Emerging economies cannot emulate monetary actions of advanced countries. Direct funding of deficit undermines discipline, central bank autonomy.
We are now near the third week of the national lockdown—long enough for its economic fallout to be starkly visible all around. It is astounding the government is yet to come out with a substantive, suitable fiscal response that everyone has been awaiting. The March 23 income support measures were measly, grossly inadequate, and limited; these did not cover the weaker small-medium businesses, or other balance sheet support.
There isn’t a clue about the manner and quantum of support that might be considered, i.e. how much to spend and on what. The mystery about why the government is taking so long, or what it is waiting for, deepens and is startling against the stark appearance of stretched finances of the states that are at the forefront of the pandemic fight and been driven to even defer salary payments. It is very evident that large fiscal deficits will emerge and the entire fiscal maths has to be reworked, quickly and urgently. But, to give the benefit of doubt, maybe the government is evaluating a fast-changing situation to prioritise expenditures, perhaps seeking to minimise balance sheet support with sequenced restoration through a quicker, staggered exit from the lockdown, or even plain and simple affordability.
Whatever be the case, markets are bracing for large expenditure on fiscal initiatives to mitigate the Covid-19 shock. No one quite knows the size, whether `1 lakh crore or `5 lakh crore, or 1-3 % of GDP or much higher, noting some advocacy to follow or exceed the US stimulus. But, the imminent need for such expenditure is undeniable as is the extraordinary borrowings for its financing. This has triggered a growing body of opinion arguing the bond market will not have the appetite for monumental borrowings; far better the central bank directly buys government debt instead. This can be done using the ‘escape clause’ in the amended Fiscal Responsibility and Budget Management Act (FRBM, 2018) that allows the Reserve Bank of India (RBI) to buy primary issues of government securities in a national calamity; this also provides for converting G-Secs held by it to ‘other’ securities by mutual agreement. The essence is that, skipping the bond market will prevent yields from hardening; else, higher interest rates could undermine economic recovery.
It is true, the long-bond yield has been irrepressible, not responding even to RBI’s battery of monetary measures. Described as ‘bazooka’, the benchmark 10-year sovereign bond yield thought otherwise and barely relented. Obviously, this was in anticipation of substantial scaling-up of borrowings, not only for crisis fiscal measures but also because the lockdowns sap government revenues. Hence, the calls for efforts to lower the term premium, avoid large bond auctions, and monetary financing.
But, the high term premia are not a recent development. These are elevated for nearly two years now and have been immune to all efforts—conventional and others—to bring them down. In the last one year, the 10-year bond yield has responded feebly, often temporarily, before climbing up again: softening 76bps against a 135bps policy rate cut in one year to this February, or before the Covid-19 shock; and assisted by numerous and varied OMOs ranging from standard to ‘twist’ and ‘long-term’. Last week’s 75 basis point policy rate cut achieved barely 12 basis points lowering of the long-bond yield. The reason for this is saturation from the unrelenting budget and under-the-table borrowings that have inundated the market. The steep yield curve is therefore, not new. On the banks’ side, the transmission channel is broken; bypassing the bond market is not going to fix it.
It is not clear that primary purchases are the better financing option. For one, it is reasonable to expect RBI cannot significantly deviate from market-determined yields as the primary issue stock on its balance sheet is for conduct of monetary policy operations; it will therefore come to the market. The government’s borrowing cost in primary market may just be marginally lower compared to friction costs of the two-leg secondary market operations or OMOs, although if the size is substantial, even that differential matters. From an economic standpoint, either result in monetisation of government debt, a concomitant reserve money increase, and thereafter, broad money supply.
Two, can we be sanguine the bond market will not react to primary market purchases altogether? For the market views are driven by fundamentals, i.e. if the government balance sheet is out of kilter with revenues or GDP.
This apart, there is another critical advantage in open market financing (OMOs), which is the maintenance of discipline—distancing between the government and the central bank, or not breaching the wall between deficits and money supply. RBI’s autonomy, i.e. control over money supply, remains intact. The intangible confidence gain—no apprehensions of return to automatic monetisation of deficits—that has been achieved through a legal monetary-fiscal separation and central bank autonomy in 1997 is preserved. Both—the removal of fiscal-monetary policy interdependence, and the subsequent establishment of fiscal rules (FRBM Act, 2003)—have immeasurably contributed to strengthen institutions, financial market development, and provided the necessary confidence for global economic integration.
These gains and central bank autonomy is best preserved. RBI is well able to handle the sequencing and timing of OMOs, in accordance with the base money growth it wants as anchor. In the forthcoming year, base money expansion is likely to accrue mostly from growth in domestic assets, unlike last year when net foreign assets were the primary source. The central bank can conduct scheduled OMOs smoothly, without disrupting the market. Looking ahead at a very deep downturn, and the world economy in recession, inflation risks are reasonably low.
It is no one’s case that large expenditures are necessary to fight a frightful pandemic, secure health and save lives with enormous economic sacrifice. The borrowings to fund health expenditures, offset economic losses and mitigate damages inflicted by the lockdowns, and to prevent a deeper downturn are not the issue here. How these are financed is: if this can be done by preserving institutional discipline and autonomy, the secondary market option may not be too high a price to pay. Although the size of crisis expenditures is not known, this may be exceptionally large, e.g. above `5 lakh crore or even 5% of GDP. In that case, a mix of primary and secondary market debt issuance can be considered. But, even for a one-time, crisis-caused act of direct monetary financing, a credible medium-term consolidation plan would be necessary to establish beliefs and prevent market reactions to fundamentals. Reversal will otherwise remain a fantasy, especially as determining the end of a crisis can be very subjective, amenable to different interpretations and growth perspectives, e.g. distinguishing between permanent or temporary output decline post-crisis.
The unfortunate truth is that emerging economies cannot emulate monetary actions of advanced countries that have numerous advantages, including of reserve issuer. Responsible, careful financing is even more important when the first steps towards inclusion of sovereign debt in global bond indices have just been taken.