Today, retail participation in domestic debt markets is more than just a ‘nice-to-have’. Amidst persistent inflation, uneven growth, rising inequity and other economic stresses, retail participation in debt markets can provide policymakers with added degrees of freedom. We explore how and consider what holds back retail debt investments.
When banks give out loans, they credit beneficiary accounts and create fresh money. Similarly, when banks make loans to the government and the government then spends, fresh money is created. During times of persistently high inflation such as now, creation of fresh money is worrisome for policymakers.
In contrast, when savers directly lend money to borrowers (including the government) via debt capital markets, no fresh money is created. Instead, savers find a medium-term destination for their money, which then moves into the hands of borrowers.
Between March 2020 and March 2022, amid higher fiscal deficits through the pandemic, the central government net borrowed a record INR 23 lakh crores. The RBI then stepped in to buy government debt via open market operations and the Government Securities Acquisition Program (GSAP). It also encouraged banks to actively buy government bonds by flooding the market with liquidity and extolling low bond yields as a ‘public good’.
As a result, bank (and RBI) credit to the government during this period increased by a record INR 15.2 lakh crores, creating fresh money to that extent. Further, because of this active intervention, the central government’s average borrowing cost was kept at a low 6.0%, below the 6.25% annualized rate of inflation through the period.
This financial repression had its inevitable side-effects. For one, fresh money was created to the extent of bank and RBI funding of government debt, much of which appears to have found its way to the beneficiaries of India’s formal economy. In addition, with interest rates well below perceived inflation, these savers have moved away from fixed income into riskier asset classes such as equities and gold. Conspicuous imported consumption also appears to have increased. Inequality has risen, as has India’s import bill.
Here are some numbers that illustrate this. Between March 2020 and May 2022, India’s income and debt oriented mutual fund schemes saw net outflows of INR 1.5 lakh crores. Likewise, while direct retail investments into government bonds have been made operationally easier now, the net flows remain negligible.
In sharp contrast, during the same period, equity, hybrid, and other non-debt schemes of mutual funds saw record net inflows of INR 4.9 lakh crores. Despite tepid foreign portfolio flows, this deluge has allowed our equity markets to rise significantly above pre-pandemic levels, increasing wealth inequality at a time of negligible economic growth and high inflation.
Likewise, India’s net imports of gems and jewellery during the period stood at a record INR 5.9 lakh crores.
To be fair to the RBI, financial repression has reduced significantly over the past few months. The RBI stopped purchasing government bonds since October 2021, despite ongoing fiscal pressures. From 6.0% a year ago, the 10-year Government of India bond yield has now risen to 7.4%, well above the 6.0% upper band of the MPC’s inflation targeting mandate, and at a level that long-term savers could find attractive.
Does this mean that retail savers will now shift into fixed income savings? Not so fast. Besides financial repression, distortions in our tax regime also come in the way of direct retail participation in fixed income markets.
Consider a saver who now buys a 4-year government of India bond, say at a yield of 7.0%. The interest coupons are taxed at her marginal rate of income tax. If she earns more than INR 10 lakhs annually (recall that most savers now are likely from India’s formal sector), she will pay a tax of over 30% on the interest income. That would bring the effective yield in her hands to below 4.9%. The post-tax real rate of return in her hands is still very low, and negative.
Paradoxically, if she chose to save via a debt mutual fund scheme, on redemption after three years, her income would be exempt from tax to the extent of inflation over the period (‘indexation’). In addition, the balance taxable amount would be subject to a capital gains tax of just 20%. Using the same example of 7.0% yield on investments, if inflation averaged 5.0% during the period, she would only be liable to pay 20% tax on the balance 2.0%. Her net debt fund yield would stand at 6.6%, much more than 4.9% (or lower) through her direct investment.
As things stand, no taxpaying investor should consider saving via direct investments in any fixed income instrument, including in government securities. Instead, she would be much better off investing via a debt mutual fund that undertakes identical investments, notwithstanding the added fund management fee.
There is a strong case to remove this tax anomaly and give the same tax relief for direct debt investments as through debt mutual funds.
First, this variance doesn’t exist for equity investments, which are taxed identically at the hands of the investor, irrespective of whether they are held directly or through a mutual fund. As an aside, the widespread interest in direct equity investments has also supported the growth of equity mutual funds.
Second, major investors in bonds – banks, insurance companies, pension funds – do not pay tax on the full coupon since they claim interest expense as a deductible. As such, the government will not stand to lose by providing similar relief to retail investors as well.
Finally, retail participation in fixed income markets would help address the original issues that we had flagged. It would reduce the need for banks to fund the government, particularly when non-government credit growth is finally recovering. It would thus reduce money creation, at a time when inflation is worrisome. It would also provide savers with meaningful post-tax real rates of return, helping control both excessive asset price inflation and imports.
(Ananth Narayan is a banking and financial markets expert. He is currently Associate Professor at SP Jain Institute of Management and Research.)
Views are personal and do not represent the stand of this publication.