No better than Enron: The finmin guide to hiding the fiscal deficit
The pension and insurance funds are carrying the can for securities issued to hide the government's budget deficits. This is a clear lack of transparency
Is the Indian government using the opaque murky state of the country's debt/fixed income markets, and its ownership of large parts of the financial system, to hide a lot of its deficit financing?
Much of the government's financing of the fiscal deficit - the gap between spending and revenues - is taking place through the issuance of "special securities", and its new avatar "special banking arrangements", or accounting arrangements of unfathomable complexity. All this is away from established markets like the one for government securities (g-secs). And the total number of such securities outstanding, dear reader, is around Rs 2,00,000 crore.
Consider that the government's borrowing programme has been announced for the second half of fiscal year 2014 with no change from what the markets were expecting. This is commendable. Except that it may be another cook-up. On just a single item in the fiscal deficit increase,- the fuel subsidy - we see the government would have to increase its borrowing programme.
Consider the fuel subsidy. The budget provided Rs 65,000 crore for the subsidy on fuel. Of this, Rs 45,000 crore is the amount in arrears carried forward from last year. The actual net budgeted amount for this year is therefore only Rs 20,000 crore. Moody's, in a recent report, mentioned that the actual under-recoveries for this year might be as high as Rs 1,80,000 crore. The difference between the actual under-recoveries for the year, and the net budgeted amount is therefore about Rs 1,60,000 crore.
This is not surprising. Both oil, and the exchange rate, have moved very adversely, as has been widely documented. For example, the under-recovery per liter of diesel, considered unmanageable at Rs 10, is still at that level.
This difference of Rs 160,000 crore is very substantial. The upstream oil companies like ONGC will have to share the subsidy burden to the extent of about Rs 60,000 crore. This will, without doubt, jeopardise their own exploration plans and capital expenditure. But never mind. Nobody thinks about long-term fuel security anyways.
That will still leave an amount of Rs 100,000 crores that the government has to be account for and finance. This is a very large amount.
Note that we are just discussing the fuel complex here. Overshooting on other items in the budget - normal in an election year - is not being discussed.
How then, can the borrowing programme not increase? And where is the money to fund just the increase in the fuel item of the deficit coming from?
Some of it could come from a diesel price hike (petrol is already decontrolled), and this month the markets will start chattering about the hike. But remember, there's always an election in India. By December, the big daddy of elections to the Lok Sabha will be just four months away. So there's even less of a chance of a substantial diesel hike before the general elections.
"Non-essential non-plan expenditure" could be cut. But that cannot be very large. How much can you save on Ambassadors, first class air travel, and scrapping conferences? Further, taking the axe to plan expenditure and reducing government outlays in a weak economy in an election year, might be politically unacceptable.
Finally, the government could confiscate unused budgeted expenditure. But the ministries might wise up this year, spend their monies on time, and not leave much for the government to confiscate. The absolute last resort is to simply roll it over to the next fiscal year, and let the new government deal with it.
Consequently, all the above measures won't amount to much. Just the additional subsidy of Rs 100,000 crore on the fuel complex alone, would force the government to increase its borrowing programme.
And yet it has not.
So why has the government not increased its borrowing programme? Because of a nifty little item called "special securities" issuance, or "special banking arrangements". This practice had been discontinued in the past but has since started again. In addition, accounting arrangements of hideous complexity are used between various entities - all government-owned - to disguise actual financial flows. In the case of the fuel subsidy, for example, these accounting arrangements take place mainly between the upstream exploration companies, the downstream marketing companies and the government exchequer.
Not many people know this, but most of India's subsidies get financed through "special securities issued in lieu of cash subsidies", "special banking arrangements", or accounting arrangements between government owned entities that only the government seems to understand.
Basically the welfare programmes of the government get financed through the budget and therefore the government securities/treasuries market. Much of the 3F subsidies - fuel, food, and fertilisers - get financed through something called "special securities" or "special banking arrangements". When the "special securities" are used for subsidising the fuel complex, they're called "oil bonds". Some of this is off balance-sheet, off-budget financing. The rating agencies count all this towards the fiscal deficit - as they should - but local analysts it seems, are more forgiving.
Proper accounting for subsidies financed through "special securities" ,"special banking arrangements" or other arrangements, would probably take the Centre's fiscal deficit to well above 6 percent of GDP, which is about right. Throw in 3 percent for the state government deficits, and we're getting close to Greece's levels of 10 percent during the eurozone crisis.
Consider the "special banking arrangement" fudge. This is done on the fertiliser subsidy. Apparently the government is one year in arrears on subsidies due to the fertiliser companies, and the companies have hauled the government to court. The government, therefore, arranges for a consortium of public sector banks to provide short-term loans to the fertiliser companies which equals the subsidy due. This is instead of the cash handouts due to them. The interest rate is set at 8 percent. The coupon is less than the g-sec yield, and therefore costs the government less than borrowing in the g-sec market. Repayment is by the government to the banks, "some time in the future when liquidity conditions improve". Effectively the public sector banks are paying out the fertiliser subsidy, and the government moves part of the fiscal deficit on to the banking system. This off budget financing is wonderful.
It is also the same sort of activity that got Enron into trouble in the first place.
Or consider the financing of the fuel subsidy through the "special securities" programme. The government, till Pranab Mukherjee stopped it, used to issue pieces of paper called "special securities" to the oil marketing companies for the subsidy component. The oil companies have to buy oil every minute of the day in world markets, as India imports 80 percent of its fuel requirements. They, therefore, just hang on to the paper. They sell the "special securities" mainly to the insurance and pension companies for cash, which they then use to buy oil in world markets. The banks don't pick up much, because the securities don't enjoy "statutory liquidity ratio" status.
The pension and insurance companies are then left with this paper on their balance-sheets, on which the government pays the coupon (interest), and will (presumably), redeem at maturity.The government, by issuing "special securities", or "special banking arrangements", is in essence running a parallel market to the g-sec/treasury market in India. This suits the government very well as it takes the pressure off the g-sec market and keeps yields - and therefore the government's borrowing costs - artificially low.
The right thing to do would be to include "special securities" and "special banking arrangements" issuance in the government securities borrowing programme. The government could then use the cash raised to pay the subsidies - in cash - to the oil companies and other entities. Such massive paper issuance would, however, cause a collapse in the g-sec bond market, take yields well into double digits, and raise the government's borrowing costs - already very high - to unmanageable levels. Hence the Enron level manipulation.
This also results in the banks, pension, and insurance companies effectively - and directly - funding a part of the government's fiscal deficit. Notice that this is besides the "statutory ratio" that compels them to buy government securities through the g-sec market.
All this means that a hugh chunk of the financial system's capital is used just by the government to fund its activities. An earlier article "Dr Rajan, your next crisis is coming up in banking" pointed out the deleterious effects on the banking system. The government confiscates 23 percent of the system's deposits through the "statutory ratio" and forces the banking system to finance its deficits. Financing the government's deficits is so profitable for banks that they park even more of their deposits - about 30 percent - with the government. Add to this the cash reserve ratio of 4 percent parked with the RBI. That's a third of the banking system's deposits locked up with the government, leaving the rest of India with just two-thirds. No wonder the interest rate is so high.
That "red line" and its consequences
All this seems a fine way to have your cake and eat it too. Presumably it allows Chidambaram to keep to that "red line" of a 4.8 percent fiscal deficit target. That the target is being met in this fashion, is another matter. It allows Chidambaram to fulfill his basic mandate - to keep the show on the road till the general election, by avoiding either an IMF programme, or a ratings downgrade. Both presumably would be politically catastrophic for the UPA.
But there are some unintended consequences to all this.
Consider the "special securities" that were issued till recently. They are not publicly traded. Because they're not publicly traded, there's no way to determine their price, or their value. So how to determine their value? Well, some bureaucrat at the RBI decided that they have to be priced to yield 25 basis points over government securities of comparable maturity. And there the matter rests.
In fact, pricing due to liquidity concerns is so aberrant, that the oil marketing companies even after issuance have faced continuing concerns on financing working capital. They sell the "special securities" at such deep discounts to the issued price, that working capital financing remains a concern even after being compensated for the subsidy. Also, since there's no tradable market for the "special securities", pricing is set by market intermediaries and middlemen, in murky negotiated off-market transactions that lack transparency. Presumably this includes the middleman's cut too.
So India's pension and insurance companies, among other entities, have presumably loaded up on tens of thousands of crores of the paper the government uses to subsidise the oil companies, for which there's no real market. In the absence of a market who will buy from these entities, if and when they come to sell? Presumably not many, given the absence of liquidity, and consequent wide bid-ask spreads. Does that mean the debt rolls over indefinitely, gets "ever greened" so to speak?
Recall also that most of the financial system is owned by the government. Almost 80 percent of the banking, insurance, and pension sector is directly owned or controlled by the government.It makes it much easier to get away with all this hera pheri with government owned companies.The problem is particularly acute in the insurance and pension space, where most of the companies are not subject to public oversight or market discipline, and are not listed on a stock market.
This almost sounds like the CBO/MBO mess that precipitated the sub-prime crisis in the US. That time, too-clever-by-half financial engineering made it difficult to value those securities. This time it seems to be the complete absence of a market that makes valuation of these "special securities" difficult.
Somebody out there needs to start investigating all these issues.
Adil Rustomjee is an investment advisor in Mumbai. Sensible comments are welcome at firstname.lastname@example.org.
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