Trends in India's private sector's cost of capital and interest rates and macro implications

Abstract

In recent times, a lot of interest has been paid to the burgeoning deficits of the Indian economy. The Fiscal Deficit is simply the government’s revenues less its expenditures. There is another measure of deficit viz. the Revenue Deficit, which is calculated as the Fiscal Deficit less the capital expenditure of the government. A revenue deficit implies that the government is borrowing to meet even regular expenses (like wages) and this is one of the indicators of an impending debt spiral. A private company operates in a vastly different environment from a government. Such an entity must necessarily have a revenue deficit that is less than or equal to zero (i.e. profits or at the least no-profit-no-loss). A private company has limits to the amount of debt it can take on to meet existing losses, as this will ultimately lead to depletion of its productive assets due to non replacement. Such a situation does not hold for a country as a whole. Suppose the government is running a revenue deficit – it will lead to an increasing trend in interest costs for the Government. However, this will not prove ruinous if offset by private sector dividends. The private sector is intrinsically linked to the government in the following way. An increase in private sector investment will increase its revenues and thus profits (assuming rational investment patterns). There will thus be a corresponding increase in taxation, which is revenue for the government. Theoretically, as long as the private sector continues to grow at a certain rate, under certain assumptions, the increased revenue to the government will offset the increased interest costs. This phenomenon is known as the satisfaction of “Domar condition” (i.e. the country has a GDP growth rate that is higher than the interest rate) for a given primary deficit. In this case, the government can perpetually continue with a revenue deficit, using the “dividend” from private sector growth to repay interest on debt. As the private sector runs a revenue surplus, it should usually ensure adequate investment to generate GDP growth higher than the interest rate. The nation (government plus the private sector) can build assets even while the government continues to run a revenue deficit. Traditional theories of economics argue that a continued fiscal deficit will need to be funded by an ever increasing mass of government debt. The government achieves this by issuing bonds and other government securities. In case of a large deficit, the quantity of debt issued will drastically increase supply with respect to demand. This will reduce the price of debt, thereby increasing yields in the economy. This will crowd out private investment, thereby reducing ultimately the growth of the country. Subsequent theories argue that this may not always be the case. For example, if the economy is sufficiently demand constrained, the additional debt will be absorbed by the banks and there will be no corresponding increase in interest levels. Other theories argue that the effect of the deficit depends on how it is financed. If the deficit is funded by monetization exclusively, this would lead to inflation and hurt the poor. This argument again does not hold if monetization results in additions to bank reserves, the economy is demand constrained and the deficit is not large enough to change this status to one of being supply constrained. If the deficit is funded by debt alone, then it would lead to increase in interest levels and this would crowd out private investment; again this will not happen if the banks have excess reserves. Thus the effect of the fiscal policy depends on the state of economy and the prevailing excess demand in either the goods or the money markets. In our study, we will study the following: 􀂃 Whether the existence of a fiscal deficit has led to an increase in private sector interest rates. While doing this we will automatically assume linkages between a reduction in interest and increase in profits (assuming operational capabilities remain unchanged). This is extended further to a linkage between a reduction in private sector interest costs and increased investments. 􀂃 We will check whether the Domar condition can be applied to the private sector i.e. the sales growth in the private sector is greater than the interest rate faced by it. By doing this we hypothesize that given continuously increasing private sector surpluses, the GDP growth will be higher than the interest rate.