State‐level borrowing costs under deregulation – an Indian experience
| Published date | 11 January 2013 |
| Pages | 68-83 |
| Date | 11 January 2013 |
| DOI | https://doi.org/10.1108/15587891311301034 |
| Author | Shubhasis Dey,Sthanu R. Nair |
| Subject Matter | Strategy |
State-level borrowing costs under
deregulation – an Indian experience
Shubhasis Dey and Sthanu R. Nair
Abstract
Purpose – This paper aims to examine the effect of deregulation of government securities market on the
cost of market borrowing of 14 major states in India.
Design/methodology/approach – Empirical models explaining changes in interest rates on market
borrowings of the Indian states under consideration are tested. The stability of the empirical
relationships are then evaluated using structural breakpoint tests conducted around known periods of
deregulation in the government securities market.
Findings – The stability tests clearly pointed to difference in the dynamics of market borrowing rates pre
and post deregulation for overwhelming majority of the states in the sample.
Research limitations/implications – The question pertaining to whether government securities market
deregulation reduced or raised states’ market borrowing rates is left unaddressed in the current study.
Originality/value – An empirical assessment of the effects of deregulation of the government securities
market on the cost of states’ borrowing in India is imperative considering the key role played by them in
the provision of various public services. The dataset created to conduct such an analysis is unique and
has the potential to uncover more interesting features about state-level borrowing in India.
Keywords Government securities market, Economic reforms, Deregulation, State governments,
Auction method, Tap method, Interest costs, Structural break, India, Borrowing
Paper type Research paper
Introduction
The government securities market has been playing a key role in financing the development
activities of the governments – central and the states[1] – in India since Independence (RBI,
2006). A key component of the economic development strategy adopted by India
immediately after Independence was large public investment in capital goods industries
(Balakrishnan, 2007; Basu, 2004). The resources needed for financing the public investment
was sourced mainly through fiscal policy in the form of taxes, deficit financing and public
borrowing[2]. Of these, deficit financing was carried through automatic creation of ad hoc
treasury bills (T-bills) (RBI, 2006). The T-bills were issued in favor of India’s central bank,
namely the Reserve Bank of India (RBI), whenever the government required funds. The RBI,
in turn, issued currency notes against the T-bills to the government.
Public borrowing was conducted by both the central and state governments through the
issuance of dated securities[3]. In order to ensure adequate resources for the
governments through regular subscription of securities and contain the interest burden
of public debt three separate mechanisms were put in place (RBI, 2006). First, the
statutory liquidity ratio (SLR)[4] was increased overtime to secure a captive investor base
for government securities. Second, the interest rate of both the central and state
government securities was administered so as to remain artificially low and
uncompetitive. Third, RBI monetized the budget deficit by way of accepting
under-subscribed government securities[5].
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VOL. 7 NO. 1 2013, pp. 68-83, QEmerald Group Publishing Limited, ISSN 1558-7894 DOI 10.1108/15587891311301034
Shubhasis Dey and Sthanu
R. Nair are both based at
Economics Area, Indian
Institute of Management
Kozhikode, Kozhikode,
India.
While the above mechanisms enabled the governments to implement deficit-financed
growth model at low cost, they gave rise to several issues which threatened the sustainability
of fiscal and monetary policies, the government securities market and country’s overall
economic growth. As there was no limit on the amount raised through deficit financing and
no compulsion to repay the funds raised, overtime, the mechanism of deficit financing had
become virtually unlimited and a permanent source to finance the additional expenditure
requirements of the government. This was done by way of replacing maturing T-bills with
fresh creation and converting them to dated/undated special securities. High levels of SLR
diverted bank credit away from the commercial sector towards meeting government’s
borrowing requirements. In order to compensate for the low yield on government securities,
banks charged higher interest rates to the private commercial sector. All of these adversely
affected the fiscal discipline of governments[6], private investment, price situation[7] and
economic growth (RBI, 2006). Finally, the conduct of monetary policy was constrained in
many ways (RBI, 2006). First, the monetary expansion due to continuous monetization of
fiscal deficit had unduly shifted the burden of controlling inflation to monetary policy.
Second, RBI’s subscription to government securities necessitated delays in upward revision
in the bank rate[8]. This was for the purpose of keeping the borrowing cost low for the
government.
The sharp deterioration in the fiscal situation during the late 1980s and its contribution to the
1991 macroeconomic crisis raised serious concerns over the sus tainability of the
government’s debt management policy[9]. Consequently, as part of India’s economic
reforms, a multi-pronged reform strategy was initiated in the spheres of fiscal, monetary and
public debt management policies starting from early 1990s (RBI, 2006; Chakraborty et al.,
2009; Vaidya, 2011). This move was aimed at imposing market discipline on fiscal activism,
relaxing the extent of fiscal dominance in monetary policy formulation and making the
government more conscious of the true costs of its borrowing. This reform strategy consisted
of two key components. The first component was fiscal consolidation aimed at reducing the
fiscal and revenue deficits by way of expenditure compression, revenue mobilization and
abolition of automatic monetization of fiscal deficit[10]. The second component was
deregulation of the government securities market. As part of this, an auction system in
primary issuances of central and state government securities was introduced, whereby the
amount to be borrowed is notified but the coupon rates on securities of the notified amount
are determined by an auction process[11]. In this way, both the size and cost (interest rates)
of government borrowing were made market-determined.
The objective of this paper is to empirically examine the effect of deregulation of government
securities market on the interest costs of market borrowings by state governments. In a
deregulated environment subscription to government securities and interest rates are linked
primarily to the overall strength and prospects of government finances. States with better
fiscal management would be able to mobilize loans at competitive interest rates. Also, the
presence of market forces is expected to discipline state government borrowing as the
interest costs are no longer administered. Hence, it would be interesting to see how the cost
of state government borrowing has behaved in the post-deregulation regime.
The paper is organized as follows. First, a brief description of the state-level system of
market borrowing in India is provided. Then the data sources are discussed, followed by the
empirical model and its findings. Finally, it is concluded with a summary of its main
contributions and directions for future work.
State-level market borrowings
The Indian Constitution assigns several important responsibilities like public order, police,
public health and sanitation, agricultural development, education, infrastructure, irrigation,
electricity and water supply to the state governments. As a result, the states incur a
substantial portion of the government expenditure in India (Gopinath, 2009; World Bank,
2005). To perform their functions, the Constitution assigns four sources of revenue for the
states, namely tax and non-tax receipts, borrowings and transfers from the central
government[12]. With respect to debt financing, although the central government enjoys
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