A Revamped Budget Could Make Deficit Monetisation Credible
It is becoming increasingly clear that following the Covid-19 pandemic, the Indian government will have to provide massive support to the healthcare sector, poor and vulnerable citizens, small firms, and the economy as a whole, over the 2020-21 fiscal.
There is a strong consensus, with support from past central bankers, that a sizeable part of this expenditure will have to be funded by the Reserve Bank of India, i.e., the deficit will have to be monetised.
In terms of macroeconomic policy stance, this implies that a major shift is taking place with an understanding that this crisis will need fiscal dominance to make a temporary comeback and monetary policy will have to play a supportive role.
Embraced Elsewhere, Hesitation In India
Many countries have quickly accepted this change and moved towards some form of deficit monetisation in these dire times.
- The U.S. Federal Reserve has started purchasing very large volumes of treasury securities and municipal bonds, thereby supporting the expenditure of the federal as well as municipal governments.
- The European Central Bank eliminated a cap on how many bonds it can buy from any single eurozone country.
- The Bank of Canada has declared that it will buy Government of Canada securities in the secondary market and began with purchases of C$5 billion per week, across the yield curve.
- Amongst developing countries, Indonesia has recently changed its laws that allowed its central bank to buy government bonds only in the secondary market. Now if the market is unable to fulfill the government’s financing target, the Indonesian central bank can buy government securities from the primary market.
Oddly enough, this thinking is not shared by Indian policymakers.
A Business Standard article on April 21 reported that the RBI was pushing back any direct or indirect monetisation of the central government’s fiscal deficit till the second half of the fiscal year. Policy experts close to the government, including NK Singh, the chairman of the Fifteenth Finance Commission, have argued that monetisation of the deficit is not in the best interests of the country. Why is the government so reluctant to go down this path and is this a sound approach? If not, what other options do we have?
Concerns And Counterpoints
There could be three important reasons for this reluctance.
- The first is that the policymakers do not want to undo the significant reforms that have been implemented in the monetary policy framework over the last three decades.
- The second is a concern with major financial outflows, particularly if there is a downgrading in our ratings as a result of any deficit monetisation.
- The third is a worry that any monetisation could be inflationary, especially if the disruptions from the lockdowns lead to major supply bottlenecks.
Each of these concerns is real and should definitely be considered seriously when any policy is framed in this context. However, several counterpoints also need equal consideration.
First, it must be understood that the reforms in the monetary framework that have been adopted until now all work towards maximising the gains from our financial openness. While these reforms will need to be relaxed temporarily for monetisation—as has been done, for example, in Indonesia—in a post-Covid-19 world, the discipline of the financial markets will surely ensure a quick return to a regime of fiscal discipline.
But what about a reversal of financial flows during the crisis if we monetise some of our deficit? While this is definitely a possibility, we need to weigh this against the likelihood of an even stronger financial outflow that may result from the economy crashing due to an insufficiently large stimulus, which may happen if we rule out monetisation.
As far as inflation is concerned, there seems to be a consensus that there is very little probability of this during the first half of the year when we will most probably face a very large demand meltdown.
It is, in fact, during the latter part of the year—when private demand could possibly make a comeback—that we might run into supply bottlenecks and inflationary episodes.
If the government is forced to monetise its debt at that point, to continue funding the health crisis for example, we will definitely have to contend with inflationary expectations.
Finally, and perhaps most importantly, it must be recognised that the volume of funds needed to mitigate this crisis is simply enormous, and market borrowings may simply not suffice. In a recent opinion piece, Arvind Subramanian and Devesh Kapur show that even with optimistic assumptions about the length of the lockdowns, a sizeable monetisation will be necessary.
Getting The Timing Right
So what would be a balanced approach to this issue that would consider both sets of concerns? Thinking through the concerns about the undoing of monetary reforms, the financial outflows due to diminished ratings, and the possibility of encouraging inflationary expectations, it immediately becomes clear that the main problem related to deficit monetisation is that it raises questions about the credibility of our policies and the capacity to manage expectations.
In normal times, these issues are dealt with by ensuring fiscal discipline. In a crisis, fiscal discipline is not an option that we have, warranting the consideration to monetise some part of the deficit. If this is so, then the current approach by the government to try and avoid monetisation as long as possible, and to push it to the second part of the year if absolutely necessary, is not a balanced one at all.
The lack of a clear underlying plan robs it of any credibility and there is nothing specific in it that attempts managing expectations.
A New Budget For FY21
A more balanced approach would involve coming out with a revamped budget for this year since the budget presented in February has become largely redundant.
This should spell out the government’s plans and priorities in terms of revenues and expenditures and a clear plan for funding the deficit, including market borrowings and monetisation.
The monetisation should include purchases of central government securities both in the primary and secondary markets as well as the transfer of excess reserves from the RBI.
The purchases in the primary market should be mostly in the form of temporary monetisation, since the money is provided specifically for the period of the crisis.
However, some of it may need to be made into permanent monetisation subsequently, depending on how much resilience the economy shows after the crisis.
Moreover, given that there are possibilities of inflationary tendencies during the second part of the year, a large part of the monetisation should happen during the first part of the year, when the challenge of managing inflationary expectations are not on the cards.
There are two clear advantages of such a budgeted monetisation plan. The first is that it will enable the private sector to understand the overall economic approach and plan their activities accordingly. This will definitely help a recovery, which will be handicapped if the private sector continues to be paralyzed due to policy uncertainty. Secondly, even foreign investors and rating agencies will feel less risk-averse with a budget, as it will signal an economy with a clear and transparent economic plan to combat the crisis.
Sabyasachi Kar is a professor at the Institute of Economic Growth, University of Delhi.
The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.