RBI's financial stability report flags risks with public debt profile

Financial risks associated with the profile of government debt can hamper the functioning of fixed-income markets, the Reserve Bank of India (RBI) said on Thursday.

A credible strategy to ensure debt sustainability calls for reducing primary deficits, the central bank said in its Financial Stability Report.

In the report, the RBI warned that while the differential between interest rates and the growth rate has largely been favourable over the past three decades, tightening monetary policies worldwide stand to erode this advantage.

“At the end of March 2021, the outstanding debt of general government (Centre and states) peaked at 89.4 per cent of GDP and is expected to remain at elevated levels until 2025-26,” the RBI said in the report.

“This will likely sustain a rising supply of issuances to the market, imparting pressure on yields, and consequent crowding out of the private sector from the financial resources envelope.”

Government borrowing has risen at a rapid pace over the past couple of years as the Centre has relaxed fiscal deficit targets to ramp up spending and nurse the economy back from the scars of the Covid crisis.

As a result, sovereign bond yields have climbed sharply as the supply of debt has stretched the market’s absorptive capacity. Government bond yields are the benchmarks for borrowing costs across the economy.

The government announced a record-high gross borrowing programme of Rs 14.95 trillion in the current fiscal year sharply higher than Rs 10.47 trillion borrowed the previous year.

Accounting for debt switch operations that have been conducted, the Centre’s gross bond sales for the current year are slated at around Rs 14.3 trillion.

The Centre is aiming to bring its fiscal deficit down to below 4.5 per cent of GDP by 2025-26, from 6.4 per cent targeted this year.

In 2018-19 (April-Mar), the Finance Ministry had amended the Fiscal Responsibility and Budget Management Act and stated a target of 60 per cent for the debt-to-GDP ratio by 2024-25.

Subsequently, the fifteenth Finance Commission, under the chairmanship of N.K. Singh suggested lowering the debt-to-GDP ratio to 85.7 per cent of GDP in 2025-26 from 89.8 per cent of GDP in 2020-21.

The size of debt-to-GDP ratio has been a key constraint flagged by rating agencies when it comes to upgrading India’s sovereign rating.

In the Financial Stability Report, the RBI said that in FY22, the weighted average yield of government bond issuances had climbed by 49 basis points year-on-year.

“Going forward, yields may continue to reflect risk premia, with spillovers on to the private sector through higher financing costs,” the RBI said.

The RBI also flagged risks from the hefty government bond redemptions lined up in the next fiscal year.

“….larger repayment obligations of Rs 3.08 trillion during 2022-23 as compared to Rs 2.86 trillion in the previous year continue to weigh on the evolution of yields.

“At the short end, more frequent rollover of treasury bills, the stock of which has increased to Rs 9.99 trillion as on June 10, 2022, from Rs 24 trillion in March 2020, may tighten market conditions going forward.”

EXTERNAL BUFFERS

In the Financial Stability Report, the RBI said as a result of accumulation of significant foreign exchange reserves in recent years, several external vulnerability indicators show improvement vis-à-vis the ‘taper tantrum’ period of 2013.

“This augurs well for mitigating external risks and global spillovers,” the central bank said.

In the previous fiscal year, foreign exchange reserves rose by $30.3 billion because of net inflows of external commercial borrowings, improved banking capital and sizeable net foreign direct investment, the RBI said.

While the headline reserves have declined to $590.6 billion as on June 17 from an all-time high of $642.5 billion in September, the current level of reserves is equivalent to nearly 10 months of imports projected for the current year, the RBI said.

This provides a sufficient buffer against external shocks, the central bank said, adding that the rupee has turned out to be one among stable currencies relative to peer currencies since the Ukraine war broke out in late February.

So far in 2022, the rupee has weakened 5.9 per cent versus the US dollar – a lesser depreciation than some other emerging market currencies and significantly lower than the roughly 20 per cent depreciation witnessed during the taper tantrum.