If Indian fiscal policy were to be summed up in one word, it would be anti-growth. Indian governments routinely borrow money to finance a substantial proportion of their expenditure; these borrowings add to their debt, and interest on them takes away a significant proportion of their revenue, which might have been used for development. The debt itself is mostly sold to banks, which are owned by the central government and obediently buy up its debt with the money common people have deposited with them. The credit that goes to the government could have been given to more productive enterprises. The current finance minister, when he came to power a year and a half ago, had promised a very gradual reduction in the debt-to-GDP ratio. He has not kept the promise. But even if he does not have the guts to bring it down, there are a number of things he can do to bring down the cost of debt.
First, he can start selling government bonds to individuals and corporates. He would thereby expand the market for bonds, and reduce the interest rate he has to pay. The reason why he does not do so is that banks are owned by the government and will buy any amount of its debt and accept any interest it gives them; private investors may not be so slavish. Just now, however, there is no real market in bonds. The Reserve Bank has created a pseudo-market in which banks in need can sell bonds to other banks. But there is no competition in the market. Private investors can buy into bonds indirectly by investing in mutual funds that hold bonds. But the mutual funds deprive them of anything between 1 and 1½ per cent for this quite unnecessary service. There is an argument against allowing private investors: that selling to them would more expensive than selling to a handful of banks. However, the government can limit the additional cost by fixing a minimum application amount. It can also enable private investors to bid through their banks, and make banks hold their bonds as nominees. India is getting old; there are millions of old people who have to save for the day they stop earning, and many would like to invest in government bonds for the safety they give.
Second, the finance minister can take a cue from International Financial Corporation, which issued masala bonds in London in November 2014 – Rs 10 billion of 10-year bonds denominated in Rupees. Since the bonds were issued in London, investors in them are foreign; but the bonds are repayable in Rupees, which means that the foreign investors bear the exchange risk. IFC raised the money to lend to Axis Bank, which in turn would relend it to infrastructure projects. In other words, IFC borrowed in its own name to lend its prestige to money raised for domestic infrastructure investment projects in India of which foreign investors may have little knowledge. The government can do the same thing: it can issue masala bonds abroad. It would not need to take the help of IFC; the government of India would be well enough known abroad. And given the $280-odd billion of reserves it is sitting on, it would be regarded as creditworthy in its own right. It would be issuing the bonds in the world financial market, which is enormously larger than the Indian banks that it has hitherto been selling the bonds to; it would pay lower interest.
Third, it can issue bonds in a more respectable international currency than the Rupee – say, the US Dollar, the British Pound or the Euro. Any investor whose currency is aligned to the currency of issue would not have to bear exchange risk; that would increase the demand for the bonds in the country or region using that currency. The currency risk would be borne by the government of India.
It can avoid the risk by aligning the Rupee to the currency in which it borrows. If India were to adopt this strategy, it would have to make up its mind to align its currency to the one in which it borrows. The dollar is the most popular currency amongst countries that raise debt abroad, because the United States has the largest capital market. The Pound would come next; the Euro would come last. Since it is easiest to borrow in the New York market, it would be best to align the Rupee to the dollar – which is more or less what the Reserve Bank does.
The point of issuing debt abroad is that interest rates abroad are much lower than in India; the government of India would save a lot of public money by issuing sovereign wealth bonds. But why are interest rates so high in India? One reason is that nominal interest rates reflect investors’ expectations of inflation; inflation in India has historically been much higher than in industrial countries. This was a given as long as the Congress was in power; it routinely overspent on mass corruption programmes, otherwise known as social expenditure, such as food subsidies and employment-oriented public works, and financed the excess expenditure by borrowing. And then it reduced the real cost of debt by running a high level of inflation.
It is possible that the new BJP-led government may end this racket. Its finance minister promised to bring down the fiscal deficit – although till now he as been as frivolous about keeping the promise as his Congress predecessors. And inflation has come down. That is partly due to the lucky accident of the fall in international oil prices: the US developed fracking technology, started producing oil and gas, and ended its dependence on middle east oil, there was a surplus in the international oil market, and prices fell. Part of the fall was due to a change in government policy: it reduced the pace at which it raises agricultural support prices. The oil surplus will last for many years. It is within the power of the government to abolish inflation if it wants.
But a fall in inflation would be disastrous if interest rates in India were to remain as high as they are. There is another factor besides inflation behind their high level, namely, bank interest rates. They are high because of bank margins, which are high because banks’ costs are high. Most banks are owned by the government; they work as a cartel, and keep lending rates high to finance their own high costs, primarily their high wages. They can be brought down, but for that, the government must allow competition in the banking industry. It must be far more liberal with bank licences, especially for smaller banks and banks in villages and small towns. That is when the credit rationing of the past four decades will end. And if the government deregulates the equity market as well, India will then be able to grow at 10 per cent and more every year.
I have outlined the financial reforms that are needed to make India a tiger. Does this government have the entrepreneurial ability and economic understanding for it? I continue to wait to be convinced.
