The liquidity requirement could be fulfilled by RBI directly monetising the deficit, which the FRBM Act allows for in case of a "national calamity"
Contours of a timely stimulus: Looming threats of global recession, melting financial markets, and an impending domestic demand destruction pose difficult questions about possible policy responses in India. There is no doubt that till now, the policy focus has been to avert the health emergency because otherwise, the economic emergency would be inevitable. But, looking ahead, it is important to keep a fiscal and monetary policy template ready to reduce any implementation delays.
The government has already utilised the elbow room offered by the FRBM Act under exceptional circumstances in the FY20 and FY21 budgets, with the targeted budget deficits being 0.5% of GDP higher than the FRBM mandated ones. This leaves limited conventional fiscal space for any stimulus, but we would argue that there could be a case for temporarily suspending the FRBM Act, as was done during the global financial crisis of 2008. In fact, given the recent trends, the FRBM Act-mandated maximum target of a fiscal deficit of 3.8% of GDP might have already been breached for FY20. Hence, we feel that any required fiscal stimulus should not be deterred by FRBM considerations as now, growth concerns outweigh worries about future macro stability risks.
Designing a fiscal package: An early assessment and acknowledgement of the extent of demand destruction (both global and domestic) is the need of the hour. The fiscal package should, ideally, be proactive (not waiting for signs of growth slowdown in high frequency data), quickly implementable (for a change, revenue expenditure should get priority over capital expenditure), sizeable (at least 0.5% of GDP), targeted (urban might need more support than rural in initial stages), and reversible.
Based on the above broad principles the following spending ideas could be considered:
Earmarking an enhanced budget for healthcare would definitely be the top priority.
Income support to people whose livelihood has been impacted (these will primarily include daily wage earners in different industries, and services like construction, travel, etc). Direct cash transfer to this group is ideal, but might suffer from proper identification challenges.
Packages for deeply affected sectors like travel and tourism (9.2% of India’s GDP) and MSMES could have three components—temporary postponement of taxes, cheaper loans, and explicit financial grants.
Frontloading public spending to counterbalance near-term headwinds
The government can also consider temporary suspension of long-term capital gains tax to incentivise flows back into the equity market in the short term.
Funding a fiscal package: Even if the government limits the fiscal stimulus to 0.5% of GDP for FY21, there is likely to be a revenue slipage of 0.8% of GDP each from both tax, and non-tax revenue components in the current environment, making the overall fiscal requirement higher by more than 2% of GDP. Three different methods could be considered to fund this.
First, the government should be optimising the windfall from the sharp drop in oil prices. Average crude oil prices could stay below $30/barrel in FY21, compared to $60 in FY20. The drop in retail prices of petrol, and diesel has lagged this sharp fall in crude prices, but we estimate that per litre potential fall in petrol/diesel prices could be ~Rs 20 from mid-Jan levels, if better pass-through happens. The government has a choice in determining how to share this oil bonanza between consumers and itself. We think that the central and state governments should try to resist the temptation of raising the taxes on petroleum products disproportionately, so that the benefits could be passed on to a large number of consumers quickly at a time when they have experienced a negative income shock, and sentiments are severely depressed. Even if the central government collects 0.5% of GDP revenues by excise duty hike of Rs 8/litre—Rs 3/litre increase has already happened—and the state governments, on an average, accrue Rs 4/litre through higher VAT (they lose revenue because of ad valorem nature of petroleum taxes), the surplus in the hands of the consumer could still be a substantial Rs 1.1 lakh crore (~0.5% of GDP). Moreover, there should be further fiscal gains from lower kerosene and LPG subsidy, worth 0.1% of GDP.
Second, the government could consider issuing a tax-free health emergency bond to tap more resources. In a volatile equity market environment, these bonds could receive good response.
The third option is direct RBI monetisation of deficit, which is allowed by the FRBM Act under special circumstances, including “national calamity”. Despite the oil windfall, the need for RBI monetisation could be 1.5% of GDP (~Rs 3.3 lakh crore) over the course of the year. This could be met through a combination of direct monetisation and OMO support to check interest rates from rising.
The monetary response: Central bankers are trying to counter the two channels of transmission of the virus shock—financial stability risk arising out of large market dislocations, and growth risk from estimated disruption in economic activity. It is important to create adequate buffers, so that the turmoil in equity market/macro economy does not spread to credit markets and cause any credit events. RBI has been infusing both dollar, and rupee liquidity to ensure that the financial systems do not freeze up. On top of it, there is scope for an immediate 25-50 bps rate cut as a first step to support growth. If our fiscal projections are correct, RBI will need to do large OMOs to compress the term premium, and the first steps in that direction have already been taken. It is possible for RBI to indirectly intervene in the corporate bond, CP market as the credit spreads have widened quite substantially. RBI might also be considering providing regulatory forbearance for retail customers, and certain specific sectors, given the extent of the negative shock. This will prevent the spread of the shock due to overburdening of the financial system, which is already facing its own idiosyncratic challenges.
Faced with significant uncertainty over the depth and duration of the negative shock, policymaking should be extremely nimble, and innovative. Nothing should be off the table!