over a 10 year horizon, which is what S&Ps current grading of ‘BB+’ suggests, seems more likely than the previous rating that suggested a less than 5 per cent probability of default.
This is because the options before the government are limited. If it faces a fiscal crunch what can it do? The obvious answers are fiscal adjustment, inflation and default. While fiscal adjustment may be the most desirable, it is also the most unlikely. In the 1990s it was possible mainly because the adjustment took the form of cuts in capital outlays.
In the current budget, privatisation of public sector enterprises was expected to bring in revenue. But with no clear political consensus over privatisation, fiscal adjustment means taking tough decisions such as raising taxes and user charges as well as cutting spending on subsidies and various government schemes. This is difficult for any government especially in a democracy.
The recent raising of the minimum support price for paddy under pressure from its coalition partners shows how unlikely a fiscal correction path may be. Moreover, Yashwant Sinha was apparently replaced by Jaswant Singh at the finance ministry to win back the dissatisfied political cadre of his party clearly at the cost of the exchequer. Thus serious fiscal adjustment hardly seems to be in the offing.
The second option that might seem to be easier is simply printing money to pay off public debt or in other words inflation. But is inflation really an ‘easier’ option, particularly in a democracy? Inflation in India clearly hurts the poor and the middle-class and governments have been known to have been voted out in India because of rising prices. If fiscal adjustment is difficult because it affects the vested interests of one group or another, inflation is even more difficult because it affects the large majority of the electorate.
The third option, default, which could primarily constitute arm-twisting banks who hold a large proportion of public debt in India to reschedule government debt, might sound much easier. Banks which have to hold 25 per cent of their liabilities as government securities as part of the SLR requirement, and a large share of which is indeed owned by the government, will have no avenue to resist.
It has fewer political implications and not much of the media outside the pink press would perhaps pay much attention to some delays and rescheduling of government debt being held by public sector banks. If faced with a crisis, the probability that the government would resort to such means is arguably much closer to 17 per cent than to 5 per cent.
But how likely is it that a fiscal crisis may occur? If what Finance Minister Jaswant Singh’s first few weeks are anything to go by then, India will soon be pushed into an internal debt trap.
The debt to GDP ratio could become explosive and non-sustainable debt path. Already, India’s debt dynamics are precarious. The combined central and state government debt stands at 70 per cent of GDP and puts India amongst the most indebted countries in the world. If the rate of interest paid on public debt is equal to the growth rate of GDP and the primary deficit — measured as the fiscal deficit minus interest payments — is zero, the debt to GDP ratio would remain constant.
Thus with any borrowing the government does other than for paying the interest on public debt, ratio of debt to GDP rises.
Last year the average interest rate paid on public debt was 8.5 per cent. Discounting for inflation, the real interest rate amounts to 5 per cent. This nearly equals the growth rate of GDP. In a situation when the real interest rate is as high as the GDP growth rate, the debt to GDP ratio can be prevented from rising only when the primary deficit is zero. Any addition to the fiscal deficit will only raise the debt GDP ratio.
If the debt to GDP ratio did not rise despite the primary deficits of the last few years, it was mainly because of falling interest rates and higher GDP growth rates. But with small savings already financing 20 per cent of the combined central and state deficit and with its share rising, reducing the total interest burden will also become a political decision.
In addition to the existing payment obligations of the government, is the rising pensions bill which stands at one per cent of GDP. The debt figure above also does not include guarantees provided by governments. The explicit guarantees provided by the central government stand at 4.2 per cent of GDP. For state governments the situation is even worse. While explicit guarantees stand at 8.1 per cent of GDP, implicit guarantees are yet to be measured. Only a few states have placed ceilings on guarantees.
What is worse, as if the existing liabilities were not large enough, the government decided to give bailouts to UTI and later this could extend to IFCI and IDBI. These will raise the primary deficit to nearly 2.5 per cent of GDP, pushing up the debt to GDP ratio by the same amount and raising the chances of more bailouts.
The current trends, if they continue, as they are likely to, can only increase the probability of default and not reduce it. If such largesse continues it would not be too surprising if in the next round of rating India’s rupee debt is further downgraded. Already institutional investors whose guidelines prevent them from investing in “junk” or speculative grade bonds are withdrawing from the Indian rupee debt market. It is time for Mr Singh to sit up and take notice!