Read the passage given below and solve the questions based on it.
The debt swap scheme is one among the various market-based debt restructuring measures available to provide debt relief without hampering the interest of the creditor. The basic notion of debt swap/conversion is relatively simple. The principle is that instead of continuing to make interest payments on outstanding loans contracted in past at a very high rate, the debtor is able to find some other means of setting the debt which is satisfactory to both the debtor and creditor. The debt swap can be of various types, the most prominent being the debt-equity swaps, or debt-to-debt swaps. Debt-equity swaps are exchange of bonds or bank loans for ownership right to equity. Such debt-equity swaps have formed part of private corporations restructuring process for some time.
The debt swap whether internal or external has an array of macroeconomic effects. It is to be noted that in any debt swap scheme, the debtor must surrender an asset in return for having a liability extinguished. For example, in case of debt-equity swap, debt is exchanged by a claim on capital stock owned by the debtor. In the case of external debt, if the government retires external debt by issuing domestic bonds, in a balanced budget there are no real effects beyond those created by the initial wealth effect: the economy will display a current account surplus, accompanied by an initial appreciation of parallel exchange rate and a high real interest rate. These effects are independent of the discounts received by the government.
The practice of debt-equity swap or debt-to-debt swap particularly in the context of external debt has given rise to active controversy. The debate covers wide-ranging issues such as welfare characteristics of such swaps, their potential for reducing net capital flows, and the degree to which swap can reduce the negative incentive effects of debt overhang. Attention has also been paid on the effect of debt swap on the secondary market prices of debt. In the case of external debt, Mexico and Brazil suspended the debt conversion programme, because they can be inflationary as they put excessive pressure on the free market for foreign exchange or because swapping of foreign debt with domestic debt can be
If the debt is swapped through money financing, it leads to an expansion of money supply. If the government can run sustained deficits, the fiscal side provides a key link through which swaps can create macroeconomic disequilibrium. In a deficit situation, if the supply of bond is increased to swap the debt, and if the discounts obtained by the government due to interest rate differential are not large enough to cover the deficit, government will have to issue fresh bonds, which in turn may push up the interest rate. Finally, if the government continues to run a fiscal deficit and to avoid inflationary effects if it relies mostly on debt for bonds swapped and if this in turn leads to an accumulation of domestic debt, which the public expects will eventually be monetized, the domestic rate of inflation will immediately begin to rise.
In the case of the debt swap scheme between central and state governments in India, states can restructure their debt by pre-payment of high cost central debt with additional market borrowing at a lower rate of interest. Essentially, this should result in the reduction in the average cost of debt of the State Government. However, that would largely depend on the volume of savings in the interest cost in relation to the outstanding debt stock available for swapping. Despite the savings in interest cost due to debt swap, if a large gap is to be filled by additional borrowing, there is a possibility that swap-induced additional market borrowing may put pressure on the interest rate. Also, in an extreme case, continuous financing of swappable debt through bond financing may fuel inflation if the holder of the bond expects that debt will eventually be monetized. It is evident from this discussion that aggressive debt restructuring proposed to reap the benefit of low interest rate regime at times may itself become the cause of hardening of future
What will happen if government decides to issue fresh bonds in a deficit situation?