The difficulties in the government borrowing a record sum of Rs 400,000 crore this year, as proposed in the Budget, are becoming apparent. Such an outsize programme could drive up interest rates, which would adversely affect bond prices. Banks, which are the largest customers for government bonds, are chary of picking up long-duration government paper because these are the ones most likely to suffer price drops if interest rates rise—and they are obliged to reflect these price losses to their profit and loss accounts. That very reluctance will force the Reserve Bank and the government to offer more attractive rates, which will then convince the banks that they were right to be cautious. This is a vicious cycle of expectations that can feed on itself.
One solution proposed is that the government open up the domestic debt market to foreign institutional investors (FIIs). This is a window that is already open to some extent, the limit on FII exposure to government securities being $5 billion (about Rs 25,000 crore). That number makes it obvious that foreign finance is not a solution; even if RBI were to double the limit on FII exposure to the debt market, all it would mean is that an extra Rs 25,000 crore could come in—which is barely 6 per cent of the government’s borrowing requirement. To be sure, everything helps at the margin, but it is obvious that the meaty solutions lie elsewhere.
Opening up to FIIs is touted by some as a desirable end in itself. There cannot be any “black or white” answer to this, because the wisdom of such a move depends on the macro-economic context. The present limit of $5 billion is modest in that it is only 1.5 per cent of total government debt. But other risk factors have to be considered—like the debt-GDP ratio and the size of the fiscal deficit, because these affect international confidence and influence FII behaviour.
Opening up does not necessarily mean that the money will come in. Less than half the present $5 billion limit has been used up today, and most of that money is in short-term securities with 91-day or 364-day maturity. In other words, FIIs are not willing to bet in long-term securities (which are what the government would want), because they fear the level of risk involved. This in itself suggests that opening up the market some more in today’s context is not a solution. All this is quite apart from the general point that FII flows tend to be pro-cyclical; they come in when least needed, and flow out when most critical, creating the de-stabilisation risk of high interest rates because money is being sucked out. It should be obvious, therefore, that opening up the debt market to FIIs should be done more liberally only after the government has got its fiscal act together.
