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Viral Acharya Warns About Risks From High Government Borrowings

A study by outgoing RBI Deputy Governor Viral Acharya had highlighted the quantitative impact of higher government borrowings.

Outgoing RBI deputy governor Viral Acharya. (Photo: BloombergQuint)
Outgoing RBI deputy governor Viral Acharya. (Photo: BloombergQuint)

Viral Acharya, deputy governor of the Reserve Bank of India, ends his stint at the central bank on Tuesday, a few months before his three-year term was set to end. Acharya, who served as the deputy governor in-charge of monetary policy, came to be known for his speeches that didn’t mince words. Not with the government. Not with market participants or bankers.

No surprise then that one of the last few missives from Acharya was also one which sends a tough message.

The Indian economy risks ‘crowding out’ of private borrowings due to high government borrowings, Acharya has cautioned, arguing that ‘less can be more’ when it comes to government borrowings. 

Acharya spoke on the subject at Indian Institute of Management, Ahmedabad last week. He had also presented on the subject in November 2018 at the KP Hormis Commemorative Lecture organised by the Federal Bank. The speech, however, was not released by the Reserve Bank of India.

The message in the speech is as important, if not more, than it was in November when Acharya first detailed the results of his study on crowding out effects of large government borrowings in India. The government will borrow more than Rs 7 lakh crore from the markets to finance its fiscal deficit of 3.3 percent of GDP in 2019-20. In addition, it will raise extra budgetary resources by borrowing through the balancesheets of public sector enterprises.

These large sovereign and quasi-sovereign borrowings could keep interest rates high even as the central bank eases monetary policy to support growth. The outgoing deputy governor raised some of these concerns at his last monetary policy committee meeting in June.

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Crowding Out: Quantitatively Speaking

The research, which Acharya said had been undertaken by him, together with Nirupama Kulkarni, Bhavika Nanawati, and Seema Saggar, made an attempt to estimate how large the quantity and price effects of crowding out might be for India.

The study reiterated that there are three main channels of crowding out:

  • The real channel: High government borrowings may increase expectations of higher corporate taxes in the future and reduce investment.
  • The banking channel: Where banks end up stuffing up their portfolios with government bonds and reduce lending to the private sector.
  • The corporate bond channel: Where government debt provides a ‘convenience yield’ to investors, who, in turn reduce investments in corporate debt.

While fears of crowding out are often discussed in time of high government borrowings, the extent of impact is rarely understood.

Impact On Bank Lending More Pronounced

Acharya and his co-researchers studied data from 1997 to 2016 and found that the largest crowding out effect is seen through the banking channel.

“When government debt increases by 10 percent of GDP, corporate debt issuances fall by 7.3 percent. In 2015-16, when total government debt increased by 12.6 percent, corporate debt declined by 9.1 percent. The bulk of this effect operated through the bank credit channel, which accounted for 6.7 percent of the decline in corporate borrowing.”

The paper said since the more limited banking resources first go toward larger, higher-rated corporates, it is small- and medium-sized enterprises that are worst impacted.

The Role Of Foreign Capital

A caveat to this is the availability of foreign capital.

If the global environment is benign and large corporations can access global savings for their borrowing needs, then the domestic crowding out impact is more limited. In contrast, when FPI flows are low, a 10 percent increase in government borrowing results in a 6.9 percent decline in total corporate borrowing.

Ideally, in such a year, it might be desirable that the government borrowing contracts in order to sustain the availability of bank loans and bonds for the private sector of the economy.

Crowding Out: Impact On Borrowing Costs

Acharya and his co-researchers also undertook a study on the impact that increased government borrowings have on the cost of financing.

Their findings showed that when government debt to GDP increases by 1 percentage point, yields of the highest-rated (AAA) bonds increase by 2.3 percentage points.

Interestingly, the impact on lower-rated (AA) bond is more limited.

The spread, or the additional interest rate that AA-rated companies pay over AAA-rated companies, does not widen much. A 1-percentage-point increase in government debt to GDP results in a 1.7-percentage-point decrease in the AA–AAA yield spread, the study said.

Crowding Out: Impact On Financial Stability

The study also found that when government borrowings rise, corporations are more likely to undertake shorter-term borrowings. This is because of longer-term borrowings, due to higher uncertainty, may cost more.

“Thus, not only does government borrowings crowd out the private sector, but it can also induce the private sector to borrow more short term, which can increase financial fragility.”

Might such forces have partly contributed to the surge in asset-liability mismatch of the NBFC for 12 months starting in the second half of 2017 when there was an upward revision in the quantum of government borrowings? Acharya said this is an intriguing possibility that is worthy of further inquiry.

Crowding Out: Impact On Monetary Policy Transmission

High government borrowings also reduce the transmission of monetary policy.

Acharya’s study found that transmission of a rate cut in India is found to be about twice as strong when the government debt is in control.

  • When government debt is below the median level, a 25-basis-point cut in the repo rate results in a 15-basis-point fall in the yields of the AAA-rated bonds and a 7.5-basis-point fall in the yields of the BBB-rated bonds.
  • When government debt is above the median level, a repo rate cut decreases yields by only 7.5 basis points and 3.25 basis points for AAA- and BBB-rated borrowers, respectively.
As more government debt floods markets, the relative safety and liquidity premium attached by investors to high-rated corporate bonds diminishes, raising the cost of borrowing, especially for AAA-rated borrowers and making it relatively less sensitive to policy rate cuts.  

In Conclusion...

In conclusion, Acharya cautioned that the trend of increased revenue expenditure, such as spending on large welfare programmes, comes at a cost to investments by the private sector in the economy.

To reduce this crowding out effect, the government has focused more on capital expenditure, which have a stronger ‘crowding in’ effect than revenue expenditure. It could also divest holdings in public sector enterprises and reduce borrowings. Or it could strengthen its commitment to fiscal responsibility by setting up an independent fiscal council.

Acharya, known for his love for music and poetry, ended this speech, like a few others with a lesson from the music world. The government should take inspiration from Sachin Dev Burman’s music in Pyaasa, said Acharya.

Burman-da proved that less can indeed be more by crowding in everyone else, so can the government!

Viral Acharya’s speech and study are available at this link.

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