India, a prominent global economy, is grappling with the financial turmoil caused by the Covid-19 pandemic. The nation’s fiscal deficit has become a significant concern, prompting discussions about potential coping mechanisms like borrowing more and monetizing the deficit. These proposals are currently under consideration by the Indian government and the Reserve Bank of India (RBI).
The Current State of the Indian Economy
Official data reveals an alarming fact; the Centre’s fiscal deficit for the first quarter of the fiscal year 2020-21 was Rs. 6.62 lakh crore, covering 83% of the budgeted target for the year. Economists suggest that the fiscal deficit could skyrocket to 8% of the Gross Domestic Product (GDP), far surpassing the government’s target of 3.5%. Further worsening the situation, the GDP contracted by 23.9% in the first quarter of 2020 compared to the same period in 2019. Concurrently, the manufacturing sector’s contraction, indicated by the IHS Markit India Manufacturing Purchasing Managers’ Index (PMI), and the continuous contraction of eight core industries, present additional challenges. An increase in bad loans and Non-Performing Assets (NPA) reported by RBI’s Financial Stability Report adds to these concerns.
Possible Approaches to Managing the Fiscal Deficit
Two primary solutions to counter the fiscal deficit are currently under consideration: borrowing from the market and monetizing the deficit.
The government has already escalated its gross market borrowing target for the financial year by over 50% due to the pandemic. However, this approach has several disadvantages like high public debt, increased interest rates due to the fear of repayment incapabilities, possible tax hikes that may lead to reduced public spending and saving, and crowding out of the private sector.
On the other hand, monetizing the deficit involves RBI buying government bonds in the primary market while printing more money to finance the debt. This strategy is typically reserved for situations where the government cannot secure loans from the market. While monetization can stimulate economic development, it is inherently inflationary and potentially harmful to the health of the central bank. It could also lead to higher interest rates and threaten financial stability.
The Role of FRBM and Monetizing Deficits
Until 1997, India practiced deficit monetization whereby the central bank would automatically monetize government deficits through ad-hoc treasury bills. However, following the agreements between the government and RBI in 1994 and 1997 and the enactment of Fiscal Responsibility and Budget Management (FRBM) Act, 2003, this practice was phased out.
The FRBM Act Amendment, 2018, however, introduces an escape clause allowing deficit monetization under special circumstances. This clause grants governments the flexibility to exceed fiscal deficit targets during challenging times or economic shocks, including calamities, war, structural reforms with unforeseen fiscal implications, and a considerable decline in real output growth.
A Sustainable Way Forward
Although the RBI has already initiated Open Market Operations and adopted a monetary policy framework to inject liquidity into the market, further monetizing the deficit risks credibility loss and inflationary pressure. Considering the inflation-prone nature of the Indian economy, deficit monetization should be viewed as a last resort. If this route is taken, it will be crucial to communicate that it’s a one-time arrangement induced by the pandemic and not a recurring financing line.
