The fiscal response challenge

It is still difficult to gauge the actual magnitude of economic destruction being caused by the spread of Covid-19. Panic in the global crude oil market is the latest example of the ongoing economic chaos. Forecasts by the International Monetary Fund (IMF) show that the global economy will contract by 3 per cent during the current year. While the US economy is estimated to shrink by 5.9 per cent, the IMF expects India to grow by 1.9 per cent. In terms of policy response, governments and central banks are intervening aggressively in the advanced economies. The US Federal Reserve’s balance sheet has expanded by about 50 per cent since the beginning of March. The US government is supporting the economy with spending worth about 10 per cent of gross domestic product (GDP). It will be running a budget deficit of over 15 per cent of GDP in the current year. The general government budget deficit in the euro area is expected to expand to 7.5 per cent of GDP, compared with 0.7 per cent in 2019. According to the IMF, global public debt is likely to increase by 13 percentage points in 2020. These projections would change in the coming months.

So where does India stand? While the government imposed the strictest lockdown to contain the pandemic, its economic response has been muted. The Reserve Bank of India (RBI) has taken several measures, including cutting interest rates and infusing liquidity. The Indian banking system now has surplus liquidity worth Rs 7 trillion. However, excess liquidity has not eased financial conditions to the extent desired. Even state governments are paying higher rates for market borrowings. This is largely because India’s fiscal response is not yet clear. 

So far the government has announced a package worth Rs 1.7 trillion for the most vulnerable section of the population. It is not clear as to how the government intends to support the broader economy and manage its own finances. It is possible that the government is waiting for more information to make targeted interventions. To be sure, managing government finance will become extremely difficult in the given circumstances. The fact that it was already under pressure will not help. For instance, the government used the escape clause of budget management rules much before the pandemic struck the Indian economy. Fiscal rules will obviously have to be rewritten. But to what extent can the government stretch its finances to support the economy? 

As things stand today, assuming output and tax collections remain at the last financial year’s level — some are forecasting negative growth for the current year — back-of-the-envelope calculation suggests that with the current year’s budgeted expenditure, the fiscal deficit would go above 5 per cent of GDP. Gross tax revenue in FY20 is likely to have fallen short by about Rs 2 trillion, compared to the revised estimates. Given that it would be extremely difficult to attain the ambitious Rs 2.1 trillion disinvestment target, the deficit could easily widen to about 6 per cent of GDP. With off-balance-sheet spending and state deficit (even without accounting for any expansion), the general government deficit would go well over 10 per cent of GDP. Now there are demands that the government should increase spending by about 5 per cent of GDP to support the economy. Since revenues are also likely to decline significantly, India’s combined deficit could go well above 15 per cent of GDP in the current year. This is what is making the bond market nervous. 

Therefore, the decision that policymakers need to take — perhaps the most difficult in recent times — is this: Can India run a general government budget deficit of over 15 per cent of GDP, and how will it be financed? In this context, the idea of monetisation is gaining popularity. However, print and spend could be an extremely tricky proposition for India. It has been argued that the government should clearly communicate that this would be a one-off event and India will adhere to the path of fiscal discipline once the crisis is over. Further, India can print and spend because there is no risk of higher inflation at this stage. Also, India should not worry about the external position as the RBI has adequate foreign exchange reserves.

However, all this may not work as desired and things can slip out of control. India does not have a very good record of fiscal management. So, what if financial markets are not convinced? Bringing down the deficit will take time and domestic financial savings may not be sufficient to finance it in the interim. Thus, monetisation could be a multi-year affair. While Covid related demand shock might keep inflation muted in the near term, it’s difficult to project how prices will behave 12-18 months from now. Finally, no amount of foreign exchange reserves would be sufficient if markets lose faith in India’s fundamentals. About $100 billion has already moved out of emerging markets. Further, pressure on government finances would affect capital expenditure and potential growth in the medium term. Therefore, while there is no easy way out, the government needs to evaluate all options very carefully. It is also important to note that no amount of deficit monetisation will solve India’s problem of poverty and low state capacity.