Bond financing and debt stability: theoretical issues and empirical analysis for India

Moorthy, Vivek and Singh, Bhupal and Dhal, Sarat Chandra (2000): Bond financing and debt stability: theoretical issues and empirical analysis for India. Published in: RBI Development Research Group Study No. 19 (10 June 2000): pp. 1-79.

Abstract

The study examines the theoretical considerations and empirical results of the switch to market borrowing, i.e. bond financing of the fiscal deficit, with correspondingly low monetisation, as part of India’s structural reforms initiated in 1991. It basically concludes that despite the sharp deterioration in State finances and persistently large market borrowing programme of the Centre, the move to market borrowings to finance the deficit is proving to be beneficial when viewed in relation to broader movements in the major fiscal variables over time. The study makes a clear distinction between the consequences of borrowing at market interest rates versus those of non-market liabilities.

In preference to recent econometric approaches to test the Government’s long run debt profile, the study proposes a simple necessary condition, popularly known as the Domar condition, to evaluate the prospects for debt stability under which GDP growth should exceed the interest rate on Government debt. Based on the premises that in the long run, it is not possible to trade growth for inflation (although such a trade off may be possible in the short run) and that the central bank is unable to influence real variables (real output and real interest rates) in the long run, the study simulates different short and long run consequences of alternative combinations of bond and money financing of budget deficits on interest rates, growth, inflation, the debt-to-GDP ratio and measures of the interest burden.

Empirical evaluation of the Domar debt-stability condition reveals that Central Government debt, under certain assumptions, may remain stable at prevailing levels of the primary deficit and monetised deficit. High administered rates in the Small Savings and Provident Fund Schemes, i.e., due to non-market based borrowing, however, pose problems for debt sustainability in future. The study argues that bond financing of the fiscal deficit has contributed to fiscal consolidation by inducing the Government to reduce primary expenditures. This conclusion holds even for the combined finances of the Central and State Governments. Robust evidence indicates that non-government borrowing costs have come down relative to those of the Government, and credit conditions for non-government borrowers are now easier, after the move to bond finance. Further, some evidence suggests that private capital formation has surged in recent years, contradicting the view that the anti-inflation policy of bond finance has crowded out private investment and adversely affected growth. However, the stability in market debt notwithstanding, the overall fiscal situation is critical because of potential instability in non-market debt and due to unfunded and contingent liabilities of the Central and State Governments.

• Item Type: MPRA Paper
• Language: English
• Keywords: bond financing; debt stability
• Subjects: G - Financial Economics > G1 - General Financial Markets; E - Macroeconomics and Monetary Economics > E6 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook > E62 - Fiscal Policy; H - Public Economics > H6 - National Budget, Deficit, and Debt > H63 - Debt ; Debt Management ; Sovereign Debt

References

Abel, Andrew, Gregory Mankiw, Lawrence Summers and Richard Zeckhauser (1987) : “A Test for Dynamic Efficiency” NBER Working Paper, No. 2097.

Alhuwalia, Montek Singh (1999) : “Financial Sector Reforms: An Overview” in James Hanson and S. Kathuria (Ed) India: A Financial Sector for the 21st Century, pp 29-56, Proceedings of a 1997 Conference.

Barro, Robert (1989) : “The Ricardian Approach to Budget Deficits”, Journal of Economic Perspectives, Vol 3, No. 2 pp 37-54.

Bauer, Peter (1973) : Dissent on Development, Vikas Publications.

Blanchard, Olivier (1990) : “Suggestions for a New Set of Fiscal Indicators”, OECD Working Paper, No.79.

Buiter, William (1990) : “Arithmetic of Solvency” in Principles of Budgetary and Financial Policy Harvester Wheatsheaf, pp. 145-151

Buiter, William and Urijit Patel (1992) : “Debt, Deficits and Inflation: An Application to the Public Finances of India” Journal of Public Economics, 47:2, 171-205, reprinted in Tax Policy and Planning in Developing Countries, (ed.) Amaresh Bagchi and Nicholas Stern (1994) pp.94-133.

Chandrashekhar, C.P. (2000) : “Economic Reform and the Budget”, Economic and Political Weekly, April 1-7, pp. 1140-42.

Chitre, Vikas, K. Kanagasabapathy, Mridul Saggar and Partha Ray (1996) : “Inflation, Interest Rates and Index-Linked Bonds, Development Research Group, RBI Study, No.12. 67

Darby, Michael (1984) : “Some Pleasant Monetary Arithmetic” Federal Reserve Bank of Minneapolis Quarterly Review, Spring, pp. 15-20.

Domar, Evsey (1944) : “The Burden of the Debt and the National Income” American Economic Review, 34, pp. 798-827.

Easterly William and Klaus Schmidt-Hebbel (1991) : “Fiscal Deficits and Macroeconomic Performance in Developing Countries” World Bank Research Observer, Vol. 8 No. 2, pp. 21-37.

Fischer, Stanley (1980) : “Seignorage and the Case for a National Money”, Journal of Political Economy, Vol. 90, pp. 295-313.

Friedman, Benjamin (1988) : “Monetary Policy: Lessons from the 1980s” Journal of Economic Perspectives, Vol. 2, No. 3, pp. 51-72.

Friedman, Milton (1967) : “The Role of Monetary Policy” Presidential Address to the American Economic Association., December 1967 published in American Economic Review, 1968, Vol. 58, pp. 1-17.

Hamilton, William and Marjorie Flavin (1986) : “On the Limitations of Government Borrowing: A Framework for Empirical Testing”, American Economic Review, 76, pp. 808-819.

Greene, Joshua and DeLano Villaneuva (1991) : “Private Investment in Developing Countries: An Empirical Analysis”, IMF Staff Papers, Vol. 38, No. 1 pp. 33-57.

Jadhav, Narendra and Balwant Singh (1990) : “Fiscal-Monetary Dynamic Nexus in India: An Econometric Model” Economic and Political Weekly, January 20, pp.159-165.

Joshi, D.K. (2000) : “Debt and Deficits: Profligacy Doesn’t Pay”, Economic Times, March 4th.

Jha, Raghbendra (1999) : “Some Rudimenary Macro Economics of the Budgetary Deficit and Debt” in Fifty Years of Development Economics:Contemporary Issues, Essays in Honour of Professor P.R. Brahmananda, Edited by A. Vasudevan, D.M. Nachane and A.Karnik, Himalaya Publishing House, 1999, New Delhi.

Kannan, R (1999) : “Inflation Targeting: Issues and Relevance for India,” Economic and Political Weekly, Vol. 34, No 3 & 4, Jan 16-22, pp. 23-29.

Khan, Mohsin and Carmen Reinhart (1991) : “Private Investment and Economic Growth in Developing Countries” World Development, Vol. 18, pp. 19-27

Khundrakpam, Jeevan Kumar (1996) : “Alternative Measures of Fiscal Deficit and Inflation Impact” RBI Occasional Papers, Vol. 17, No. 1, March.

——(1998) : “Sustainability of Central Government Debt”, RBI Occasional Papers, Vol. 19, No. 1, March.

Mohanty, Madhusudan and Nishita Raje (1998) : “Effective Cost of Small Savings” RBI Occasional Papers, Vol. 20.

Moorthy, Vivek (1998) : “The Stability of Bond Financed Deficits: A Critique of the Literature”, IIMB Working Paper, No.115.

—— (1995a) : “Print Bonds, Not Money”, Economic Times, July 25th.

—— (1995b) : “Why Gentlemen Still Prefer Bonds”, Economic Times, September, 4th (Reply to Venkitaramanan, 1995 a, b).

Okun, Arthur (1980) : Prices and Quantities: A Macroeconomic Approach, Brookings Institution.

Rajaraman, Indira and Abhiroop Mukhopadhyay (1999) : Sustainability of Public Domestic Debt in India” Seminar on Issues before the 11th Finance Commission, January 5-6. Rangarajan, Chakravarti (1988) : “Issues in Monetary Management”, Presidential Address, 71st Annual Conference of IEA, reprinted in Essays on Money and Finance UBSPD, 1999.

Rangarajan, Chakravarti and Madhusudan Mohanty (1997) : “Fiscal Deficit, External Balance and Monetary Growth: Evidence on the Indian Economy, RBI Occasional Papers, Vol. 18, No. 9, pp. 583-653.

Rangarajan, Chakravarti and Arif, R.R. (1990) : Money, Output and Prices: A Macroeconometric Model” Economic and Political Weekly, April 21.

Rangarajan, Chakravarti, Anupam Basu, and Narendra Jadhav (1989) : “Dynamics of Interaction Between Government Deficit and Domestic Debt in India” RBI Occasional Papers, pp. 163-205.

Sargent, Thomas J. and Neil Wallace (1981) : “Some Unpleasant Monetarist Arithmetic” FRB Minneapolis Quarterly Review, Fall, pp. 1-17.

Scarth, William (1998) : Macroeconomics: An Introduction to Advanced Methods, Harcourt, Brace and Jovanovich, 2nd edition.

Singh, Charan (1995) : “Ricardian Equivalence and Consumption in India”, RBI Occasional Papers, Vol. 19, pp. 39-60.

Solow, Robert and Alan Blinder (1973) : “Does Fiscal Policy Matter? Journal of Public Economics, Vol. 2, pp. 319-337.

Spaventa, Luigi (1987) : “The Growth of Public Debt: Sustainability, Fiscal Rules and Monetary Rules”, IMF Staff Papers, pp. 374-399.

Stiglitz, Joseph and Andrew Weiss (1984) : “Equilibrium Unemployment as a Worker Disciplining Device”, American Economic Review, Vol.74, September.

Vasudevan, A., B.K. Bhoi and Sarat C. Dhal (1999) : “Inflation and Growth: Is there a Gateway to Nirvana?” in Fifty Years of Development Economics: Contemporary Issues, Essays in Honour of Prof. P.R. Brahmananda, Edited by A. Vasudevan, D.M. Nachane and A.Karnik, Himalaya Publishing House, 1999, New Delhi.

Venkitaramanan, S. (1995a) : “Some Unpleasant Monetarist Arithmetic” Economic Times, June 29th.

———— (1995b) : “Should We Prefer Bonds or Money?”, Economic Times, August 9th.

———— (2000) : “Some Unpleasant Monetarist Arithmetic” Times of India, April 2nd, 2000.

Wilcox, David (1989) : “The Sustainability of Government Deficits: Implications of the Present Value Borrowing Constraint”, Journal of Money, Credit and Banking, 21, pp. 291- 306.