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Stimulating the Indian economy in post-covid era.

  • Posted By
    10Pointer
  • Categories
    Economy
  • Published
    8th Aug, 2020
  • Context

    Economic Slowdown aggravated by the onslaught of COVID-19 pandemic.

  • Background

    • The economic impact of Covid-19 pandemic has caused unprecedented damage to the global and India is no exception. It is clear that, for the first time in many decades, India’s economy will contract significantly.
    • Moreover, India being a developing economy, the deleterious impact of an economic contraction is long and deep, especially on the poor.
    • There will be a significant impact on the social sphere as well, as much of weaker sections of Indian society may slip back into poverty and unemployment.
    • Thus, greater public spending by the government as the sine qua non of economic revival. In this context, several economic experts have proposed the government to explore the option of borrowing debt from international institutions or monetize the deficit.
  • What should government do at this juncture of slowdown?

    • Greater public spending will increase the fiscal deficit and this expansion has to be financed.
      • Fiscal deficit is the?total amount of borrowings Required?to Bridge the gap between governments spending and revenues.
    • There are different ways of financing the expansion
      • Raising Revenue: Theoretically fiscal deficit can be financed by higher taxes, but when the economy is slowing it is unpopular & prevents further spending by people.
      • Debt Financing: This involves borrowing from public (issuing bonds), borrowing external sources like World Bank and the International Monetary Fund (IMF)
      • Direct Monetization of Deficit: This involves government selling treasuries to Reserve Bank of India (RBI).
    • Government should follow the principle of (Keynesian Economics) to revive the economy
  • What are the challenges with Debt Financing?

    India’s long track record as an impeccable borrower with no default, timely repayments and full transparency make us an ideal borrower for these institutions.

    • Imposition of Changes: Borrowing from World Bank & IMF usually comes with conditionality on Economic restructuring (recall 1991 reforms that was part of bailout package)
    • Disturbs Inter-Generational Equity: Increased borrowings now means increase in interest payment for future generation and reduced scope for borrowing
    • Burden of repayment: Not only have the moneys to be repaid, they will have to be paid back in hard currency.?
    • This would involve India having to earn hard currency by stepping up exports which is herculean task under present global mood of protectionism.
      • For ex: If a stimulus of approximately 10% of the GDP is envisaged, with exports at 25% of GDP, it would imply stepping up exports by close to 50%.
    • Takes Attention from Govt’s fight against COVID-19: A loan is bound to take some time to be negotiated, taxing the energies of a government that ought to be engaged in the day to day battle with COVID-19.
  • What is direct monetisation or money financing?

    • Printing Money or Deficit Monetisation imposes high intangible and institutional costs.
    • The government asks RBI to?print new currency in return for new bonds?that the government gives to the RBI.
    • In lieu of printing new cash,?which is a liability for the RBI (since, every currency note has the RBI Governor promising to pay the bearer the designated sum of rupees), RBI gets government bonds, which are an asset for the RBI
    • Government bonds are asset to RBI because they carry?the government’s promise to pay back the designated sum at a specified date.
    • The?government would have the cash to spend and alleviate the stress?in the economy?
    • This is different from the “indirect monetisation” that RBI does when it conducts the Open Market Operations (OMOs) and purchases bonds in the secondary market.
  • What are the disadvantages of Direct Monetisation which lead to its discontinuation?

    • High Inflation: Monetisation involve expansion of money supply that can potentially result in inflation
    • Reduces incentive for efficient Spending: ?Availability of direct monetization route means reduced incentive for government to be fiscally disciplined.
    • Promotes Populism: Governments would usually spend on populist measures rather than long-term structural measures knowing fully well that they have a way out for increased fiscal deficit.
    • Past Lessons: The usage of direct monetisation route recklessly caused fiscal indiscipline that ultimately led to the balance of payments crisis in 1991.
    • Rupee Depreciation: When there is excess supply of the currency due to printing of new currency, it could lead to a fall in rupee value, leading to its depreciation.
    • Lowers Investor Confidence: Markets/Investors will fear that the constraints on fiscal policy are being abandoned, when direct monetisation path is adopted. They may see the government as planning to solve its fiscal problems by inflating away its debt.
  • Can direct monetisation be used to finance the deficit in post-COVID period?

    • Change in economic situation calls for change in policies.
    • Inflationary impact of direct monetisation may not be very high at this juncture of Indian economy due to the demand slowdown the economy is experiencing.
    • Increased money supply will revive the depressed demand and kick-start production reviving the economy.
    • However, when the economy enters the recovery path, increased money supply could proportionately lead to a higher inflation rate.
  • What should be the way forward?

    The macroeconomic fundamentals of Indian economy remain strong and India may not have opted either of the above options in near future. Government may take the following steps.

    • Increasing the MGNREGA funding and expanding to urban areas: The Mahatma Gandhi National Rural Employment Guarantee Act 2005 (MGNREGA) programme has proved to be bedrock of support in the normal times and during times of difficulty (like Covid-19) and it will be a good idea to expand the scheme to urban areas.
    • Transfer of Cash benefits: A meaningful cash transfer can restore confidence in these families. Money in the hands of people can provide an immediate sense of security and confidence, which is the cornerstone to restoring economic normalcy.
      • It will raise the consumption and demand of the economy and can bring back the virtuous cycle in play.
    • Issues with the Banking system: COVID-19 assistance measures undertaken by the Reserve Bank of India (RBI) and the government such as interest rate reductions, credit guarantee and liquidity enhancement schemes are welcome steps.
    • Although banks have largely failed to take initiatives as they are not confident of lending.
    • Thus, reviving the health of the banking sector is the immediate need of the hour.

    Conclusion

    Money financing is a viable route to take us back to pre-COVID-19 levels of output along with that allowing institutions such as the RBI, public sector banks, bankruptcy boards, securities and insurance regulators to function freely and professionally is the foundational step to restoring confidence in the financial system.

Verifying, please be patient.

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