Deficits and Interest rates

With the projected fiscal deficit of nearly 6.7% of the GDP, the focus has now shifted to the means of financing this deficit and the impact it would have on the interest rates. The government has decided to push growth through government spending. This is one of the appropriate steps that had to be taken considering the fallout of the financial crisis. The fiscal deficit would have many impacts. lets concentrate on one of them arising out of the probable financing of the deficit.

Following are the few ways traditionally used to financethe deficit,

1) Market borrowing:

Government's issue bonds and raise money from the market.

2) Monetisation:

The central bank may resort to money printing to fund the deficit.

3) Asset sale:

Proceeds from sale of assets like disinvestment program could also be used to fund the deficit.

Each of the above has a different impact on the Indian economy,

1) Market Borrowings

Over the last few years, the financing of the fiscal deficit has been primarily through market borrowings. This has been through issue of dated securities and 364 day treasury bills. Nearly 65%-75% of the financing has been through market borrowings. If going by the past history the government plans to raise money by issuing securities, the pressure on interest rates is going to increase. The borrowing program of the government may lead to lack of availability of credit to the private sector thus increasing the cost of money. We are currently facing a falling interest rate regime, due to subdued investment activity. With the economy expected to improve by early next year, the pressure on credit availability is expected to increase. This is might lead to a scenario of increasing interst rates by 2009 end of early 2010. The increase in interest rates is dependent on the return of economic growth.

2) Monetisation

Monetisation might be away of not pressuring the credit pool. Monetisation leads to an increase in money supply. This leads to potential inflationary pressures in the economy. This should be one of the last resorts of financing of the fiscal deficit.

3) Asset sales

Disinvesment in government companies woudl lead to reduction in the government borrowing program. Thus by not crowding out the private sector, the interst rates might be under control.

Currently the government has not indicated a dedicated program for disinvestment. But, this would definetly be one of the ways in which the government would finance its deficit.

Another way in which the government might be able to reduce the impact of the deficit on interest rates would be to attract foreign investment into India. The availability of external funding for private sector would reduce their dependence on domestic funds. Thus keeping the interest rates low.

Ideally the government should look at using a mixture of the above means of financing.