Fiscal relief to deal with coronavirus pandemic — choices and implications

Harsh Vardhan

The COVID-19 pandemic has brought about an unprecedented economic calamity that is going to have deep and wide negative impact on the Indian economy.

While most analysts have already downgraded the GDP forecasts for FY21 close to 1 percent, they are likely to be further downgraded as the crisis and its containment through lockdown continues. It is abundantly clear that there will have to be a massive economic relief — both fiscal and monetary — to bring the economy back to normalcy.

The Reserve Bank of India (RBI) has already taken several actions using all its instruments of monetary policy. It has injected enormous amount of liquidity into the banking system, significantly reduced policy interest rates and given relief to debtors through moratorium on repayment. In addition to providing monetary stimulus, the RBI also has to deal with financial instability arising from the pandemic.

Already, despite creating oceans of liquidity through actions, large parts of the financial system, especially non-banking finance companies (NBFCs) are struggling to get liquidity. The RBI has used monetary policy tool (LTRO) to direct credit to these liquidity-starved sectors.

By now, it is clear that these monetary actions by the RBI will not be enough. It will have to be matched with a sizeable fiscal relief. Governments (both central and states) will have to spend to get the economy back to normalcy.

Fiscal consolidation has been a priority of the Indian economic management for a long time. This year’s (FY21) Budget had projected the fiscal deficit of the central government at 3.5 percent of the GDP.  Clearly, this target will be missed by a large margin. The lockdown and the disruption to the economy will reduce revenue for the economy and there will have to significant additional spending.

Need for large government spending to stimulate the economy is raising important questions about financing the deficit. What are the sources that the government will have to tap to support the relief package? How much monetization will have to be undertaken? Will there be an increase in taxes? And so on.

In order to understand the challenges the government will face in financing this large deficit and the choices it has, we have to understand the issue systematically.

There are four important questions that will decide the structure and magnitude of the relief package and it is financing:

1. Where (i.e. for which class of beneficiaries) should the fiscal relief be targeted?
2. How big (in Indian Rupees) this package needs to be in order to meaningfully impact the targeted sectors?
3. What are the possible sources of funding the package?

4. What implications will the pattern of funding have on key economic variables such as GDP growth rate, inflation, interest rates, financial stability, etc.?

Contours of a possible relief package:

Following these questions, we can speculate about that the broad contours of a likely relief package. It is obvious that the bulk of the relief will be focused on the most vulnerable part of the economy — supporting consumption for the poorest sections of the population and to provide relief for the micro, small and medium enterprise.

For the poor, the support may take a form of direct cash transfers into the accounts of beneficiaries on similar lines of the program launched for distressed farmers some time ago. In addition to such transfers, there may also be subsidies on essential consumption goods. For the MSME, relief could come in the form of debt waivers for very small businesses. For example, the Mudra loan borrowers would all suffer greatly through the pandemic and hence, there could be a partial or total debt waiver for them.  There could also be longer moratoriums and some interest waivers on other MSME borrowing.

Large companies may not get direct debt relief but they could also get longer debt moratoriums. The government could create a credit enhancement or guarantee program that would encourage the banks which are gripped with extreme risk aversion, to start lending to these companies again. There could also be a facility sponsored by the government to provide finance directly to companies that are struggling to raise it due to the pandemic.

The extent of support needed could only be decided when the pandemic is under control and the lockdown is eased. Currently, there is no clarity on the extent of support needed and hence the size of the relief package cannot be determined. All we can say at this stage is that the likely size of the package could be as high as 4 percent to 5 percent of the GDP.

Funding the relief package

The choices with the government for funding the stimulus package include:
1. Redoing the Budget and switching some of the expenditure budged to the relief package.
2. Raising taxes by levying a COVID cess.
3. Raising resources from foreign sources issuing foreign currency denominated government bonds.
4. Borrowing from multilateral agencies — World Bank, IMF, ADB, etc.
5. Selling government assets — stake in PSUs.
6. Borrowing from the market through issuance of bonds; may be a special class of COVID bonds.

7. Monetizing the deficit — borrowing from the RBI directly.

Each of these sources would bring in financing over varying quantum and over varying time horizons. As a result, overall financing scheme for the relief package is likely to include all these sources.

Some hard truths

No matter what composition of the financing of the relief package, we have to acknowledge some hard truths:
1. A large proportion of the relief will go towards supporting consumptions and hence will have very low (if any) multiplier. The impact of this part of the relief on the output (i.e. GDP) will be marginal at best.
2. Widening deficit, no matter the pattern of financing, will create inflationary expectations and will result in debt markets hardening long term yields. We have already seen some hardening of the longer end of the yield curve despite enormous volumes of liquidity injected. The claim that there is no pressure of inflation ‘right now’ is no comfort as any uptick is GDP post the relief would be highly inflationary with so much more money chasing stagnant or marginally growing output.
3. While we may want to ignore the credit rating agencies, sovereign rating will be under pressure and any downgrades or lowering of outlook will have impact on the yields.
4. Higher inflation expectations and larger deficits will also put pressure on the exchange rate. Collapsed oil prices have relieved pressure on the current account, which is close to being balanced now. However, we have to factor is a sharp downturn in exports which could again widen the current account deficit.
5. Monetization and continued open market operations by the RBI will swell its balance sheet and it may take years for it to be brought down since we are a non-reserve currency country and the only way for the RBI to reduce its bond holding is to sell it in the domestic market.

6. Credit defaults will rise, and along with rising interest rates, will continue to pose a challenge to financial stability. Deposit growth will slow down and household savings will decline. NBFCs, especially small and mid-sized will continue to face funding challenge. Some of them will face acute solvency challenge due to borrower defaults and funding squeeze. Rising defaults could result in capital erosion in the banking system and the government as owner of two thirds of the banking system will have to face new demands of bank capitalization.

The government essentially faces a set of difficult choices. While it must provide a large fiscal relief to support the economy, such a package will have negative implications for interest rates, inflation and financial stability.

It will also be critical for the fiscal and monetary policy to work in very close coordination so that fiscal and monetary actions are chosen and sequenced thoughtfully. Only monetary action will not be enough and fiscal relief without careful thinking on its monetary implications may actually add to the economic challenge.

Just as the best way of dealing with the health challenge of the novel coronavirus is acting together as a community, so it will be for dealing with the economic challenge arising from it.

Harsh Vardhan is Executive-in-Residence at the Centre for Financial Studies (CFS) of the SP Jain Institute of Management and Research. The author thanks Prof Ananth Narayan for very helpful comments. Views expressed here are personal.



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