This article presents analysis of a recent report by the State Bank of India (SBI) that suggests direct monetisation as an effective strategy to fund the Centre’s deficit without escalating inflation or impacting debt sustainability.
Direct Monetisation: Defining the Concept
Direct Monetisation is a financial technique where the Reserve Bank of India (RBI) directly funds the Central government’s deficit through the procurement of government bonds or securities. Up until 1997, this strategy was employed regularly with the government selling securities straight to the RBI. This method allowed the government to essentially print equivalent currency amounts to meet its budget deficit. However, due to concerns over its potential to trigger inflation and infringe on fiscal prudence, the practice was ceased. It’s crucial to understand that this strategy differs from what is known as “indirect” monetisation, which is undertaken by the RBI when it carries out Open Market Operations (OMOs) or buys bonds in the secondary market.
The Looming Threat of Increasing Debt
Acknowledging the economic downturn, several agencies forecast India’s Gross Domestic Product (GDP) to contract by more than 5% in FY 2020-21. This shrinkage in economic activity will inevitably lead to a reduction in government revenues, causing the government to fall short of its revenue targets and be compelled to accumulate more debt. The SBI has observed that the GDP decline is pushing up the debt-to-GDP ratio by at least 4%. Predictions for FY21 suggest that India’s debt-to-GDP ratio will rise to around Rs. 170 lakh crore, or 87.6% of GDP, up from Rs 146.9 lakh crore (72.2% of GDP) in FY20. An increasing debt-to-GDP ratio implies a decreased likelihood of the nation paying back its debt, thereby heightening the risk of default.
Recommendations of the SBI Report
Interestingly, the SBI report posits the Covid-19 pandemic as an exceptional circumstance under which the Fiscal Responsibility and Budget Management (FRBM) Act, 2003 permits direct monetisation of deficit. The report argues that this would not be inflationary given the stagnant demand in the country. It posits that reviving growth is more crucial to debt sustainability than adhering to fiscal conservatism, which involves lower public spending, taxes, and government debt. The report also reassures that current level of foreign exchange reserves are sufficient to meet any external debt obligations and since most of the debt is domestically owned, servicing internal debt isn’t a cause for concern.
The Real Challenge: Contraction of Economic Growth
The report identifies contraction of economic growth as the real challenge that can turn the interest rate-growth differential into a positive trajectory. This differential, a key metric observed by agencies to assess debt sustainability, indicates a negative trend when growth surpasses the interest rate on debt. Achieving higher growth is necessary from a sustainability perspective, as the resultant expansion in government revenue will outpace any spike in debt repayment.
