India’s budget explosion could see RBI resort to direct funding
New Delhi: The Indian government is running out of options to finance its budget and may soon have to knock again on the central bank’s door for support.
The administration can ask the Reserve Bank of India to buy sovereign bonds directly or increase dividends to help supplement income, which has been hit by a crippling economy lockdown to contain the spread of the virus. The government faces a budget deficit of up to 7% of gross domestic product, the largest in more than two decades, according to some estimates.
It would “make sense to immediately opt for some form of deficit monetization,” said Sabyasachi Kar, RBI professor at the National Institute of Finance and Public Policy in New Delhi. “The creation of demand can only happen if the government spends.”
U.S. central banks in Japan are helping fund record fiscal stimulus from their governments amid the pandemic. This has even been the case in emerging markets like Indonesia – where the central bank agreed this week to buy billions of dollars in bonds directly from the government. The approach, however, carries risks for developing economies, in particular for inflation, currency and central bank independence.
India’s Fiscal Responsibility and Fiscal Management Act prevents the RBI from purchasing bonds directly from the government in the primary market, but the law does include a safeguard clause in the event of a national disaster or severe downturn.
The RBI has so far made some quiet secondary market bond purchases, but the government debt manager has yet to set out a plan on how it will handle the record Rs12 trillion ( $ 160 billion) in government borrowing in the current fiscal year through March. .
For now, banks are hoarding sovereign bonds with optimism that the central bank will absorb the supply of debt. Lenders inundated with liquidity, given the weak demand for loans in the economy, increased their holdings of sovereign bonds to Rs.41.4 trillion as of June 19, up 13% from the end of March.
“We still believe that it is possible to finance a deficit of around 11% of GDP – center and states – without resorting to significant funding from the RBI,” said Sergi Lanau, deputy chief economist at the International Institute. of Washington’s finances. “Banks have already bought a lot of bonds and with an economy in recession, they may not have a lot of opportunity to lend to businesses anyway.”
A possible downgrade is another risk for India, which is heading for its first economic contraction in more than four decades this year. The credit rating of Asia’s third-largest economy is only a step away from junk at Fitch Ratings and Moody’s Investors Service, both of which have kept the sovereign on negative watch by citing deteriorating fiscal strength.
Economists in a Bloomberg survey expect the country’s budget deficit to reach 7% of GDP this year – a level last seen in 1994 – against a target of 3.5%. The International Monetary Fund projects that the country’s public debt will rise to 85.7% of GDP next year, from around 70% currently.
While the threat of a downgrade may reduce the likelihood of the central bank buying bonds directly from the government, the RBI has the option of saving the government through a dividend payment in August.
The “RBI would be required to partially bail out the government by allowing the use of its revaluation reserves,” said Kunal Kundu, an economist at Societe Generale GSC Pvt., Adding that there is also the possibility of the government issuing a ” special Covid obligation. “to meet the expenses or the loss of earnings caused by the virus.
The government budgeted 600 billion rupees in dividends from the central bank this year, while it received a record amount of 1.76 trillion rupees last year. The RBI pays dividends to the government every year, based on the profits from its investments and the printing of banknotes.
The forbidden fruit
The government has so far limited actual fiscal stimulus to 1% -1.5% of GDP. Lately it has cut spending, which Bloomberg Economics’ Abhishek Gupta says will exacerbate concerns about the recession. It forecasts a 10.6% GDP contraction for the current fiscal year.
For decision-makers, it is a tightrope walker with no easy solution. While inflation has been more or less under control since the creation of a monetary policy committee headed by the governor of the central bank four years ago, these gains could easily evaporate.
The experiences of the 1980s, when India resorted to deficit financing and which led to double-digit inflation, are likely a reason the central bank would be reluctant to intervene, according to Hugo Erken, senior economist at Rabobank International at Utrecht in the Netherlands.
“There is a risk in all of this,” Erken said. “Once you start using the ticket printer and hit the ‘forbidden fruit,’ it’s hard to go back.”