Sunlight on the ledger

Indian Express, 20 February 2009

The Central Government is slated to raise more debt in the coming year than it has ever done in the past. It will borrow at least Rs 3.3 lakh crore. The cost of this borrowing needs to be kept low, the risks to the economy resulting from such large borrowing should be minimised, and the credibility of the goverment maintained. Fortunately, even before the ballooning of the deficit this year, the government had already initiated work on finding ways to handle its large borrowing needs. It must now speed up implementation of a Debt Management Office, an initiative that takes on even greater importance after the deficit estimates for the coming fiscal year have been announced.

Why does a large deficit put the DMO at the top of the policy agenda? Think about how a private company like Infosys or Reliance would have handled its borrowings. Infosys has a balance sheet size of Rs.17,000 crore and zero debt. Reliance is a much bigger company, with a balance sheet of Rs.150,000 crore. But Reliance has borrowings of Rs.40,000 crore.

Suppose both these companies decide to do fresh borrowing of 20% of the balance sheet size. For Infosys, that means doing a bond issue of Rs.3,400 crore. That's a trivial matter for Infosys. The bond market sees that Infosys has zero debt to start with, and that repayment of this bond issue would be easy. In terms of the mechanics of how they go about it, they can get away with informal mechanisms: all the Infosys CFO has to do is make a few phone calls and he will get Rs.3,400 crore. The services of an investment banker are not particularly required there.

On the other hand, if Reliance wanted to do fresh borrowing of 20% of its balance sheet, this is not a simple matter. This amounts to fresh borrowing of Rs.30,000 crore. This comes on top of existing debt of Rs.40,000 crore. The bond market will view this with some nervousness. Reliance would have to think about keeping the costs of the debt low.

How would Reliance go about this? In all likelihood, Reliance would hire smart investment bankers. They would think about what kinds of bonds are to be issued, about the maturity, the currency composition, the target investors. Special efforts will be put in to do discussions with investors, explaining the outlook for the company, and why the company has the ability to repay this debt.

In other words, informal mechanisms for debt management are acceptable when the borrower is starting from a sound position. But when the existing indebtedness of the borrower is large, fresh bond issuance is a non-trivial problem. It requires special thought and care to do this properly.

How are these principles relevant in the case of the Indian government? The true fiscal deficit for 2008-09 for the centre and states will probably work out to 12% of GDP, which is comparable to the level found prior to the 1991 crisis. Next year this highly indebted entity is going to be borrowing on a massive scale.

How does the management of Government debt work in India today? First, markets have only a hazy idea what what the total borrowing of the entire government of India are. The lack of transparency on off-budget items, and public sector enterprises is enhanced by lack of timeliness in deficit numbers for the states. Not even good guesstimates are available for the total Public Sector Borrowing Requirement (PSBR). This is unlike OECD countries where decisions to borrow more are based on informed decisions at least about the total size of the debt and the current borrowing of the total public sector and government, including lower tiers of government.

Second, the RBI acts as the investment banker of the government. This involves many conflicts of interest with monetary policy and has been one of the main reasons why the RBI has in the past recommended the setting up of a separate Debt Management Office.

Third, the bulk of government bonds are held by banks, the majority of which are public sector banks. Banks are statutorily required through the Stautory Liquidity Ratio(SLR) to hold one forth of their total assest in government bonds. So banks borrow from the public and redirect that money to the government. Regardless of how large the government debt is, regardless of whether the govenment has the ability to pay this debt or not, the Indian public is forced to (through the intermediation of banks) lend to the government. This is not the case in developed countries who have active government bond markets and who do not force their citizens to hold this risk. Indeed, the bond market often demands higher interest rates when it deems the bonds to be riskier. Governments are punished by the bond market for borrowing too much. Our public sector banks have little choice and in the matter.

Let us not forget that RBI, the government's investment banker also regulates banks. It can offload risky government bonds onto banks and overlook the risks when it comes to bank supervision. While explicit costs remain high, implicit costs through higher risk in the banking system are high. Also when banks are forced to lend cheaply to the government they recover their costs of deposits from the private sector. This shifts the burden to individuals and households borrowing from banks.

These issues have come to prominence in recent weeks, where the financial markets have been concerned about large borrowing requirements of the government. Given that RBI does all three functions (banking regulation, investment banking, monetary policy), these concerns immediately spill over into concerns about what banking regulation might do next or what monetary policy might do next, in order to assist the investment banking function of RBI. This adds to the atmosphere of uncertainty that prevails in the economy today.

The establishment of the DMO has been advocated by RBI, and by a number of expert committees, from 1999 onwards. This culminated in a budget announcement by the UPA government to this effect. A Ministry of Finance working group has worked out the mechanics of how the DMO should be setup ( The task before the government now is to swing into action.

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