Virtually the entire literature on public debt is focussed on determining how much is too much, beyond which it becomes a systemic threat to the economy. In this article, Pronab Sen outlines some of the considerations which should be taken into account while determining the minimum stock of public debt and its flow counterpart, the fiscal deficit.

In a recent article, I had examined the recommendations of the Report of the FRBM (Fiscal Responsibility and Budget Management Act) Review Committee¹ through the prism of the debate contained in the Note of Dissent by Chief Economic Adviser Arvind Subramanian, one of the members of the Committee, and the Rejoinder of the Committee to the Note of Dissent. Despite their differences on a number of important counts, both protagonists implicitly agreed that a secularly declining public debt-to-GDP (gross domestic product) ratio was unambiguously a good thing, and indeed recommended fiscal rules which led to precisely such an outcome².

Intuitively I found this view seriously problematic, despite the fact that it is entirely in consonance with the established view of the economics profession. Virtually the entire literature is on determining how much public debt is too much, beyond which it becomes a systemic threat to the economy. My discomfort primarily stems from the fact that government debt is the only interest-yielding risk-free asset in any country³, and is therefore central to a wide range of key economic variables and decisions in a modern economy. Unless these aspects are explicitly taken into account while assessing the ‘optimal’ level of public debt, any fiscal rule would be seriously flawed, and indeed perhaps dangerous.

The purpose of this article is to outline some of the considerations which should be taken into account while determining the desirable stock of public debt and of its flow counterpart – the fiscal deficit.

Monetary considerations

In all modern economies, national currencies are backed by some form of sovereign debt. Central banks, such as the Reserve Bank of India (RBI), issue currency on the basis of their holdings of sovereign bonds and sometimes of gold. In an autarchy, therefore, the minimum level of public debt held by the central bank would be equal to the value of the national currency in circulation minus the value of gold holdings. In India this would amount to roughly 14% of GDP. In an open economy, however, this tight relationship between currency and public debt can be loosened by the central bank holding sovereign assets of other countries – that is, foreign exchange reserves.

As things stand, the rupee is backed almost entirely by foreign assets as per the RBI’s balance sheet. Nevertheless, the RBI always needs to hold a certain amount of central government debt instruments⁴ in order to carry out its monetary management responsibilities in a credible manner⁵. There is no hard-and-fast rule governing how much public debt a central bank should carry in its books; but as a rule of thumb, if the currency is not convertible, then the more open the country is to foreign portfolio flows, the higher should be the quantum. At present the RBI holds 15% of the stock of central government securities, which is 10% of all government securities. This does not seem excessive for the roles that RBI has to perform.

Fiduciary considerations

In any country, a large part of household wealth is held for precautionary purposes and for meeting post-work-life consumption needs. For such investments, the return is less important than the security of the principal. By and large, countries with low risk thresholds and with poor or non-existent social security systems, such as India, will tend to place much more importance on and have a higher share of such assets in the total household financial wealth⁶.

All countries recognise this imperative and impose fiduciary status on institutions offering specific forms of assets⁷. The common forms are life insurance, pension/provident funds, and certain types of mutual funds and asset management company products⁸. In India, there is an additional asset class called small savings instruments for which the government itself is the fiduciary, that is, bears 100% of the liability⁹. This amounts to about 11.5 percentage points in the total public debt stock of 68% of GDP.

The other assets which bear fiduciary protection comprise another 25% of GDP. The laws governing these assets, which take into account the fiduciary commitment, specify that at least 50% of the value must be invested in public debt instruments, which includes both central and state securities¹⁰. Therefore, just for compliance with the law, the stock of public debt must be a minimum of around 12.5% of GDP on this count alone.

Although legally commercial banks are not fiduciaries, the perception of the depositors is usually quite different, and they tend to view bank deposits as a form of low-yield secure assets. Therefore, even if banks don’t have legal fiduciary status, they certainly bear a moral fiduciary responsibility. Most governments recognise this tension between the legal and the moral/perceptual status of banks, and address it through “prudential regulations”. In India, prudential regulations stipulate that 20% of the total net liabilities of banks (called the statutory liquidity ratio (SLR)) must be held in government bonds; this works out to 18% of GDP¹¹.

Therefore, if we add up the minimum amount of public debt required by law to meet fiduciary responsibilities in India, it comes to 42% of GDP; comprising 11.5% for small savings instruments, 12.5% for insurance/provident funds/ etc., and 18% for commercial banks.

Interest rate considerations

The interest rate is one of the most important economic variables in any economy which influences a number of decisions taken by a wide range of economic agents. Savings and investment decisions are the most obvious, but interest rates also determine the choice of technology by firms, and play an important role in influencing the production structure of the economy¹².

Sovereign debt instruments provide the anchor for all interest rates, since they are the only financial instrument with zero default risk. Theoretically, the interest rate on private debt of a particular maturity should be the interest rate on government bonds of the same maturity with a premium reflecting the default risk of the private borrower¹³. For it to effectively play this role, however, government bonds must be freely and actively traded so that their yield (which is the effective interest rate) accurately reflects the market risk and liquidity premia¹⁴. It is, therefore, necessary that an active market should exist for government bonds.

The market for government bonds in India is essentially a whole-sale one, with no retail participation at all. The participants are banks, other financial institutions, foreign portfolio investors (FPI)¹⁵ and some non-financial corporates. As far as the volume is concerned, although the total stock of government bonds is nearly 48% of GDP, the volume “in float” is a much smaller 17%, since the statutory holdings by banks and other fiduciary institutions simply can’t be placed on the market. Thus the market is limited to the excess holdings of these institutions (6%), the holdings of non-fiduciary bodies (6%) and that of RBI (5%). Thus, the range of participants and the float are large enough for a reasonably efficient market.

The market maker, to all intents and purposes, is the RBI. However, the RBI’s functioning in the market is different from that of standard private market makers in that its objective is not to maximise profits from arbitrage and trading fees, but to attain the desired level of the interest rate. In order to carry out its mandate, therefore, the RBI necessarily has to have a target rate around which it can work.

Most central banks have a base value of the real interest rate which is publicly stated, and monetary management is about deviations from this base value depending upon cyclical factors. The RBI has not articulated what it considers to be the desirable level of the real interest rate. One way to get around this problem is to assume that the coupon rate on treasury bills reflects the Finance Ministry’s take on this¹⁶. At present, the coupon rate on 10-year treasury bills is 7%.

In order to judge whether the voluntary holdings of government securities are too high, the actual market-determined yield should be compared to the desired rate. If the yields are higher, it implies that there is an excess of government securities in the market. If, on the other hand, the yields are lower, it means that there is an excess demand for government bonds, and any reduction in their supply will lower interest rates even further, thereby distorting the various decisions that are contingent on the interest rate¹⁷.

At present, the yields on 10-year treasury bills are marginally below the coupon rate of 7%. Therefore, the voluntary holdings of public debt amounting to 12% of GDP are by no means excessive, and may even be too low.

Minimum public debt

Coming back to the main inquiry, if the voluntary holdings of public debt are added to RBI’s holdings and the mandated holdings, the minimum public debt stock comes to at least 58% of GDP.

However, this is only the current position. In view of the government’s push towards greater ‘financial inclusion’ in the form of bank deposits and insurance coverage, it is likely that this ratio will trend upwards in the foreseeable future. Therefore, a certain amount of cushion needs to be provided for contingencies. Seen in this light, the FRBM Committee’s recommendation of a target public debt ratio of 60% seems eminently sensible, but as a floor and not a ceiling.

Fiscal deficits and composition of public debt

The stock of public debt is only one part of the story. Consideration must also be given to the fiscal deficit, which is the annual rate of generation of public debt. There is little point in having a desired level of public debt to GDP ratio if the addition to this stock is not consistent with maintaining the ratio over time. If the nominal GDP grows at 11.5% per year, the debt ratio will decline by 6.2 percentage points annually if there is no addition to the debt stock. Therefore, consistency demands that the fiscal deficit should be maintained as 6.2% per annum in order to stabilise the public debt ratio at the desired level¹⁸.

Also, the steady-state relationship between the fiscal deficit and the debt stock ratio assumes that the composition of the debt does not matter. However, the fact of the matter is that it does, and any analysis which ignores this is seriously flawed. A basic distinction has to be drawn between government securities and all non-securitised public debt instruments such as provident funds, external borrowings, etc: It is the former which determine the market yields and thereby the interest rate structure of the economy, while the latter has no direct role to play¹⁹.

As things stand, of the total public debt of 68% of GDP, securities account for 47.5 percentage points and the rest for the remaining 20.5²⁰. In comparison, as has been assessed, of the minimum public debt of 60% of GDP, securities should be 48 percentage points and others 12²¹. Therefore, the supply of government securities is already below its optimal level²². Although this is not an immediate problem since the gap is small, it should not be allowed to persist.

This compositional inconsistency has an important implication for financing of the current fiscal deficits: government securities must account for at least 5% of GDP in the total financing of the consolidated fiscal deficit for the immediate future. Unless this condition is met, the gap between the actual and desired stock of government securities will continue to widen to a point where fiduciary institutions will be under stress both from being unable to meet their legal requirements and from reduced income flows from their holdings of public debt instruments.

The Ministry of Finance needs to assess these considerations, and perhaps so should many other countries.

This article is based on a longer paper with the same title.

Notes:

1. Popularly known as the N.K. Singh Committee.
2. The main justification for a steady reduction in public debt appears to be the views of international rating agencies. Why this should matter at all is not clear in view of the excessive foreign portfolio investments that India has received despite not too favourable ratings. In particular, the Chief Economic Adviser has publicly been critical of the rating agencies, and yet invokes their views to justify his position on this particular issue.
3. Government securities of course do carry some market risk, in that changes in inflation can alter the real returns and that their prices can change according to demand-supply changes, but not default risk.
4. State government bonds cannot serve this purpose since they are not sovereign.
5. One of the more important roles of central bank holdings of public debt is the sterilisation of foreign capital inflows in excess of the amount needed for the desired growth of money supply. India has faced this issue on a number of occasions.
6. Physical assets such as real estate and gold are usually preferred when there is insufficient trust in the financial system. This has been the case in India for a long time, and its consequence has been a much lower level of savings available for productive purposes than would be the case otherwise. Building public trust in the financial sector must, therefore, form a key component of the government’s development strategy and the assurance given by public debt instruments may play an important role in this.
7. A fiduciary is defined as: “a person to whom property or power is entrusted for the benefit of another”. A fiduciary is required to act in the best interest of the client, and protection of the principal is a central objective.
8. Any fund or product which guarantees the principal falls into this category.
9. This class also includes the provident funds of government employees.
10. Whether the 50% requirement is adequate for securing the fiduciary obligation is a question beyond the scope of this article. However, any such rule has to draw a balance between security and a minimum acceptable level of returns.
11. Unfortunately, the RBI of late has been treating the SLR purely as an instrument of liquidity management rather than a means of fiduciary protection. This needs to be seriously debated and a view taken at the highest political level.
12. In principle, a relatively high interest rate encourages the growth of labour-intensive sectors vis-à-vis capital-intensive ones.
13. Under the assumption that the interest rate on the government bond fully captures the market risk premium (inflation risk and interest-rate risk) and the liquidity premium for that particular maturity. The default risk, on the other hand, for any single private entity can vary with the maturity.
14. The market risk and liquidity premium is the difference between the yield and the coupon rate.
15. In India, these are also known as Foreign Institutional Investors (FIIs).
16. Usually coupon rates are set as close as possible to the expected yield in order to minimise auction volatility. However, there is no indication of the considerations that have gone into Finance Ministry’s choice of the coupon rate.
17. The ‘investor community’ and the rating agencies will of course welcome both the reduction in public debt and the lowering of the interest rate, but is this the constituency that the government should be catering to?
18. This figure is derived from the standard equation that relates the steady-state value of the public debt ratio (d) with a constant fiscal deficit-to-GDP ratio (fd) and a constant steady-state nominal growth rate of GDP (g) fd = d.[g/(1+g)]
    If d is 60% and g is assumed to be 11.5%, then fd works out to 6.2%.
19. These will of course have an indirect role through a general equilibrium effect.
20. The break-up of the present stock is:
    Securities: Banks – 21.5%; Insurance, etc.: - 15%; RBI – 5%; Corporates, FPI, etc: - 6%
    Others: Small savings, Provident fund, etc.: - 11.5%; External debt – 3%; Reserve funds and deposits – 6%.
21. The break-up of the minimum stock is:
    Securities: Banks – 22%; Insurance, etc.: - 15.5%; RBI – 5%; Corporates – 5.5%
    Others: Small savings, provident fund, etc.: - 12%.
22. This may be one of the reasons why in the last year, the yield on T-bills has dropped by 60 basis points and the rupee has appreciated.