Subhash Garg: Assessing the real costs of low-cost loans

The real costs of loans from organisations such as the World Bank has to take into account the fact that this causes excess liquidity which then has to be mopped up through costly market stabilisation funds

A World Bank press release last month highlighted that World Bank's total support to India of $2.89 billion (Rs 12,600 crore) in financial year 2005 was the largest amount received by an individual country, and more than double the $1.4 billion recorded in financial year 2004.

It was further stated that India was also the largest recipient of International Development Association (IDA) assistance, with credits totalling $1.1 billion. India received approvals for projects of $1.8 billion of non-concessional World Bank loans and $1.1 billion of cheaper and long duration IDA credits.

Total loans from the non-concession window exceeded the total support in financial year 2004. World Bank President also assured India of annual loans of $3 billion during his visit to India this month.

India borrowed twice as much from the World Bank in foreign currencies at a time when the Government of India has issued market stabilisation bonds in excess of Rs 71,000 crore to suck excess liquidity created by inflow of foreign currencies in the country.

The government pays interest on these bonds without using the funds. Flows from the World Bank and other multilaterals/bilaterals are largely used to finance rupee expenditures as such projects are largely in social sectors and for adjustment operations.

These flows straightaway lead to excess liquidity, which is mopped by issue of market stabilisation bonds. Rs 12,600 crore is only one-sixth of the market stabilisation bonds issued, but if we add the flows received from all multilaterals and bilaterals over the last few years, it would form a large part of the liquidity overhang.

With LIBOR rates firming up consequent to constant raising of fed funds rates by the Federal Reserve, the underlying interest rate on external assistance loans are currently over 4 per cent, inclusive of the spread charged by the Bank.

If we add the interest rate of 6 per cent paid by the Government of India on market stabilisation funds, the effective cost of World Bank funds comes to around 10 per cent.

Even if we adjust the rupee appreciation premium of about 2-3 per cent per annum, the effective interest paid by the Indian government on these loans is higher than the interest payable on market loans. IDA credits and other soft loans are, of course, better to the extent of lesser interest charge.

It is understandable that short-term interest rates movement and liquidity movements should not dictate long-term relationship with external official partners, but why increase the loan financing by over 100 per cent amidst plenty of liquidity and current account surplus?

The government borrows more for states projects now than for its own projects and transfers the full proceeds of loans received to the states. States are rightly constrained constitutionally to borrow only within the territory of India.

Loan commitments for states' ongoing projects from all multilateral and bilaterals exceeded 74,500 crore at end 2004-05 in equivalent rupees. The government used to transform the financial terms and conditions of external loans taken for state projects.

While the same nominal amount of loan received was transferred to the states, 70 per cent of the amount transferred was treated as loan and the remaining as grant until 2004-05. The government charged a rate of interest equal to the rate charged for other loans to states (9 per cent during 2004-05) and assumed the foreign exchange risk.

Maturity and moratorium on loans were also transformed. Front-end fee and commitment charges were not recovered from the states. Transformed loan was so different from the original underlying loan that it was very difficult to determine whether a state benefited from the transformation or lost on account of it.

It was quite easy to understand that many states pleaded before the Twelfth Finance Commission that this business of transformation should be stopped and externally-aided projects funds should be transferred to them on a back-to-back basis.

Their anxiety was heightened on account of the rupee appreciating vis-à-vis the dollar since 2002 and very low rates of interest on foreign currency loans. As rates of interest on foreign currency loans was approximately 2-3 per cent during 2003-05 and the rupee was appreciating by at least the same percentage, the total interest charged by the government amounted to the spread for the latter (ignoring MSB costs).

The Twelfth Finance Commission, accepting the request of states, recommended that the Centre should pass on external assistance loans on a back-to-back basis to the states and manage it through a special fund in the public account. As per the action taken report placed in Parliament, Union Cabinet accepted the recommendation.

It was a welcome decision. Besides bringing down the costs to the states, the whole transaction would have become completely transparent. The states could have also decided whether to take such loans or not if the interest rates were to rise and vice versa.

As transferring the external assistance finance funds to the states for their projects does not in any way amount to Government of India's expenditure; this change would have neutralised unnecessary effect on the government's fiscal deficit. External assistance loan intermediation for states' projects is more like a banking/treasury operation and should, therefore, be better managed through public account.

Union Budget 2005-06 did not provide for any provision of loans to the states indicating that external loans for states would be operated outside the Consolidated Fund of India and on a back-to-back basis.

However, from the supplementary demands placed before Parliament during the current monsoon session, it appears that the government has gone back on this decision and would be transferring external assistance loans again through the Consolidated Fund.

Whether the recommendation of the finance commission has been fully jettisoned or the government has decided to implement a "back-to-back" arrangement through the Consolidated Fund is not clearly known as yet. In either case, it seems to be a good opportunity missed.

(The author is an IAS officer currently serving the National Institute of Public Finance and Policy. Views expressed are personal)