9th June 2020 The Hindu Analysis

Who's afraid of monetisation of the deficit ?

The shrill clamour against it is based on misconceptions; fears of inflation lack substance

As the government began to wrestle with the severe downturn caused by the novel coronavirus pandemic, some economic pundits urged the government to go out and spend without worrying about the increase in public debt. They said the rating agencies would understand that these are unusual times. If they did not and chose to downgrade India, we should not lose too much sleep over it.

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Rating and fundamentals

Well, the decision of the rating agency, Moody’s, to downgrade India from Baa2 to Baa3 should come as a rude awakening. The present rating is just one notch above the ‘junk’ category. Moody’s has also retained its negative outlook on India, which suggests that a further downgrade is more likely than an upgrade.

The rationale given by Moody’s should especially make people sit up. The downgrade, Moody’s says, has not factored in the economic impact of the pandemic. It has to do with India’s fundamentals before the onset of the pandemic and the extended lockdown with which India responded. The message should be clear enough. Any further deterioration in the fundamentals from now on will push India into ‘junk’ status.

What is the problem that monetisation is trying to solve?

• If government crosses Rubicon, markets will fear that constraints on fiscal policy are being abandoned.the finance minister said that she is keeping her options open on monetisation of the deficit by the Reserve Bank of India (RBI). How the government and the RBI decide on this will have significant implications for India’s economic prospects in the short-term, and indeed in the long-term.
• First off, two clarifications. Monetisation of the deficit does not mean the government is getting free money from the RBI. If one works through the combined balance sheet of the government and the RBI, it will turn out that the government does not get a free lunch, but it does get a heavily subsidised lunch. That subsidy is forced out of the banks. And, as in the case of all invisible subsidies, they don’t even know.
• Second, it is not as if the RBI is not monetising the deficit now; it is doing so, but indirectly by buying government bonds in the secondary market through what are called open market operations (OMOs). Note that both monetisation and OMOs involve printing of money by the RBI. But there are important differences between the two options that make shifting over to monetisation a non-trivial decision.

To understand the issue, some historical context will help. In the pre-reform era, the RBI used to directly monetise the government’s deficit almost automatically. That practice ended in 1997 with a landmark agreement between the government and the RBI. It was agreed that henceforth, the RBI would operate only in the secondary market through the OMO route. The implied understanding also was that the RBI would use the OMO route not so much to support government borrowing but as a liquidity instrument to manage the balance between the policy objectives of supporting growth, checking inflation and preserving financial stability.

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In hindsight, the outcomes of that agreement were historic. Since the government started borrowing in the open market, interest rates went up which incentivised saving and thereby spurred investment and growth. Also, the interest rate that the government commanded in the open market acted as a critical market signal of fiscal sustainability. Importantly, the agreement shifted control over money supply, and hence over inflation, from the government’s fiscal policy to the RBI’s monetary policy. The India growth story that unfolded in the years before the global financial crisis in 2008 when the economy clocked growth rates in the range of 9 per cent was at least in part a consequence of the high savings rate and low inflation which in turn were a consequence of this agreement.

The Fiscal Responsibility and Budget Management Act as amended in 2017 contains an escape clause which permits monetisation of the deficit under special circumstances. What is the case for invoking this escape clause now even if it means potentially jeopardising the hard won gains of the government-RBI agreement?

The case is made on the grounds that there just aren’t enough savings in the economy to finance government borrowing of such a large size. Bond yields would spike so high that financial stability will be threatened. The RBI must therefore step in and finance the government directly to prevent this from happening.

But there is no reason to believe that we are anywhere close to that situation. Through its OMOs, the RBI has injected such an extraordinary amount of systemic liquidity that bond yields are still relatively soft. In fact the yield on the benchmark 10 year bond which was ruling at 8 per cent in September last year has since dropped to just around 6 per cent. Even on the day the government announced its additional borrowing to the extent of 2.1 per cent of GDP, the yield settled at 6.17 per cent. That should, if anything, be evidence that the market feels quite comfortable about financing the enhanced government borrowing.

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Both monetisation and OMOs involve expansion of money supply which can potentially stoke inflation. If so, why should we be so wary of monetisation? Because although they are both potentially inflationary, the inflation risk they carry is different. OMOs are a monetary policy tool with the RBI in the driver’s seat, deciding on how much liquidity to inject and when. In contrast, monetisation is, and is seen, as a way of financing the fiscal deficit with the quantum and timing of money supply determined by the government’s borrowing rather than the RBI’s monetary policy. If RBI is seen as losing control over monetary policy, it will raise concerns about inflation. That can be a more serious problem than it seems.

India is inflation prone. Note that after the global financial crisis when inflation “died” everywhere, we were hit with a high and stubborn bout of inflation. In hindsight, it is clear that the RBI, on my watch, failed to tighten policy in good time. Since then we have embraced a monetary policy framework and the RBI has earned credibility for delivering on inflation within the target. Forsaking that credibility can be costly.

If, in spite of all this, the government decides to cross the Rubicon, markets will fear that the constraints on fiscal policy are being abandoned and that the government is planning to solve its fiscal problems by inflating away its debt. If that occurs, yields on government bonds will shoot up, the opposite of what is sought to be achieved.

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Finally, the biggest question is this: What is the problem that monetisation is trying to solve? There are cases when monetisation — despite its costs — is inevitable. If the government cannot finance its deficit at reasonable rates, then it really doesn’t have much choice. But right now, it is able to borrow at around the same rate as inflation, implying a real rate (at current inflation) of 0 per cent. If in fact bond yields shoot up in real terms, there might be a case for monetisation, strictly as a one-time measure. We are not there yet.

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• If India is downgraded to junk status, foreign institutional investor or Flls, will flee in droves.
• the stock and bond markets will take a severe beating
• the rupee will depreciate hugely and the central bank will have its hand full trying to stave off a foreign exchange crises.
• Many economist as also the Reserve Bank of India (RBI) except India's economy to shrink in FY 202021.
• The combined fiscal deficit of the center and the states is expecting to be in the region of 12% of GDP.
• Moody's expect India's public debt to GDP ratio to rise from 72% of GDP to 84% of GDP in 202021.
• The banking sector had nonperforming assets of over 9% advanced before the onsetof the pandemic.
• Non investment grade spectacular' or Junk status 
• A bond with a low rating ,Bond rated less than Baa3 By Moody's or BBB-by S&P or Fitch are considered high-yield bonds
• This rating sinnals to potential investors that the risk of South Africa's debt has increased because the government might not have enough money to pay back what borrows. 

Causes for Baa3 rating

• slow reform momentum
• vulnerabilities in India's credit profile
• high debt burden
• lower tax revenue
• credit crunch 
• government efforts not adequate

Monetised Deficit

• Monetised deficit is the monetry support the Reserve Bank of India (RBI) extends to the Centre as a part of the govenments borrowing programme.
• In other words, the term refer to the purchase of government bonds by the central banks to finance the spending need of the governmeent.
• Also known as the debt monetisation the excercise leads to an increase in total money suooly in the system and hence inflation, as RBI create fresh money to purchase the bond.
• The same bond are later used to bring down inflation are sold in the open market, this help the RBI suck excess money out of the market and rein the rising prices.

The critical role of decentralised response

Strategies in tackling the COVID-19 crisis must include local governments being equipped and fiscally empowered

The novel coronavirus pandemic has brought home the critical role of local governments and decentralised responses. In terms of information, monitoring and immediate action, local governments are at an advantage, and eminently, to meet any disaster such as COVID-19. While imposing restrictive conditionalities on States availing themselves of the enhanced borrowing limits (3.5% to 5% of Gross State Domestic Product, or GSDP) for 2020-21 is unwarranted, the recognition that local governments should be fiscally empowered immediately is a valid signal for the future of local governance. This article makes some suggestions to improve local finance and argues that the extant fiscal illusion is a great deterrent to mobilisation.

Context:

• The novel coronavirus pandemic has brought home the critical role of local governments and decentralised responses.

• This article makes some suggestions to improve local finance and argues that the extant fiscal illusion is a great deterrent to mobilisation.

Advantages to the local government:

• In terms of information, monitoring and immediate action, local governments are at an advantage, and eminently, to meet any disaster such as COVID-19.

• While imposing restrictive conditionalities on States availing themselves of the enhanced borrowing limits (3.5% to 5% of Gross State Domestic Product, or GSDP) for 2020-21 is unwarranted.

• The recognition that local governments should be fiscally empowered immediately is a valid signal for the future of local governance.

Core issues:

• COVID-19 has raised home four major challenges:

• economic,

• health,

• welfare/livelihood and

• resource mobilisation.

Critical areas for local government empowerment:

• Own revenue is the critical lever of local government empowerment.

• The several lacunae that continue to bedevil local governance have to be simultaneously addressed.

• The new normal demands a paradigm shift in the delivery of health care at the cutting edge level.

• The parallel bodies that have come up after the 73rd/74th Constitutional Amendments have considerably distorted the functions-fund flow matrix at the lower level of governance.

• There is yet no clarity in the assignment of functions, functionaries and financial responsibilities to local governments. Functional mapping and responsibilities continue to be ambiguous in many States. Instructively, Kerala attempted even responsibility mapping besides activity mapping.

• The critical role of local governments will have to be recognised by all.

Resource mobilisation issues under three heads:

• A few suggestions for resource mobilisation are given under three heads:

• Local finance,

• Members of Parliament Local Area Development Scheme, or MPLADs, and

• The Fifteenth Finance Commission (FFC).

Local finance:

• Property tax collection with appropriate exemptions should be a compulsory levy and preferably must cover land.

• The Economic Survey 2017-18 points out that urban local governments, or ULGs, generate about 44% of their revenue from own sources as against only 5% by rural local governments, or RLGs.

• Per capita own revenue collected by ULGs is about 3% of urban per capita income while the corresponding figure is only 0.1% for RLGs.

• There is a yawning gap between tax potential and actual collection, resulting in colossal underperformance.

• When they are not taxed, people remain indifferent. LGs, States and people seem to labour under a fiscal illusion.

• In States such as Uttar Pradesh, Bihar and Jharkhand, local tax collection at the panchayat level is next to nil. Property tax forms the major source of local revenue throughout the world.

• All States should take steps to enhance and rationalise property tax regime. A recent study by Professor O.P. Mathur shows that the share of property tax in GDP has been declining since 2002-03. This portends a wrong signal.

• The share of property tax in India in 2017-18 is only 0.14% of GDP as against 2.1% in the Organisation for Economic Co-operation and Development (OECD) countries.

• If property tax covers land, that will hugely enhance the yield from this source even without any increase in rates.

Land monetisation:

• Land monetisation and betterment levy may be tried in the context of COVID-19 in India. To be sure, land values have to be unbundled for socially relevant purposes.

• Municipalities and even suburban panchayats can issue a corona containment bond for a period of say 10 years, on a coupon rate below market rate but significantly above the reverse repo rate to attract banks.

• We are appealing to the patriotic sentiments of non-resident Indians and rich citizens.

• Needless to say, credit rating is not to be the weighing consideration.

• That the Resurgent India Bond of 1998 could mobilise over $4 billion in a few days encourages us to try this option.

MP fund scheme:

• The suspension of MPLADS by the Union government for two years is a welcome measure.

• The annual budget was around ₹4,000 crore.

• The Union government has appropriated the entire allocation along with the huge non-lapseable arrears.

• MPLADs, which was avowedly earmarked for local area development, must be assigned to local governments, preferably to panchayats on the basis of well-defined criteria.

Fifteenth Finance Commission:

• A special COVID-19 containment grant to the LGs by the FFC to be distributed on the basis of SFC-laid criteria is the need of the hour.

• The commission may do well to consider this. The local government grant of ₹90,000 crore for 2020-2021 by the FFC is only 3% higher than that recommended by the Fourteenth Finance Commission. For panchayats there is only an increase of ₹63 crore.

• The commission’s claim that the grant works out to 4.31% of the divisible pool and that it is higher than the 3.54% of the FC-XIV is obviously because the size of the denominator is smaller.

• Building health infrastructure and disease control strategies at the local level find no mention in the five tranches of the packages announced by the Union Finance Minister. The claim for a higher award to LGs is loud and clear.

Suggestion for fixing grant:

• The ratio of basic to tied grant is fixed at 50:50 by the commission.
• In the context of the crisis under way, all grants must be untied for freely evolving proper COVID-19 containment strategies locally.
• Further the 13th Finance Commission’s recommendation to tie local grants to the union divisible pool of taxes to ensure a buoyant and predictable source of revenue to LGs (accepted by the then Union government) must be restored by the commission.

Way ahead:

• Flood, drought, and earthquakes are taken care of by the Disaster Management Act 2005 which does not recognise epidemics, although several parts of India experienced several bouts of various flus in the past.

• The new pandemic is a public health challenge of an unprecedented nature along with livelihood and welfare challenges.

• The first Report speaks of mitigation funds and even prepared a disaster risk index, to map out vulnerable areas.

• These are redundant in the present context. The 2005 Act may have to be modified to accommodate the emerging situation.

Resume dialogue with Nepal Now

The time of a pandemic is no longer the time to enjoy a adversarial neighbourhood. At this moment, India must always ideally lead in creating momentum for deeper regional and sub-regional cooperation in South Asia. Paradoxically, the most modern traits with Nepal enjoy been the reverse of that. India and Nepal enjoy reached a brand fresh low in bilateral family members when both countries are going by a humanitarian disaster.

• On May 8, Defence Minister of India tweeted : Delighted to inaugurate the link Road to Mansarovar Yatra today.
• The BRO achieved road connectivity from Dharchula to Lipulekh (China Border) known as Kailash Mansarovar Yatra Route .
• Also flagged off a convoy of Vehicles from Pithogarh to Gunji through Video conferencing.

• In a statement, the Napalese Ministry of Foreign Affairs expressed regret at India's move 
• It said 'As per SugauliTreaty (1816) at the territories east of Kali (Mahakali) River including Limiyadhura, Kalapani and lipu, belong to Nepal
• India and Nepal enjoy a unique relationship that goes beyond diplomacy and the governments of the day.
• Both countries are interdependent through shared social cultural, economic and other civalizational links.
• Here, the ties are not between the government alone. Over three million Napalese live in India and lakhs of India and Nepal.
• The Gurkha Rifles, Known for the Best in welfare, are incomplete without the Napalese.
• They fight to keep India secure, so where is the scope for conflicts? The people of Nepa faught for India's independence 
• B.P Koirala and many more Napalese made enourmous scale during the freedom struggle.
• Both countries have open borders and unique ties 
• This reminds us that both countries have shared interest while respecting each others ' sovereignty. there is no place for a 'big brother' attitude.
• Article 8 of the IndiaNepal Friendship Treaty 1950 says far as matter dealt with herein are concerned , this Treaty cancel all previous Treaties, agreement and engagement entered into on the behalf of India Between the British Government and the Government of Nepal", though the treaty does not define the IndiaNepal boundry.
• On the issue of defining the boundry, the Treaty of Sugauil (1816) and the 1906 agreement between India and Nepal on the Terai District prevail.
• The Sugauli Treaty outlines the east of Mahakali Rivers as Nepal's territory and the west of its as India's territory 
• The disputes today is with regard to the origin of the Kali River.
• Nepal claims that the origin is in the origin is in the higher reaches of the hilly territory which would established its claim on Kalapani and Lipulek.

The e-diplomacy experiment

Cyber security and productivity are concerns but e-summits must go on as diplomacy must go on

The first India-Australia virtual leaders’ summit on June 4 had a lot on the menu, ranging from military interoperability to jointly tackling COVID-19. The two countries upgraded their relations to a ‘comprehensive strategic partnership’. The summit was noteworthy for its novel modus operandi.

Adapting to the times

Prime Minister Narendra Modi and the Indian delegation were on a video conference call with Prime Minister Scott Morrison and the Australian delegation. The dangers posed by COVID-19 have compelled the traditionally glad-handing, backslapping and tourism-promoting art of summit diplomacy to adapt. Just as corporations and educational institutions have migrated to online mediums, nation states are left with no choice but to do the same. E-summits are physically safer for leaders and also time-saving and economising events where costly physical journeys with entourages can be avoided.

Mr. Modi has engaged in a few multilateral ‘e-diplomacy’ rounds since the COVID-19 outbreak. He convened the SAARC leaders’ video conference on March 15, joined the Extraordinary G20 Leaders’ Summit via video link on March 26, and made his maiden appearance at the Non-Aligned Movement virtual summit on May 4. These were all single-issue focused and brief affairs. But the bilateral summit with Australia was elaborate and involved the exchange of multiple agreements.

It has been a maxim in diplomacy that face-to-face interactions at the highest level mark the zenith of foreign relations. The British scholar Ernest Satow dubbed “summits a permanent feature of diplomatic topography”. The formal negotiations during summits, the closed-door restricted sessions, the fireside chats, the walks in the woods, the photo-ops and the outreach to live audiences in the host and home countries are all part of the package. But now without all the protocols and structured dialogues in cozy settings, it is doubtful if major breakthroughs or deals requiring direct intervention of leaders can happen. There is a danger that ‘e-diplomacy’ will become less productive in terms of deliverables, especially where crucial sticking points need ironing out. While the backroom legwork and minutiae of agreements can be hashed out by lower-level bureaucrats communicating remotely, online summits will simply not satisfy the broader political goals and bigger objectives that heads of state carry with them.

Threat to cyber security

Another threat to virtual summits comes from cyber insecurity. In pre-COVID-19 times, summit venues used to be thoroughly sanitised and debugged to prevent sensitive foreign policy content from being spied upon or leaked. E-diplomacy is riskier and could be subject to hacking of classified content, making the leaders warier. This could reduce the spontaneity and candour of their conversations. It is arguable whether new ideas or proposals which entail geo-strategic alignments can emanate out of e-summits.

Yet, having some summit is better than no summit at all. However artificial and unsatisfying the video conferencing medium is, key partners like India and Australia have to get on with it and hold high-level meetings as part of their strategic signaling. With Australia and India trying to forge coalitions of middle powers in sustaining the balance of power in the Indo-Pacific, gaps in diplomatic summits can convey weakening of collective resolve.

For those missing the drama and the trappings of a ‘real’ summit, social media-savvy politicians might generate visuals to cherish in spite of the limits of virtual diplomacy. In a build-up to the India-Australia e-summit, Mr. Morrison offered vegetarian samosas via Twitter and Mr. Modi replied that he wanted to enjoy them together “once we achieve a decisive victory against COVID-19.”

In-person summits will restart one day. But the online interlude has to go on because diplomacy has to go on.

• e-diplomacy round since the COVID-19 outbreak .He convenced the Saarc leaders video conference on March 15, joined the Extraordinary G20 Leader' Summit via video link on March 26, and made his maiden appearence at the non Aligned Movement vitual summit on May 4.
• The formal negotiation during summit, the closeddoor restricted session, the fireside chat, the walks in the wood the photoops and the outreach to live audience in the host home countries are all the part package.
• but now,without, all the protocol and the structed dialogues cozy settings, it is doubtful if major breakthroughs or deal requiring direct intervention of lead 
• There is a danger that 'ediplomacy ' will become less productive in terms of deliverables , espicially where crucial sticking point ironing out.
• Another threat to virtual summit comes from cyber insecurity preCOVID19 times, summit venues ussed to be throughly sanitization and debugged to prevent sensetive foreign policy content from being spied upon or leaked.
• E-diplomacy is riskier and could be subject to hacking of the content, making te leader warier.

Selling Space 

For the United States to send American astronauts to space from American soil after a gap of nine years is a milestone in itself. That this took place at the time of one of the biggest civil rights upsurges since the 1960s makes it almost like an escape to fantasy, riding on the wings of a public-private partnership between NASA and Elon Musk’s SpaceX. The less expensive journey is a clear financial advantage as the U.S. has been paying the Russians $80 million to put one astronaut into space ever since they stopped NASA’s human space launch programme. Thus, SpaceX comes in to provide advantages in costs, innovation and safety. In the 2000s, when Mr. Musk showed off his rockets and lobbied in Washington DC, he was mostly ignored, yet now, NASA wants him to find customers for space flights. This can expand the power of U.S. commerce exponentially. Japanese billionaire Yusaku Maezawa has already signed up as a potential traveller to the moon and back. With this partnership, Americans have taken yet another leap of faith in creating commerce in space. If his plans get realised, Mr. Musk could make space flights as common as domestic flights. Technologically, it is a remarkable feat. The collaboration brings in a ‘willingness to fail’ which has kept SpaceX alive. This is coupled to the propensity to ‘qualify every component’, which has been NASA’s strength.

NASA has partially outsourced its work of innovating, testing and building new technology to market players such as SpaceX. It has made clear its desire to invite more such innovative space companies to participate. India under Prime Minister Modi has also opened up the space sector including ISRO facilities to private players. The emergence of successful partnerships here will likely depend on how well they stand up against the American example of allowing for failure. ‘Fly, test, fail, fix’ has been the rubric followed by SpaceX. India has not witnessed such huge experiments in space except by the state-led ISRO, its most recently celebrated one being the Mars Orbiter Mission at the cost of ₹7 per km, which is cheaper than autorickshaw travel as cited by Mr. Modi himself, famously. ISRO already has a competitive edge in the global market for space technology. The opening up of space technologies could harbour many an innovation of this kind; however, it calls for a high degree of accountability coupled with a non-partisan approach on the part of all players. The state’s role as a just arbiter in finding a delicate balance between entrepreneurial adventure and vested interests is a prerequisite to compete in space with the superpowers.

Context:

• United States to send American astronauts to space from American soil after a gap of nine years is a milestone in itself.

• That this took place at the time of one of the biggest civil rights upsurges since the 1960s makes it almost like an escape to fantasy, riding on the wings of a public-private partnership between NASA and Elon Musk’s SpaceX.

• The less expensive journey is a clear financial advantage as the U.S. has been paying the Russians $80 million to put one astronaut into space ever since they stopped NASA’s human space launch programme.

Advantages in costs, innovation and safety:

• SpaceX comes in to provide advantages in costs, innovation and safety.

• In the 2000s, when Mr. Musk showed off his rockets and lobbied in Washington DC, he was mostly ignored, yet now, NASA wants him to find customers for space flights. This can expand the power of U.S. commerce exponentially. Japanese billionaire Yusaku Maezawa has already signed up as a potential traveller to the moon and back.

• With this partnership, Americans have taken yet another leap of faith in creating commerce in space. If his plans get realised, Mr. Musk could make space flights as common as domestic flights.

• The collaboration brings in a ‘willingness to fail’ which has kept SpaceX alive. This is coupled to the propensity to ‘qualify every component’, which has been NASA’s strength.

Innovating, testing and building new technology:

• NASA has partially outsourced its work of innovating, testing and building new technology to market players such as SpaceX.

• It has made clear its desire to invite more such innovative space companies to participate. India under Prime Minister Modi has also opened up the space sector including ISRO facilities to private players.

• The emergence of successful partnerships here will likely depend on how well they stand up against the American example of allowing for failure.

• ‘Fly, test, fail, fix’ has been the rubric followed by SpaceX.

• India has not witnessed such huge experiments in space except by the state-led ISRO, its most recently celebrated one being the Mars Orbiter Mission at the cost of ₹7 per km, which is cheaper than autorickshaw travel as cited by Mr. Modi himself, famously.

• ISRO already has a competitive edge in the global market for space technology. The opening up of space technologies could harbour many an innovation of this kind.

Conclusion:

• However, it calls for a high degree of accountability coupled with a non-partisan approach on the part of all players.

• The state’s role as a just arbiter in finding a delicate balance between entrepreneurial adventure and vested interests is a prerequisite to compete in space with the superpowers.