# **Box 1: Will Low Interest Rates Solve the Problem?**

Do the record lows in interest rates mean that the emphasis on unsustainable debt dynamics is misplaced? No, for the following reasons: • Low interest rates stem not from better macroeconomic fundamentals but from weakness in the global economy and capital inflows. To the extent that capital flows into India have been driven by one-off events since September 11, 2001 including fears of increased scrutiny of accounts held overseas as part of anti-money laundering drives or by the instability in Iraq more recently, it would be risky to slow fiscal reform on a gamble that such flows will continue indefinitely. If capital flows subside and the global economy picks up, interest rates will once again be determined by medium-run inflationary expectations as molded by fiscal and macro fundamentals, which have weakened.

- Low interest rates for the government do not automatically mean low interest rates for the private sector, except for the best credits, as argued later in this paper.

• Low interest rates do not automatically improve debt dynamics. In fact, the increase in GGD/GDP has accelerated from less than 2 percentage points of GDP per year over the first three years of the Ninth Plan period (1997/98 to 1999/00) to over 4.5 percentage points of GDP per year over the last three years (2000/01 to 2002/03) notwithstanding the low interest rates. Why? First, primary deficits have gone up during the Ninth Plan period relative to the Eighth, increasing borrowing needs. Second, what matters is the difference between interest rates and growth rates. Slowing growth could offset the beneficial impact of lower interest rates.<sup>21</sup> Third, what matters for debt dynamics is the average cost of GGD. Low interest rates at the margin obviously help, but will have to persist for sufficiently long (depending upon the inherited cost and maturity structure of the outstanding stock of GGD) to make a dent on the average rate. On the other hand, since the low interest rates have resulted from low global inflation, domestic inflation has also come down with India’s increasing openness, which hurts to the extent that high nominal coupon debt has been issued in the past.<sup>22</sup> The net effect is therefore ambiguous: low marginal interest rates help, low inflation hurts.

One “solution” that has been proposed is to engage in debt swaps in order to capitalize on the current low interest rates. However, these have to be carefully approached. To the extent that these are between the center and states, they will not affect the position of the general government unless the center can pre-pay the ultimate creditor without penalty; and to the extent that they are with banks, but not market-based (as for example in a scheme where the resulting capital gain is shared between banks and the government or fully captured by the government), they will weaken both the balance sheets of banks and erode their income with negative consequences down the road. But aligning small savings rates and provident fund (PF) returns with market indicators will lower the cost of new borrowings.<sup>23</sup> Another option is to prepay external debt. The first two possibilities are to use divestment receipts or raise funds by borrowing in the domestic market to pay off external debt. The two are equivalent. If divestment receipts are used to prepay debt instead of financing the fiscal deficit then new borrowing would go up exactly by the amount of the divestment receipts. Thus, prepayment is equivalent to replacing an external liability with a domestic one; it does not change the balance sheet of the government. Interest payments will go down if the external debt carries a much higher interest rate (apart from posing exchange rate risk) than the new domestic borrowing. However, engaging in such prepayment also has its limits. Domestic financial institutions are already carrying some of the highest levels of government paper in the world relative to deposits and additional borrowing in the domestic market to pay off external debt means less funding for the private sector. The third possibility is to borrow from the RBI which then uses its reserves to pay off debt. This will improve the joint income position of the government and RBI (but not the joint balance sheet) if returns on reserves are lower than the rates paid on external debt.<sup>24</sup> Thus, while debt swaps and <u>prepayment may lower interest payments at the margin, a more fundamental fiscal adjustment is needed.</u> 21 But why doesn’t growth pick up with lower interest rates? An answer is attempted below.

22 Thus, RBI (2003a), page IV-20, notes that the average interest rate on new Central Government securities issued during the year reached a peak of 13.75 percent in 1995/96, declining gradually to 11.77 percent in 1999/00 and 9.44 percent in 2001/02. Even these latter rates are “high” relative to today’s inflation rates and growth.

23 However, pre-paying debt now held by the NSSF that creates a wedge between its obligations and what it receives from the government will only create a contingent liability.

24 It will also replenish RBI’s holdings of government securities, which have been depleted by the sterilization of capital inflows. Of course to the extent this happens, it worsens the income position of RBI as foreign exchange reserves typically have lower returns than domestic government paper.

10