The impact of the RBI’s low interest rate policy on the Union budget

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The budget deficit for the current fiscal year 2021-22 has been revised to 15.9 trillion. When this year’s budget was presented last February, the budget deficit was expected to reach 15.1 trillion. The budget deficit is the difference between what a government earns and what it spends.

The government finances a large part of its deficit by issuing bonds and borrowing money. In 2021-22, approximately 8.8 trillion of its borrowings should be covered by issuing bonds. This tells us that the total public deficit is not only financed by bonds. The other major way is the money that goes into the small post office savings plans net of repayments. Every year, certain investments made in past years by people in such schemes mature and need to be repaid. This year, the government expects approximately 6.8 trillion to invest in these plans. The expected redemption is 86,749 crore, which leaves about 5.9 trillion.

This 5.9 trillion will be used to finance the budget deficit. Thus, borrowing through the issuance of bonds and money invested in small savings schemes finance a large part of the government’s budget deficit.

This is where things get interesting. When the budget was presented last February, the government assumed that approximately 4.8 trillion will be invested in these schemes in 2021-22. Any further, 91,343 crore would be redeemed, leaving 3,900 billion, which would be used to finance the budget deficit.

In the place of 3.9 trillion, the government ended up with 5.9 trillion, or 2 trillion more. Why did this happen? The repo rate or interest rate at which RBI lends money to banks was 6.5% in January 2019. In February 2020, around the time the covid pandemic hit, RBI l had reduced to 5.15%. In May 2020, the central bank had further lowered the repo rate to 4%, where it has remained since.

Before the pandemic hit, the idea was to lower interest rates so that people would borrow and spend more, and businesses would borrow and grow, helping the economy, which was going through a rather moribund phase. After the pandemic, the idea was to also help the government borrow at lower interest rates.

In addition to cutting its key interest rate, RBI also printed and pumped money into the economy. After the crisis, bank lending growth collapsed, pushing interest rates on term deposits held with banks even lower.

Since most of the financial savings of Indian households are made up of bank deposits, this has hurt households and pushed them to seek higher returns. Stock markets beckoned. In 2019-2020, on average, about 420,000 demat accounts were opened each month. In 2021-2022, this number reached 2.76 million demat accounts. A similar rise was seen even in the case of mutual funds, through which people buy stocks indirectly. As the Securities and Exchange Board of India points out in its latest monthly bulletin: “On average [2.39 million] new investor folios are added every month.”

Not everyone wants to take on the increased risk associated with stocks. Consequently, many individuals have increased their investment in small savings plans. While the interest rates on these schemes are lower than they were in the past, they are still higher than what bank deposits have to offer. This explains why investment in these plans has increased dramatically this year and, net of refunds, 2 billion more than the Center expected.

This shows us the indirect effect of monetary policy and the impact it has had on the Union budget. Low interest rates pushed people into small savings plans, which increased total government revenue. Aided by this increase in revenue, coupled with an increase in tax revenue, the government has increased its expenditure for this year to 37.7 trillion against the $34.8 trillion he had budgeted.

It doesn’t stop there. There will also be effects of this effect. As mentioned earlier, money invested in small savings plans matures over a period of time and must be repaid. It is repaid using new money invested in these schemes during the year of maturity of past investments. In this sense, these systems have a pyramid structure, where older investors are paid using the money brought in by new ones.

This basically means that future generations will pay for the current generation’s expenses. Of course, all long-term public debt is like that. The problem is that in difficult times like these, considerations of intergenerational equity run counter.

As Arun Jaitley said in his first budget speech: “For me, fiscal prudence is of paramount importance because of considerations of intergenerational equity. We cannot leave behind a legacy of debt for our future generations. But that is precisely what is happening and the reason is simple: future generations do not yet have the right to vote. They have to bear the cost of our free meal.

Vivek Kaul is the author of “Bad Money”.

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