New buyers of government bonds needed to lower the cost of borrowing
Does the interest rate the government pays on the debt it incurs even matter? Interest on public debt is a transfer from taxpayers to savers (who hold government bonds), and since the outstanding debt is primarily domestic, it is only a hand-to-hand transfer. the other within the economy. Tax for one is income for another. In addition, unlike private borrowers, who are very concerned about the cost of borrowing, government decision-makers are not directly affected by the interest rates offered, and are therefore less worried.
However, the cost of government borrowing is significant. The sharp increase in debt to GDP last year means interest charges as a percentage of GDP could be 1 percentage point higher than they were previously (for state and central governments combined) , limiting its ability to spend elsewhere. But more importantly, this rate also affects the cost of borrowing for much of the economy. While the public discourse mostly focuses on the rate set by the RBI, two additions to this rate set by the RBI determine the interest rates paid by private borrowers. If they had not increased over the past two years, actual borrowing costs would have been almost 1% lower than they are now.
The two add-ons are the term premium and the credit spread. To simplify the jargon, the RBI sets the repo-rate, which is the short-term risk-free rate. That is, the loan has to be repaid within 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. This is risk-free because the government can, in the worst case, print money to pay off its repayments, but the lender wants higher returns given the longer term of the loan. The difference between the repo rate and the government’s cost of borrowing, for example on a 10-year loan, is called the term premium. When a private company takes out a 10-year loan, it also presents a credit risk, which means that a credit spread is added to the 10-year risk-free rate.
Of the two, it is the term premium that currently poses the greatest challenge to policymakers. At an average rate of 73 basis points since 2011 (one basis point equals one hundredth of a percent) and 120 basis points in 2018 and 2019, the 10-year term premium is currently 215 basis points , after increasing by 35 basis points. since budget presentation, and among the highest in the world.
Financial markets are forward looking and, as a collective expression of the opinions of thousands of participants, efficient markets can sometimes “predict” what will come next. But the Indian bond market is not: the view that the rise in the term premium reflects future rate hikes by the Monetary Policy Committee (MPC) is wrong, in our opinion. The Indian bond market is still too illiquid and not sufficiently diversified to predict future trends. Even if some pandemic-related measures are withdrawn, the MPC continues to be accommodating, and for several months at least, headline inflation is unlikely to force a sharp change. Either way, the surge in post-budget returns indicates that the causation is fiscal rather than inflation related.
But even the budgetary justification seems weak. Compared to what the bond market predicted, the Union budget provided for an increase in bond issuance of Rs 80,000 crore during fiscal year 2020-21 and of Rs 60,000 crore during fiscal year 2021-22. Since then, the Centre’s tax collection for the 2020-21 fiscal year has been significantly above target, and state governments have also borrowed Rs 60,000 crore less than expected. In addition, 14 states (accounting for three-quarters of all state deficits) budgeted deficits for fiscal year 2021-22 at 3.3 percent, well below the 4 percent average expected earlier. These factors alone suggest that the total of bonds issued by central and state governments should be lower than what the market feared before February 1, when the Union budget was presented. Yet the government’s borrowing costs have not returned to pre-budget levels.
In our opinion, this reflects a market dysfunction. Why else would a government borrow at a higher cost than a mortgage on a house? While the latter, we understand, is against a collateral (the house), was not the loan to a sovereign supposed to be without risk?
The roots of this dysfunction can be traced to the fact that residential mortgages are among the most competitive loan categories, a category in which even public sector banks are active. On the other hand, there is a structural shortage of demand for government securities; in such a market, the marginal buyer holds all the cards and, like any buyer, demands higher returns.
In 15 years, the banks’ share of holding outstanding central government bonds has risen from 53% to 40% today, as policy rightly seeks to reduce financial repression (i.e. – say to oblige banks to deploy the deposits they collect in government bonds). But no sizable alternative buyer has emerged to fill the space left vacant: despite improved insurance penetration and formalization leading to growth in pension inflows, their share of outstanding bonds has in fact declined. decreased over the past 15 years. The RBI sometimes buys bonds to inject money into the economy, but in recent times this space has been used to buy dollars in order to save the rupee from appreciation.
Since it may be inappropriate to change the share of funds that banks, insurance companies or pension funds must deploy in government bonds, the solution may lie in obtaining new types of buyers. Opening the RBI to direct purchases by retail investors is a step in that direction, although it may not make sense for a few years.
That leaves us with the use of foreign savings. The share of government bonds that foreign portfolio investors (REITs) can buy has been steadily increased, but without Indian bonds included in global bond indices, these flows might not be significant and would be volatile, as they are. have been over the last year. . To enable inclusion in bond indices, the RBI and the government have reserved special grade bonds that are fully accessible (FAR) by foreign investors.
The FTSE has placed India on a watch list for “potential future inclusion” in the emerging market government bond index as “users of the global index … (showed). .. interest in Indian government securities issued via the (FAR) ”is a step forward, and hopefully triggers similar actions by other index providers. However, this process must be accelerated. This is not only for the government’s fiscal space, but also to ensure that the cost of borrowing in the economy is conducive to a post-pandemic recovery.
This column first appeared in the paper edition on April 6, 2021 under the title “Dysfunction in bond market”. The author is co-head of APAC strategy and Indian strategist for Credit Suisse