The government finances its fiscal deficit by borrowing from the bond market. Government borrowings fund 85% to 90% of fiscal deficit.
Government approaching the market to fund its fiscal deficit is good practice as the market determines the rate of interest for the government. Higher the amount of borrowing, higher the interest the market will demand to fund the government.
Government sells dated government bonds to the market and this predominantly funds the fiscal deficit. The government can also issue short term (less than one year) treasury bills to fund its fiscal deficit but does not use this route as it prefers to elongate the maturity of its borrowing.
The outstanding stock of government securities is Rs 35,250 billion as of 31st January 2014. The government has borrowed Rs 24,000 billion from the bond market over the 2008-09 to 2013-14 period. The government has increased its total debt through issue of government bonds by three times over the last six years.
The government is paying the price for the rising borrowing through rising interest costs as ten year benchmark government bond yields have shot up from levels of 6% to 8.75% over the 2008 to 2013 period. Higher levels of bond yields pushes up interest costs for the government leading to more borrowing that again pushes up bond yields. A self fulfilling cycle
The government depends on banks to absorb its borrowings. Banks have to compulsorily hold 23% of their NDTL (Net Demand and Time Liabilities) in government securities. Banks hold around 54% of total government outstanding debt. Insurance companies hold around 19% while RBI holds around 13% of government debt.
FII limit in government bonds as of January 2014 is USD 30 billion and if the government continues to borrow heavily to fund its fiscal deficit it will have to raise this limit as domestic investors may find it difficult to absorb the supply of bonds.