The daunting deficit

Borrow, Borrow, Borrow

The third-quarter data on India's GDP showed that it has come out of the recession. The data shows a substantial increase in consumer spending, by nearly 18% as compared to the previous quarter. This shows positive consumer sentiment. GDP growth has turned positive and the signs are for continued upward momentum during the fourth quarter as well. As we look at financial year 2021-22 (FY22), which has just begun, there is understandable optimism about a sharp V-shaped recovery and growth of nearly 11%. The Union Budget proposals have contributed greatly to reviving both consumer optimism as well as business confidence. But much of the high growth next year is a matter of the economy simply recovering ground lost during the pandemic year. As a result, after two years, the economic size of India will be barely 2-3% above what it was in 2019.

The high growth expected will depend quite a bit on the lead to be taken by the private sector, on strong consumer spending as well on industrial investment. The ratio of investment to GDP has to rise from the current 28% to nearly 36% for the economy to show a sustained growth rate of 8%. Fortunately, agriculture production is at a record level of 303 million tonnes this year. This is almost 10% more than the average for the previous five years. Some resolution to the impasse in the negotiations between the central government and farmers agitating against the new farm laws for more than four months now will go a long way in reviving growth optimism. It will also address the shortages that have arisen due to the blockade, and disruption in delivery of crucial inputs like coal, fertiliser and even transportation fuel to Punjab and adjoining states.

One of the main reasons for the growth optimism comes from the fiscally expansionary stance adopted by the Finance Minister. Though the overall spending is budgeted to go up by only 1%, the expenditure on infrastructure will go up by nearly 25%. And the expenditure on healthcare, including vaccinations and sanitation, is up by nearly 100%.

Two noteworthy features of the Budget were, firstly, the transparency in disclosing all liabilities, and secondly, admitting a very large fiscal deficit. This large fiscal deficit of 6.8% for FY22, not only is far in excess of what is specified by India's own fiscal responsibility law but also cocks a snook at international rating agencies. There is an irreverent disdain towards the fear of a rating downgrade. A full chapter in the economic survey explains how international rating agencies have always been unfair to India despite the country’s track record of zero default and currently a high stock of foreign exchange.

But this high-risk deficit, while bold and ambitious, should not make us complacent about the challenge of financing it. The gross borrowing requirement of the Centre alone is more than Rs 12 lakh crore, or over Rs 1 lakh crore every month. That is just about equal to the monthly GST collection. The total borrowing requirement will eat up the entire incremental deposit in the banking system, assuming an 8% growth in FY22. Actually, if the borrowing requirements of state governments is factored in, as well as those of public sector enterprises (PSEs), that number is above Rs 23 lakh crore. This huge borrowing cannot simply be met by the available pool of household savings in the country. If the private sector capacity expansion and investment requires another Rs 12 lakh crore, it will put pressure on interest rates, since there is not enough funding available to accommodate this huge borrowing requirement.

It is here that the Reserve Bank of India has to step in. Of course, it cannot simply print money, because that would be tantamount to monetisation, which is explicitly prohibited by a 1997 agreement between the RBI and the Centre. Besides, direct monetisation could be inflationary. The RBI can do an indirect monetisation by buying all the bonds issued by the Government of India (GoI) in the secondary market. Indeed, it has been doing so for the last two years. When it buys the bonds against money that it has created, the RBI’s balance sheet expands. That balance sheet has grown by 50% in the past two years. And it will grow even further. But a huge volume of borrowing through the market process, i.e., sale of bonds, can put upward pressure on interest rates, as well as crowd out private investments, which too are seeking to borrow from the same banking system, and from the capital markets.

One way to ease this pressure is for the RBI to do a direct deal with the Centre and give it a fixed term five-year loan at a low interest rate against a pledged asset. That pledged asset could be all the shares that GoI owns in PSEs. The combined value of all the shares owned by GoI today is more than Rs 20 lakh crore, thanks to the exuberant stock market. Such a bilateral sweetheart deal is technically not monetisation, nor does it disrupt the credit markets, and hopefully will take off the pressure on interest rates, too.

Another source of financing for GoI is, of course, foreign funds. Thankfully, the inflow into the rupee-denominated government debt market has been quite strong and is expected to remain so over the year. The government may also consider floating an international dollar-denominated semi-sovereign bond through a proxy such as the State Bank of India. This, too, can garner funds equivalent to Rs 1-2 lakh crore.

It is obvious that none of the required financing can depend on increasing the level of taxation at a time when the economy is coming out of recession. Thus, FY22 is going to be a difficult balancing task for RBI. On the one hand, to ensure adequate financing for the government and, on the other, to not let inflation or interest rates get out of hand, while also keeping the currency stable. Not an enviable job at all!

(The writer is an economist and Senior Fellow, Takshashila Institution)(Syndicate: The Billion Press)