Covid-19 crisis: Budget blowout may see RBI resort to direct financing

The central government is running out of options to fund its Budget and may soon have to knock on the central bank’s door once again for support.

The administration can get the Reserve Bank of India (RBI) to buy sovereign bonds directly or boost dividends to help supplement revenue, which has been hit by an economy-crippling lockdown to contain the virus’s spread. The government is facing a Budget deficit of as high as 7 per cent of gross domestic product, the widest in more than two decades, according to some estimates.

It would “make sense to go for some form of deficit monetisation” right away, said Sabyasachi Kar, RBI chair professor at the National Institute of Public Finance and Policy in New Delhi. “Demand creation can only happen if the government spends.”

Central banks from the US to Japan are helping to fund record fiscal stimulus from their governments amid the pandemic. That’s even been the case in emerging markets like Indonesia — where the central bank this week agreed to buy billions of dollars of bonds directly from the government. The approach though carries risks for developing economies, especially for inflation, the currency and the independence of the central bank.

The Fiscal Responsibility and and Budget Management Act prevents the RBI from buying bonds directly from the government in the primary market, but the law provides an escape clause in the event of the country facing a national calamity or a severe slowdown.

Discreet purchases

The RBI has so far made some discreet bond purchases in the secondary market, but the government’s debt manager is yet to outline a plan on how it will manage the administration’s record Rs 12 trillion ($160 billion) of borrowings in the current fiscal year to March.

For now, banks are amassing sovereign bonds on optimism the central bank will soak up the debt supply. Lenders awash with cash, given poor demand for loans in the economy, have raised their holdings of sovereign notes to Rs 41.4 trillion as of June 19, up 13 per cent from end-March.

“We still think it is feasible to finance a deficit of around 11 per cent of GDP — Centre and states — without resorting to large amounts of RBI financing,” said Sergi Lanau, deputy chief economist at the International Institute of Finance in Washington. “Banks have already bought many bonds and with an economy in recession, they may not have many opportunities to lend to firms anyway.”

A possible credit rating downgrade is another risk for India, which is heading for its first economic contraction in more than four decades this year. The credit score 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 citing deteriorating fiscal strength.