Government borrows to fund its deficit. We often come across something like crowding out of private investment in articles when the writer is talking about government borrowings. Let’s understand what it means.
Crowding out basically refers to a situation where the private sector gets elbowed out of the debt market due to higher demand for government funds. Let’s say banks garner Rs.100 via deposit. 23% of the same goes into gilts & SDLs (SLR requirement). 4% of it goes to RBI given CRR is a mandatory liquidity requirement. Balanced fund is then lent to consumer and Industry for their varied needs. When government increases its borrowing it consequently increases demand of money which in turn increases interest rates. The problem is that the government can always pay the market interest rate, but there comes a point when corporations and individuals can no longer afford to borrow at higher rates. Also Banks then prefer investing in Gilts rather than lending to other non government entities as high interest rates increases risk of default. Thus Private borrowers which includes Industry (Term Loan, Working Capital Loan, Machinery Loan, etc) and Individuals (Personal Loan, Home Loan, etc) finds it difficult to get a loan more importantly at a cheap rate. This fall in investment by Individuals and Corporates affects long term growth thereby impacting a number of macroeconomic indicators like IIP, Unemployment, Inflation, etc
Governments’ borrowing to incremental deposit of banks is a good indicator to measure the crowding out effect.
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