From UPSC perspective, the following things are important :
Prelims level : Not much.
Mains level : Paper 3- The crowding out effect, effects of the Government borrowing on various variables.
Market borrowings of the government do not always squeeze credit for the private sector in India.
What is ‘crowding out’ effect?
- Increased government spending and borrowing: It refers to how increased government spending, for which it borrows more money, tends to reduce private spending.
- Why does private spending reduce? This happens because when the government takes up the lion’s share of funds available in the banking system, less of it is left for private borrowers.
- Relationship with interest rate: Higher borrowing by the government and subsequent crowding out also impacts interest rates in the economy.
How the Government borrowing works and the role of RBI
- Local borrowing local spending: Typically, the government funds its fiscal deficit by borrowing from the domestic bond market.
- Its expenditure is also local in nature.
- Overdraft from RBI: The Reserve Bank of India (RBI) is the official banker to the government-which spends money by first taking an overdraft from the central bank.
- This overdraft gets repaid through bond market borrowings.
- Why overdraft? The understanding is that any such government spending should ideally not affect the availability of funds to other borrowers in the market.
- Excessive borrowing and effects on the interest rate: Excessive government borrowing from the bond market, many cautions, could lead to a rise in interest rates for the government itself and consequently for everyone else in the economy.
Analysis of the effects of borrowing on other variables
- Analysis of the data reveals the following trends.
- No impact on other variables: Local borrowing and spending by the Indian government does not impact any other macroeconomic variables like-
- The availability and cost of funds for other participants in the economy.
- Deposit growth, at the current deficit level—that is, with the state and central combined figure above 6% of GDP.
- What impacts the interest rate the most?
- The two most important variables that impacted interest rates were inflation and the repo rate. Which tend to move together.
- What does it indicate? This clearly indicates that RBI is extremely proactive in the way it manages interest rates.
- Effects of funds on inflation: Such borrowings that are funded by the central bank could lead to inflation, the same is true for large external inflows to domestic money markets.
- The foreign borrowings finally get reflected in the country’s foreign exchange reserves, which have a very strong relationship with inflation.
- Effects on interest rates: Technically, any large inflow of a foreign currency sterilized by RBI does have the potential to move the inflation needle up, thus placing upward pressure on interest rates.
- Relationship between borrowing and growth: It is clear that government borrowing and spending actually drives GDP growth.
- Government borrowing should not impact bank lending to companies, as the sums borrowed return to the market almost immediately.
- How RBI controls bond yield?
- RBI ensures that bond yields don’t shoot up because of the excessive borrowing, by taking bonds onto its books to be released back into the market in good times.
The uniqueness of the Indian money market
- Why is it unique? India market is a unique money market, different from the rest of the world, for the following reasons-
- We have investors who are explicitly required to invest in government debt.
- Banks, non-banking financial companies, insurers, provident funds, and pension funds are all forced to invest in government debt as a condition for their licence to operate in India.
- We also find that RBI works towards aiding the government borrowing programme rather effectively, ensuring that interest rates do not change too adversely.
The government should not be excessively worried about the government living beyond its means at this juncture. Government spending being the main driver for the country’s GDP growth, it could be a good way to put the economy on a higher growth trajectory. Perhaps it is time to revisit the entire FRBM framework.