As Unlock 1.0 has been initiated in most of the non-containment zones, there are two likely challenges. On the one hand, the lockdown will result in lower productivity, lower income levels and a sharp fall in direct and indirect tax collections. On the other hand, the government is expected to spend heavily on fiscal incentives and job creation. The government has announced a package of Rs21 trillion to recover from the COVID pandemic. While half of this package is monetary, other half consists of fiscal measures and bank finance. Since most of these loans will be guaranteed by the government and eventually the government recapitalizes the banks, the overall allocation is still huge.
The net result will be a sharp spike in budget deficit. For FY20, the fiscal deficit has shot up from 3.5% to 4.6%. For FY21, the government has already hiked the borrowing target from Rs790,000cr to Rs120,00,000cr. With divestment of LIC and Air India in doubt due to tepid market conditions, the only option could be monetizing the deficit. Even RBI veterans like Dr. C Rangarajanhave suggested monetizing the deficit as a temporary solution.
How exactly is deficit monetized?
Monetising deficit refers to the monetary support that RBI extends to the government as part of the borrowing programme. It refers to the direct purchase of government bonds and securities by the RBI to finance spending needs. This was the practice till 1997. Each time the government issued bonds; the shortfall automatically devolved on the RBI. In 1997, RBI governor Dr. Rangarajan stopped this practice. Deficit monetization could be brought back in 2020 as a special case.
What happens when the deficit is monetized? It leads to an increase in total money supply in the system. Unlike the commercial banks that have an investment book, the RBI investing in government bonds leads to creation of fresh money supply. To that extent, it is like printing fresh notes and introducing them into the market. Monetizing the deficit is, therefore, inflationary. These bonds can be later sold in the market to suck out the liquidity and control inflation, but that is in the future.
Why the need to monetize the deficit this year?
The need to monetize deficit arises only when the budget shortfall is likely to shoot out of control. The former Finance Secretary (Subhash Chandra Garg) has made some reliable estimates of the likely shortfall in FY21 in his blog post. According to Garg, the budget shortfall for the fiscal year 2021 would be closer to Rs10-11 trillion. This figure is estimated on the premise that revenues will come down sharply and government spending will go up.
The 42-day lockdown is estimated to result in business losses to the tune of $200-$250 billion. Garg estimates that the impact on direct and indirect tax revenues during the year could be closer to Rs400,000cr. In addition, the weak capital market conditions and the ban on dividends by PSU banks will result in a further revenue shortfall of Rs150,000cr resulting in an overall revenue shortfall of Rs5 trillion. On the expenditure side, Garg estimates that the government may have to spend an additional Rs600,000cr to ensure that downstream impact of the lockdown on vulnerable sectors is mitigated. Put together it could result in an overall budgetary shortfall of Rs11,00,000cr that needs to be bridged.
Is monetizing the deficit the real answer?
There are no simple answers but monetizing deficit looks like the best way. Previous RBI governors and deputy governors have vouched for this approach on a short term basis. The total borrowings of the centre and states stood at Rs13,00,000cr in FY2020 and could be closer to Rs23,00,000cr in FY2021. There is no way investors can absorb this kind of spurt in borrowings. The only answer is to monetize the deficit. Of course, what the RBI and the government can do is to designate these borrowings as catastrophe bonds (COVID Bonds) and have a clear timetable to defray these bonds. That seems to be the only option since tax revenues are going to be hit, disinvestments could be tepid and the government has already exhausted other options like PSU dividends and RBI transfers. Therefore, monetizing the deficit may be the only practical solution in the current scenario.
Beware the risks of monetizing the deficit
What are the risks of monetizing the deficit? The eminent economist, Nouriel Roubini, has sounded words of caution about monetizing the deficit.
• Monetizing deficit looks like a zero cost strategy but it leads to hyper-inflation. You could end up with stagflation; high inflation and weak growth.
• COVID bonds is off-balance sheet financing. This gives an artificially flattering view of the fiscal situation and is frowned upon by rating agencies. With Moody’s lowering India’s ratings to Baa3,India cannot afford to get into Speculative grade.
What really matters, is how quickly, this monetization of deficit is unwound and inflation brought under control. That would depend on the market conditions and also the maturities used to monetize the deficit. For the government it will be a choice between a rock and a hard place!