The Hindu Business Line : Does Govt borrowing push up interest rates?

In the context of private sector debt funding, there’s a special name for this – ‘crowding out’. The more efficient capital deployer in an economy not only has less capital available because the Government pre-empts it, but must also pay more for it.

Sounds logical, but is it necessarily true?

To take the US case, the Obama administration is well on its way to making the biggest deficit and borrowings in American history. Bond yields have risen sharply from their lows – ten-year Treasuries, for example, touched 4 per cent after bottoming at a little over 2 per cent last December. (They are now close to 3.5 per cent).

Can this surge be attributed to dependence on the market for funding spending?

As a matter of fact, this has not been generally cited as the proximate cause for the jump in yields. The far more frequent explanations centre around the reality or prospect of the economy coming out of recession and – yes – inflationary expectations. To the extent that the latter are a function of the debt-financed deficit, it must be acknowledged that there could be an adverse impact on bond prices.

counterweights

Still, there are a number of counterweights. First, the liquidity and depth of US capital markets make it the first choice for investment of trade surplus in emerging economies, despite the low yields on Treasuries. (The outstanding example of this is, of course, China). Second is anaemic credit growth, both to business and consumers.

Contrary to the fear of ‘crowding out’, the private sector is enjoying cheaper credit, both because Fed rates are near zero and risk spreads over Treasuries have narrowed considerably.

While some economists see Armageddon in the Government’s borrowing binge, investors don’t seem to share their fears.

Third, given the degree of slackness in labour and manufacturing, both in the US and elsewhere (a recent report speaks of a multimillion jobs shortage in China), the market probably thinks inflation worries are overblown.

What about India? Again, the mistake lies in thinking that if Government absorbs funds from the market, interest rates must go up. This would be true if the money is not spent, as it would reduce system liquidity. But the Government borrows just to spend.

As liquidity is unaffected, the only reason yields can go up is because investors demand a premium for inflation risk – which may well happen or is happening. That is quite different from a mere debt supply-driven increase.

Not too long ago, in the late nineties and early 2000s, bond yields actually fell amidst higher Government borrowings because of falling inflation and weak economic conditions.

Nothing in economics fortunately (or unfortunately) is written in stone.

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