Interest rates to rise due to increase in government borrowing

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Interest rates to rise due to increase in government borrowing

  • The government has projected a fiscal deficit of 6.4 per cent of Gross Domestic Product (GDP) for financial year 2022-23 indicating its reliance on economic growth to drive fiscal consolidation
  • It is in line with the aim of fiscal consolidation, announced last year, to achieve a fiscal deficit of 4.5 per cent by 2025-26.
  • The government said it will pursue a “fairly steady” decline in deficit levels over this period.

Fiscal deficit

  • For the financial year 2021-22, the revised estimates in the Budget pegged the fiscal gap at 6.9 percent against the 6.8 per cent estimated during the 2021-22 Budget.
  • Higher buoyancy in tax collections is helping fund elevated capex, while bringing down fiscal deficit but at a slow pace.
  • The Fiscal Responsibility and Budget Management (FRBM) Act mandated the Central Government to limit the fiscal deficit up to 3 percent of gross domestic product by the 31st March, 2021.
  • Factors responsible for increased deficit: Covid-19 pandemic and resultant lockdown led to a sharp rise in deficit level as government spending jumped to support the economy.
  • Factors which bring reduction in deficit: virtuous cycle of growth, resulting from higher investments boosting private sector Capex and aggregate demand

Tax Revenue

  • During April-November 2021, total revenue receipts of the Centre, at about 76 percent of budget estimates, were significantly higher than the last five years, moving average of 50.3 percent of Budget Estimates (BE).
  • Tax revenue (net to centre) and Non-tax revenue receipts achieved 73.5 percent and 91.8 per cent of their budget estimates, respectively.

Interest payments

  • Interest payments are the largest component of Centre’s revenue expenditure.
  • In revised estimates of 2021-22, interest outgo is estimated at about Rs 8.14 lakh crore, which is 25.7 percent of revenue expenditure.
  • For the next year, total interest payments are estimated at about Rs 9.41 lakh crore, or 29.4 percent of the revenue expenditure.

Government borrowing

  • The government increased the gross market borrowings expected to be at Rs 14.95 lakh crore for the upcoming fiscal, compared to Rs 10.46 lakh crore as per revised estimates of 2021-22.
  • It would put pressure on bond yields which could touch 7 per cent in the near future.
  • The 10-year bond yield surged sharply and closed at 6.85 per cent
  • This indicates that overall borrowing costs will rise in future.

Possible effects of increased government borrowing

  • Higher debt interest payments: As borrowing increases, the government has to pay more interest rate payments on those who hold bonds. This can lead to a greater percentage of tax revenue going to debt interest payments.
  • Higher interest rates: In some circumstances, higher borrowing can push up interest rates because markets are nervous about the government's ability to repay and they demand higher bond yields in return for perceived risk.
  • Higher interest rates on government bonds tend to push up other interest rates in the economy and reduce spending and investment.
  • Crowding out of the private sector: the government borrows from the private sector by selling bonds and because the private sector lends money to the government, they have less money to spend and invest. Therefore, although government spending increases, private sector spending falls.
  • Increased tax rates: If the debt to GDP ratio rises rapidly, the government may need to reduce debt levels in the future. It means future budgets will need to increase taxes and/or limit spending.
  • Capital flight vulnerability: If a government finances its deficit by borrowing from abroad it encourages foreign investors to sell which causes more pressure on the economy.
  • Inflation: increased borrowing leads to inflation if government finances its deficit by printing money which reduces the value of the exchange rate and makes foreign investors less willing to hold that countries debt