Who's afraid of monetisation of the deficit?

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Who's afraid of monetisation of the deficit?

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  • A suggestion: As economic downturn grew, some experts recommended to the govt. that it must spend without hesitation, and not really bother about the rating agencies.
  • Baa2 to Baa3: When rating agency Moody's downgraded India to one notch above investment grade (at Baa3), it also added that the outlook was negative. And Moody's says that this is before the pandemic struck. 
  • Danger with that rating: Big institutional investors are bound by rules that often need them to exit countries that fall below investment grade. So the danger does exist. FIIs will leave. Stock and bond markets will sink, and rupee will depreciate.
  • Concerns of Moody's: It said that slowing growth, rising debt and weakening financial sector are the issues. 
    1. Almost all expect GDP of India to shrink in FY 2020-21.
    2. Combined fiscal deficit is 12% of GDP
    3. Public debt to GDP ratio may go from 72% to 84%
    4. Banking sector NPAs may rise sharply from present level of 9%
    5. The GoI has promised to manage the "fisc" so it does not spiral out of control.
    6. GoI has kept discretionary fiscal deficit at just 1% (this is what happens due to clear government policy, and not slowing growth)
  • What about growth: That 1% keeps rating agencies happy about debt to GDP ratio, but what about growth? Without high growth soon enough, that ratio will anyway worsen. Stimulus package (ANBA) is totally dependent on more credit flow via banking. That won't happen. Govt. has to now spend on infrastructure.
  • The road ahead: To increase discretionary fiscal stimulus without increasing public debt, we have to monetise the deficit. So central bank has to fund the govt. 
    1. This is not just 'printing of notes'. In real terms it means buying Treasury Bills of the government.
    2. The MMT experts say that don't even do this, but just credit the Treasury's account (with itself) through an electronic accounting entry. (MMT - Modern Monetary Theory)
    3. That extra money, when spent, increases the 'base money' (= currency + banks' reserves)
    4. So expansion of money supply has happened, but not like merely printing of notes.
  • Objection, my Lord: Experts object to it fearing inflationary pressures. But since aggregate demand has collapsed in India, and unemployment is sharply up, deficit monetisation will help in raising actual output closer to potential output. (with minimum inflation)
  • A finer point: There are two ways the government's higher expenditure can be funded - it can issue bonds either to banks, or to the RBI. Either way, base money expansion is same. 
  • Secondary markets: Worldwide, central banks have done heavy buying of government bonds in the secondary markets. RBI started it recently. This is OMO - Open Market Operations. The impact on money supply is the same.
  • Temporary versus Permanent: Experts fear OMOs less as they claim it's a temporary expansion of RBI's balance sheet, but direct monetisation is a permanent expansion. But how temporary is temporary? It's a useless logic. Today's low inflation scene makes that reasoning invalid.
  • Summary: The GoI must not go beyond the extra Rs.4.2 trillion borrowing announced. Then, start monetising the additional deficit. So debt to GDP may be kept under check. Rating agencies must focus only on inflation, and little else.
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                                        PT's IAS Academy: Who's afraid of monetisation of the deficit?
                                        Who's afraid of monetisation of the deficit?
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