Can crowding out be avoided in India

Sure it can be, it’s very easy

Recently there has been lot of talk about the phenomenon of “Crowding Out”, which in simple words means that the government through its excessive borrowing reduces the availability of funds for investment and consumer lending to the private sector and thus leads to a phenomenon of stubbornly higher interest rates and lower economic growth.

The phenomenon of higher government borrowing has come up globally over the last one year (specifically) due to the economic turmoil globally and it mainly stems from the apparent failure of monetary policy easing in reviving economic activity. (Which essentially means that even after the record reduction of key rates by central bankers globally demand on an aggregate basis has not revived)?

This has lead, especially over the last six months to calls for the governments all over the globe to take over the mantle of creating economic growth. Over the last twenty years it was largely consumer demand and private sector investment demand that drove economic growth globally. However due to the severe financial crisis, reducing real income levels (specially in the Western economies which account for 60% of the worlds GDP) and a severe lack of confidence there is an apprehension that despite the reduction in interest rates and increased availability of money the private sector will take time to start consuming and investing and under the circumstances the government has to spend more in the short term and revive the confidence.

Because of this we have seen China announcing a stimulus package of over $ 580 billion, US passing the economic stimulus bill of around $ 800 billion, Germany announcing a $ 250 billion package etc. This has been followed up by stimulus packages by various governments all over the world including India where the government has announced higher spending along with significant tax cuts over the last six months.

However a combination of slowing economic growth, cut in taxes and higher government spending has led to the government in the current year borrowing nearly Rs 1,35,000 crores more that what it had estimated at the beginning of the year from the markets. Because of this, despite there being a significant slowdown in both economic growth and bank credit growth interest rates have not come down as sharply as they should have. Despite the RBI infusing huge liquidity due to the cut in CRR by over 5% and Repo Rate also by a similar amount the yield on 10 year government of India bonds still stood at 7% and has recently come down to 6.2%. This is at a time when inflation rate in India has become virtually zero and is likely to stay at that level for atleast three months. As such real rates in India are one of the highest in the world. These real rates need to come down for the economic activity to revive rapidly.

In the current financial year the government has budgeted to borrow nearly Rs 2,40,000 crores in the first half of the year, which is around Rs 10,000 crores per week. When there was a huge influx of dollars in the boom years the RBI had sucked out liquidity by issuing MSS bonds and it can redeem or convert these bonds into regular GOI bonds, however the amount of such bonds outstanding now is just Rs 89,000 crores.

India is just around 2% of the global economy today. I believe that inflation is now a global phenomenon and the rise and fall in inflation in India was largely due to the increase and decrease in global commodity prices. As such one way for the RBI to reduce the real rates in the system is to pursue quantitative easing i.e. print currency. Due to the global slowdown this is unlikely to cause an increase in inflation atleast over the next one year. This will increase money supply and lead to a reduction in interest rates rapidly. This will improve credit availability to the consumer as well as to the corporates. However such a move will be criticized by lot of economic commentators,foreign analysts and rating agencies. ( when an emerging economy does this it is criticized, but when countries like the US and UK are doing it at a massive scale it is condoned).
The second way which I think is the best way is for the government of India to go in for a sovereign borrowing issue as soon as a new government comes in. A $ 20-30 billion issue will bring in nearly Rs 1,00,000 -1,50,000 crores into the economy and will reduce the requirement for the government to borrow from the domestic markets. The government will easily be able to borrow at an interest rate of 200 bps over libor i.e. around 3 % in US dollar terms (for a 10 year bond). This in my view will lead to an immediate fall in 10 year government bond yields by upto 150 basis points or 1.5%, which will actually be magnified as it translates into lower interest rates for the private sector where the reduction in rates will be 1.5% to 3%. A $ 20 billion issue will just amount to 2% of India’s GDP and is not a significant amount for a sovereign borrowing. However it will be a massive boost to the domestic economy and will lead to a very sharp revival in economic growth.
This should be a long term bond of 10 -30 years and in my view longer the tenure better it is from a repayment standpoint as over a 30 year period the rupee should appreciate vis a vis the dollar and my personal view is that 30 years from now the rupee could be anywhere between Rs 15-25 to the dollar and as such the actual repayment in rupee terms at the end of the tenure of the bond will be much lower than what has been borrowed.

This avoidance of “Crowding out” can add 1.5-2% to India’s GDP growth over the next two years.

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