In 2002, as interest rates started sliding and there were early signs of a rebound in growth at a time when the global economy was yet to recover, the Budget division of the Finance Ministry started analysing the government’s expenditure trends for potential cuts and savings. They noticed that, unsurprisingly, close to half the government’s revenues went in interest payments on past borrowings made at high rates in the 1990s. In that fiscal year — 2002-03 — alone, India’s interest payments was estimated at Rs 1,15,663 crore. On the positive side, receipts were good, inflation was relatively low, and foreign exchange reserves were rising — which led the Ministry to consider buying back some of the high-cost debt on the government’s books. The average interest rate on a large chunk of borrowings then was over 12%, and there was no exit clause, with the maturity of most bonds set at 5-10 years, or a little more.
Given the need to involve the central bank, which handles the government’s debt management, discussions took place among the Additional Secretary, Budget, Dhirendra Swarup, RBI Governor Bimal Jalan, and Deputy Governor Y V Reddy. After the contours of a debt swap scheme emerged, Finance Secretary S Narayan and Swarup flew to Mumbai to meet with chiefs of banks and financial institutions at the RBI office to sound them out on the proposal to buy back some of the costly securities or debt on their books. On the way, the two officials discussed the options to push the proposal through.
For banks and other lenders, it is mandatory to buy government securities and hold it as a prudential measure, as they offer security and liquidity. Most were unenthusiastic about the prospect of letting go of such bonds or securities offering high interest rates — it would mean sacrificing income in the form of treasury gains for the next few years at a time when interest rates were sliding. But saying no to the government, the owner of state-owned banks and institutions, would have been considered sacrilege.
Finally, the government agreed to buy back 19 high-cost bonds with a face value of Rs 14,434 crore, which were hardly traded, at a premium of Rs 3,472 crore, and replace them with four new bonds — signalling the start of a new debt management strategy. To sweeten the deal for the banks, a tax incentive was offered in the next fiscal, if they utilised the income generated to set aside funds for bad loans. The idea of prepaying relatively high-cost foreign loans of the central government too was worked upon — and loans worth $ 3 billion taken from the World Bank and Asian Development Bank many years ago were repaid.
Other debt mitigation measures too were employed. In 2002, for the first time, the government as a borrower introduced a call option or exit option before the maturation of its borrowing to repay and get out. Management of cash in government departments also saw changes, with monthly and quarterly limits being introduced.
But policymakers in New Delhi and officials at India’s central bank recognised that the ticking time bomb was the borrowings of state governments from the central government. A debt management strategy wouldn’t work without cleaning up the books of state governments too, they agreed.
The secular decline in interest rates, including sharp cuts in small savings schemes in 2002, helped. Jaswant Singh, who moved to the Finance Ministry in late 2002, announced a scheme to help states lower their interest and debt burdens, just like the central government. In 2002-03, states owed Rs 2,44,000 crore to the central government. Over Rs 1,00,000 crore of this debt was at interest rates higher than 13%.
As part of the debt recast, states were allowed to use the proceeds of small savings, and replace these high-cost borrowings with lower-cost borrowings, paving the way for fiscal consolidation a couple of years down the line. With growth picking up from 2003-04 onward, both the central and state governments managed to reduce their fiscal deficits progressively. States were reckoned to have saved over Rs 81,000 crore on interest and deferred loan repayments over the remaining period of their loans. Twenty-five states participated in that debt recast scheme. A push was provided by the recommendation of the 12th Finance Commission on debt management.
This was also the time when, in a unique move, a large chunk of bonds issued by the government to state-owned banks for boosting their capital was, for the first time, converted into securities at market related rates.
In that phase of the new debt management strategy, Jaswant Singh spoke of having carefully balanced fiscal consolidation with the need for a contra-cyclical policy stance, something which is being echoed now too in the Finance Ministry. The government’s latest debt management strategy report for the next three years unveiled a few weeks ago reflects some of these measures — though in a vastly changed scenario in terms of the size of the economy, the market and the reforms that have been carried out over the past decade. But the key question is whether some of the debt management strategies would work in the same way as in 2000-02, when interest rates fell sharply from double digits. Unlike then, interest or coupon rates on both central and state government bonds are on average far lower, and the prospects of those yields rising appear weak now — especially with the RBI bound to meet a target for inflation. Unless there is a deep economic slowdown like in 2000-02.