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Posted by: Deepa Vasudevan on Mon, Apr 9th, 2012

Why RBI may not aggressively cut rates in H1 FY2013

FY12 ended with (a) a market already crowded with government paper and (b) a structural liquidity deficit that was partly eased with an end-of-fiscal year CRR cut.  FY13 has begun with an ambitious borrowing program. The Union budget announced a fiscal deficit target of 5.1% of GDP for 2012-13. The deficit is to be financed through gross market borrowings of Rs.513590 crore. Net market borrowings are budgeted at Rs.479000 crore. This is nearly 10% more than last fiscal. Managing this level of debt issuance will need (a) market liquidity (b) appropriate yields that reflect fiscal challenges of the government. Last year, a combination of OMO and CRR cuts were used to deal with these issues.


However, the Union Budget has complicated RBI’s balancing technique by creating the risk of renewed inflation in FY13. The budget announced a cap of 2% of GDP on total subsidies. The implication is that prices of subsidized diesel, LPG or kerosene may be raised significantly. A petrol price hike is already overdue. A rise in prices of fuel products usually leads to higher prices of products and services across the economy. Excise taxes have been raised by 2%. Service tax coverage has been significantly widened, and the levy rate increased to12%. These measures are revenue-generating but inflationary, because indirect taxes tend to be passed on to consumers. Persistent and high inflation over the last 3 years has already eroded the domestic savings and investment rate. Another year of widespread price increases may reduce private consumption-the largest component of GDP (about 58% in 2011-12) and its most important driver since the 2008 global crisis.


On the other hand, if political compulsions prevent the government from increasing prices of fuel products, or reducing food and fertilizer subsidies, the fiscal deficit will be much higher than targeted. Slippages in subsidy targets can push the deficit higher. Such a scenario will seriously damage India’s fiscal credibility and therefore, its sovereign credit rating. All global rating agencies have criticised the lack of fiscal consolidation in the Union Budget. Yields on government debt will go up, and so will interest rates.


Both scenarios are challenging for a government that needs to raise large amounts as cheaply as possible. Let us consider both separately: 

  • Inflationary expectations arising from, say, diesel price hikes, would restrain RBI from reducing interest rates.  Without interest rate cuts, and with liquidity already tight, the government would be forced to borrow at relatively higher rates. This may increase interest outflows and in a vicious circle, further raise fiscal deficit.
  • Higher deficits will push up yields. Thus government debt will be issued at high rates, unless RBI carries out substantial monetary easing through further CRR cuts, or runs OMO auctions parallel to auctions of government debt.


About 65% of the borrowing is scheduled  to take place in the first half of the fiscal year. This could be cost-saving, because borrowings could be completed before either of the two scenarios plays out fully. This is also practical, since bulk of the redemptions will come up in the first half of 2012-13. RBI’s choice to reduce interest rates at the start of FY13, will help market liquidity and government borrowing in the second half, but will work at cross purposes if inflation numbers and the deficit move up by the second half.  The current signals point to weak monetary policy easing in the first half, and further calibrations, based on how the inflation and fiscal indicators play out during the year.

Deepa Vasudevan on Fri, Apr 13th, 2012 10:35:52 am

Dear Sanat, We are moving towards a precarious debt situation in two ways. First, external liabilities at 22% of the total are not too high, but much of it is short term and needs to be repaid/rolled over this year. That puts pressure on the exchange rate to depreciate. Second, of the fresh borrowings each year, about 70-75% go towards funding current expenses, rather than creating new productive assets. Yes, govt and institutions need to seriously introspect on improving fiscal management along the lines of spending less on expenses, and borrowing to fund investment.

Deepa Vasudevan on Fri, Apr 13th, 2012 10:34:24 am

Dear Sanat, On first comment. This is a good point, and not much discussed in forums. Corporate debt restructuring has been very high this fiscal- press reports indicate that it is about 3 times last year. Gross NPAs of banks are expected to be 3% of assets this year, up from 2.3% last year. So restructuring loans- or rather giving companies more time to pay their dues while retaining the loan as a normal asset on bank books- is happening a lot. That is typical of periods when interest rates are high and demand and profits slowdown. But that alone is not responsible for the huge LAF. An important reason is RBI activity in forex markets - selling dollars and purchasing rupees to control depreciation. Also, the government is borrowing huge amounts from banks and other institutions on a weekly basis. This sucks out much of their liquidity. So there is a structural deficit here- and non-recovery of loans by banks is one factor, and potentially a dangerous one. If banks fail, it has serious repercussions for the economy.

sanat on Thu, Apr 12th, 2012 4:37:52 pm

Are we not creating a situation of falling into Debt Trap. If you analyse outstanding approx 30 lac Crore of G Sec , 90% of this has been the borrowed in last 10 year alone. And if We continue our Fiscal management in this way , our stated Debt to GDP ratio of 65% approx should be competing alone with Greece or Italy . Don`t you think we need serious introspection at the resource available and fiscal management of resourced utilized ???????

Sanat on Thu, Apr 12th, 2012 4:28:51 pm

A Serious thought is needed to analyse , Why Banks need huge LAF to meet liquidity . Why LAF has become a routine than exception. Is it Bank are not able to collect its due , recoverable, receivable from the earlier advances , and in order best not to be declared as NPA , this unrecovered accurals getting recycled as fresh Loans . If this is true , all macroeconomics of inflation , money supply and fractional banking system is for Toss . Pl comment ?????

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