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GS Paper: GS3-03.Government Budgeting

  • What are Off-Budget Borrowings?

    Finance Minister is all set to present the Union Budget 2021 on February 1st with all eyeing on off-budget borrowings to reduce Fiscal Deficit.

    Try this PYQ:

    With reference to the Union Government, consider the following statements:

    1. The Department of Revenue is responsible for the preparation of Union Budget that is presented to the Parliament.
    2. No amount can be withdrawn from the Consolidated Fund of India without the authorization from the Parliament of India.
    3. All the disbursements made from Public Account also need authorization from the Parliament of India.

    Which of the statements given above is/are correct?

    (a) 1 and 2 only

    (b) 2 and 3 only

    (c) 2 only

    (d) 1, 2 and 3

    What are off-budget borrowings?

    • Off-budget borrowings are loans that are taken not by the Centre directly, but by another public institution that borrows on the directions of the central government.
    • Such borrowings are used to fulfill the government’s expenditure needs.
    • Such borrowings are a way for the Centre to finance its expenditures while keeping the debt off the books — so that it is not counted in the calculation of fiscal deficit.
    • But since the liability of the loan is not formally on the Centre, the loan is not included in the national fiscal deficit. This helps keep the country’s fiscal deficit within acceptable limits.
    • As a result, a CAG report of 2019 pointed out that this route of financing puts major sources of funds outside the control of Parliament.

    Eyes on fiscal deficit

    • One of the most sought after details in any Union Budget is the level of fiscal deficit.
    • It is essentially the gap between what the central government spends and what it earns. In other words, it is the level of borrowings by the Union government.
    • This number is the most important metric to understand the financial health of any government’s finances.
    • As such, it is keenly watched by rating agencies — both inside and outside the country. That is why most governments want to restrict their fiscal deficit to a respectable number.
    • One of the ways to do this is by resorting to “off-budget borrowings”.

    How much would the borrowings be?

    • According to the last Budget documents, in the current financial year, the Centre was set to borrow Rs 5.36 lakh crore.
    • However, this figure did not include the loans that public sector undertakings were supposed to take on their behalf or the deferred payments of bills and loans by the Centre.

    How are off-budget borrowings raised?

    • Issuance of Bonds: The government can ask an implementing agency to raise the required funds from the market through loans or by issuing bonds.
    • Utilizing savings: For example, the food subsidy is one of the major expenditures of the Centre. In the Budget presentation for 2020-21, the government paid only half the amount budgeted for the food subsidy bill to the Food Corporation of India. The shortfall was met through a loan from the National Small Savings Fund.
    • Borrowing: Other PSUs have also borrowed for the government. For instance, public sector oil marketing companies were asked to pay for subsidized gas cylinders for PM Ujjwala Yojana beneficiaries in the past.
    • Bank sources: Public sector banks are also used to fund off-budget expenses. For example, loans from PSU banks were used to make up for the shortfall in the release of fertilizer subsidy.

    Its implications

    • Given the various sources of off-budget borrowing, the true debt is difficult to calculate.
    • For instance, it was widely reported that in July 2019, just three days after the presentation of the Budget, the CAG (cumulative aggregate growth) pegged the actual fiscal deficit for 2017-18 at 5.85% of GDP instead of the government version of 3.46%.

  • Good economics must also make good politics

    The article suggests the reforms that should be included in the next budget to boost the Indian economy.

    Need for further reforms

    • Government has leveraged the Covid-19 slowdown as an opportunity for introducing transformative reforms.
    • The recently introduced reforms include liberalising agricultural markets, diluting the onslaught of labour laws, credit guarantees for SME loans, and a liberal PLI to stimulate manufacturing.
    • These reforms have created a cautious optimism among investors worldwide awaiting the forthcoming Budget.
    • India’s reforms require further acceleration, and a consensus that good economics makes good politics.

    Reforms required to attract investment

    • Cost of acquiring land has increased substantially, which needs to be reduced.
    • The government must categorise 44 central laws into compensation, social security, industrial relations, and health and safety—and draft a unified model labour law to replace archaic laws for adoption by states.
    • India’s trade-to-GDP ratio must improve.
    • Having turned away from the RCEP, India needs to conclude trade agreements with the UK and other major economies. Announcing such intent would be welcome.
    • Effective corporate tax rate for domestic companies is 25.17%, while that for foreign firms is 43.68%, India should maintain tax parity across domestic and foreign companies.
    • With such parity, India will enhance investment attractiveness.
    • In view of the recent international arbitration rulings, India should discontinue retrospective taxation.
    • Defence FDI could be raised from 74% to 100% under automatic route.
    • The rationale to maintain FDI in the insurance sector at 49% now holds limited logic, India could increase it to a majority stake or even 100%.
    • Bottled-in-origin and bulk spirits attract a high basic customs duty (150%), deterring companies eyeing the Indian market, and depriving India of the corresponding FDI.
    • Phased reduction of duty on these products to 75% and finally to 30% is advisable.

    Areas that need increased spending

    • Spending on public healthcare needs to rise from 1.3% to 3% of GDP with Covid-19 exposing glaring inadequacies.
    • Revising the National List of Essential Medicines to exempt inexpensively-priced medicines from price controls would help investments in innovation and API manufacturing.
    • If the New Education Policy is to be implemented properly, public spend on education and skill development must rise from 3% to 4.5% of GDP.
    • The government must raise defence allocations to over 2.5% of GDP given India’s new threat perceptions and increase capital component of total fiscal allocations for defence could be increased from 34% to 40%.

    Other measures to boost the economy

    • Developing data adequacy agreements with the UK and other key countries would facilitate cross-border movement of personal data based on a mutual adequacy basis.
    • The online gaming industry should be supported by a model law, tax regime and self-regulation so that the government accrues tax revenues estimated at Rs 15,000 crore.
    • Most countries tax domestic corporate dividends at lower rates and, therefore, FPIs’ dividend income should be taxed at 10%.
    • Foreign banks must be brought at par with Indian banks with 8.5% deduction for NPA provisioning.
    • Excluding financial services from the e-commerce equalisation levy would be appropriate.
    • PSU disinvestments have slowed, and the Budget needs to announce measures for their acceleration as a privatisation push would be transformative for India in the long run.

    Consider the question”What are the hurdles in making India the more attractive to the investors? Discuss the measures to make India more attractive for investors.” 

    Conclusion

    As developed countries contemplate relocating their manufacturing supply chains to destinations besides China, a progressive Budget would send positive signals to overseas investors and would propel India’s rightful ambition to be the world’s next manufacturing workshop, in consonance with the Atmanirbhar Bharat vision.

    Source:

    https://www.financialexpress.com/opinion/union-budget-fy22-good-economics-must-make-good-politics/2173553/

  • Bank Investment Company (BIC)

    Banks, especially the Public Sector Banks have to play an important role in the pandemic afflicted economy. With that aim, the government has been envisaging the Bank Investment Company (BIC) for the improvement of PSB governance. The article discusses the issues with the BIC.

    Background of the BIC

    • Recent reports suggest that the upcoming budget may include proposals for a Bank Investment Company (BIC), anchoring the government’s shareholding in its banks.
    • The BIC was proposed by the P J Nayak Committee constituted by the RBI in 2014 to examine governance at public and private sector banks.
    • The committee had offered two options — privatisation or a complete overhaul of bank governance.
    • The overhaul of bank governance is envisaged in the form of a gradual disassociation of the government from the operations, management and governance of PSBs.
    • The BIC is a welcome step in as much as it signals the government’s intent to pursue reforms to improve the governance and performance of PSBs.

    Concerns with the BIC

    • The ownership and governance of the BIC itself will be crucial.
    • BIC will need to be allowed to garner the requisite talent and expertise and operate with freedom.
    • In the absence of this, it would merely add another layer while preserving the status quo.
    • The less than encouraging experience of the Banks Board Bureau (BBB) that was to precede the BIC is instructive.

    Why BBB failed to achieve its objectives

    • The BBB was set up in 2016 to advise on the selection and appointment of senior board members and management.
    • However, in practice, the BBB’s advice has not always been heeded to, and appointments have not always been made on time.
    • The BBB, as originally conceived, was to consist of three senior bankers.
    • However, it was expanded to include representatives from the RBI and the government.
    • The BBB was also originally envisaged by the committee as a temporary arrangement.
    • However, no further steps have been forthcoming after its establishment.

    Way forward for BIC

    • The government would need to ensure the necessary freedom for the BIC to operate while circumscribing its own role.
    • The ultimate success of these reforms will depend on how the government disassociates itself and empowers the BIC.
    • The objectives of the BIC would have to be clearly defined too.
    • If capital raising is one of the goals, the structure of a holding company — with a portfolio of comparatively better performing and non-performing banks — to attract investments must be assessed.
    • In this regard, the RBI has reportedly, in the past, expressed reservations on the BIC structure being a potential challenge for investors to assess the relative risks, returns and performance of the banks.
    • This raises the question of whether privatisation would not be a better alternative, particularly as the transition of the government from an owner to a pure financial investor in its banks is likely to take time.

    Conclusion

    Given these concerns, privatisation may be a better alternative. The budget could signal this intent by announcing the first step — the repeal of the Bank Nationalisation Acts and the State Bank of India Act.

  • Improving fiscal situation through budget

    The budget could be an opportunity to increase the consumption which has been impacted by the pandemic and still continues to show the declining trends.

    Continuing decline in consumption

    • The first advance estimates of GDP for 2020-21 are much better than the earlier market consensus.
    • The demand side, however, continues to be in a decline with private consumption falling by 9.5 per cent and its share in the overall GDP reducing by full 100 basis points.
    • Per capita private consumption has contracted by 10.4 per cent, while capital formation has contracted by 14.5 per cent, with imports and exports also contracting.
    • Only government consumption remains in positive territory.

    What should be the growth in nominal GDP for 2021-22?

    • In terms of specific numbers, the average growth in nominal GDP for the decade ending in 2013-14 was 15 per cent, but the average GDP deflator at 7.6 per cent far outpaced average real GDP at 6.8 per cent.
    • For the six year period ending in 2019-20, average nominal GDP growth was 10.4 per cent, with real GDP growth of 6.8 per cent far outpacing the GDP deflator at 3.6 per cent.
    • It is thus extremely important that we ensure that the current inflation trajectory is kept under control through policy interventions.

    Policy recommendations for the farmers

    1) Changing condition for renewal of loan on Kisan Credit Cards

    • Out of the outstanding bank credit of about Rs 12 lakh crore to the agriculture and allied activities sector, Rs 7 lakh crore is for Kisan Credit Cards.
    • The KCC portfolio of banks is under stress over the years due to a variety of factors like crop losses, unremunerated prices, debt waivers and the rigidity of the KCC product.
    • Currently, the renewal of KCC loans with payment of both principal and interest ensures interest subvention.
    • It is proposed that for renewal of KCC loans of small and marginal farmers and for loans of other categories of farmers for amounts up to Rs 3 lakh, the payment of interest must be a sufficient condition for renewal as with other loans.
    • The above measure has the potential to reduce the credit cost for banks considerably on KCCs as NPAs can be prevented more easily and the interest rate on KCC loans can be further reduced.

    2) Formalise tenancy and provide credit to tenant farmers

    • There are 11.5 crore farmers who are PM-KISAN beneficiaries — 6.5 crore farmers have KCC.
    • Thus, the remaining 4-5 crore could be land owning cultivators and at least 3-4 crore of such could be tenants/lessees/landless.
    • Currently, such tenant farmers are not formalised into the credit deliveries of scheduled commercial banks.
    • As of now, it requires state interventions for tenancy certificates which is only available in Andhra Pradesh.
    • Formation of a SHG model under the Deen Dayal Antodoya Yojana will formalise tenancy even without formal documentation of tenancy.
    • This will enable formal lending to take place to three crore landless farmers.

    3) Increasing investment in health and education

    • For health, it government could introduce medical savings account with a defined scheme to deduct interest from the savings account and pay towards a Mediclaim policy.
    • For the record, the size of the health insurance is Rs 32,000 crore and the savings bank interest is Rs 1.15 lakh crore.
    • The government should also consider exempting all retail and health insurance products from GST.

    Three suggestions on the fiscal situation

    • First,Withdraw all tax appeals.
    • Second, accept all domestic arbitration decisions against government departments/agencies.
    • Third, clear all outstanding dues to all parastatal agencies within a stipulated time.
    • This will be a milestone structural administrative change that could be even thought of as a one-time balance sheet entry recognising liabilities and paying them off.
    • As a consequence, we could jump multiple positions on the Ease of Doing Business rankings.

    Conclusion

    By implementing these steps in the budget the government could use this opportnity to stimulate the economy and aid the economic recovery.

  • India’s New Deal moment

    The article explains the opportunity presented by the budget to steer the economy out of the uncertain territory.

    3 characteristics of India’s economic recovery

    • First, India has broken the link between virus proliferation and mobility earlier and more successfully than many countries.
    • Second, the employment rate gradually improved till September but has weakened since then, even as the economy has progressively opened up.
    • CMIE’s labour market survey still reveals 18 million fewer employed (about 5 per cent of the total employed) compared to pre-pandemic levels.
    • A third phenomenon is large firms have endured the crisis better and are gaining market share at the expense of smaller firms.
    • To the extent there is a migration of activity from the informal/SME firms to larger firms, tax collections and Sensex/Nifty earnings should get a boost, even holding the economic pie constant.
    • Greater scale and formalisation undoubtedly augur well for medium-term productivity but could increase near-term labour market frictions and boost pricing power.

    Increased prospects of K-shaped recovery

    • Above 3 factors increases prospects of a K-shaped recovery from COVID, a phenomenon playing out globally.
    • Households at the top of the pyramid are likely to have seen their incomes largely protected, and savings rates increased.
    • Meanwhile, households at the bottom are likely to have witnessed permanent hits to jobs and incomes.

    3 Implications of K-shaped recovery

    • 1) What we are currently witnessing is pent-up demand from the upper-income households.
    • However, households at the bottom have experienced a permanent loss of income in the forms of jobs and wage cuts, this will be a recurring drag on demand, if the labour market does not heal faster.
    • 2) To the extent that COVID has triggered an effective income transfer from the poor to the rich, this will be demand-impeding in the steady state.
    • This is explianed by the fact that marginal propensity to consume at the bottom is higher than that at the top, just as the marginal propensity to import at the top is higher than at the bottom.
    • 3) If COVID-19 reduces competition or increases the inequality of incomes and opportunities, it could impinge on trend growth in developing economies by hurting productivity and tightening political economy constraints.

    Factors that need to be considered to decide the policy response

    • Policy need to look beyond the next few quarters and anticipate the state of the macro economy post this expression of pent-up demand.
    • The key factor is wheather private sector starts re-investing and re-hiring.
    • With manufacturing utilisation rates below 70 per cent pre-COVID, an investment revival, in turn, will depend crucially on the
    • Exports should benefit from strengthening global growth as the world gets progressively vaccinated and more US fiscal stimulus.

    Upcoming budget: India’s New Deal moment

    • It’s against this backdrop that the upcoming budget presents India with its New Deal moment.
    • Given the prevailing demand uncertainties, the budget represents an opportune moment for the Centre, in conjunction with the states, to embark on a large physical and social infrastructure push.
    • This will simultaneously boost near-term aggregate demand, crowd in private investment, create jobs to soak up the unemployed, and improve the economy’s external competitiveness.
    • Job creation, health and education, in turn, will be a start to help mitigate COVID-induced inequalities.

    How to finance the investment?

    • Gradual near-term consolidation coupled with a credible medium-term fiscal plan will be key to anchoring the bond market and underscoring an adherence to macro stability.
    • How then can public investment increase meaningfully if the headline deficit (projected above 11 per cent of GDP) must come down?
    • Public investment could be increased only if the public investment push is financed by aggressive asset sales-strategic sales, disinvestment, land and infrastructure monetisation.
    • In this manner, expenditure to GDP can actually rise next year — generating an expansionary fiscal impulse to the economy — while automatic stabilisers are used to reduce the headline fiscal deficit.

    Conclusion

    India’s faster-than-expected rebound is very encouraging. But given labour market pressures and prospects of a K-shaped recovery around the world, the economy will need to be carefully nurtured and stoked. The budget presents a crucial opportunity to make a big down payment towards this end.

  • Economic recovery and its discontents

    The article highlights the measures taken by the RBI in the recent MPC meeting to assure the buyers of the Government bonds and ensuring the policy rate transmission.

    Dealing with the rate transmission issue and why it matters

    • The gap between the repo rate and the average lending rate of banks is at a record high.
    • So, the RBI and the MPC focused on improving rate transmission.
    • This gap can be broken up into two parts:
    • The first is the gap between the RBI-set repo rate and the rate at which the government of India borrows (the GSec yield).
    • It is also called the “term premium” can be influenced by the RBI’s actions.
    • The second is the gap between the GSec yield and the rate at which individuals or private firms borrow.
    • This gap reflects risk aversion in the financial system and a lack of capacity.
    • The RBI has avoided directly influencing the term premium, perhaps to maintain its credibility and independence, staying clear of accusations that it is financing the government’s fiscal deficit.
    • However, unless the rate at which the government borrows comes down borrowing costs for the whole economy will stay elevated.

    Challenge of Balance-of-Payment surplus (i.e. excess dollars)

    • Over the past few months, the country’s foreign currency reserves have been growing at an unprecedented rapid pace.
    • This means that India is getting far more dollars than it needs. Three factors are responsible for this.
    • 1) Some short-term factors responsible are weak imports and a faster normalisation of exports.
    • 2) There have also been structural shifts in India’s economic policy which point to a persistent BoP surplus.
    • In addition to low energy prices, policies supporting Atmanirbhar Bharat mean lower imports and the push towards making India a participant in global value chains mean higher exports.
    • 3) At the same time, India’s capital account is being opened up: The special-category government of India bonds, for example.

    Why BoP surplus is opportunity

    • When the excess dollar inflows turn into a deluge, as they have over the past six months, the supply of rupees in the domestic economy also becomes excessive.
    • If the RBI can direct this surplus into government bonds, it can maintain its independence and credibility, and at the same time achieve its target of rate transmission.

    Measures by the RBI to assure the bond market

    • The buyers of government bonds need to feel reassured of not getting hurt by the volatility in bond prices.
    • When bond prices rise, the yields fall, and vice versa.
    • Banks parking trillions of rupees with the RBI at 3.35 per cent overnight would earn nearly 6 per cent if they bought government bonds.
    • That they did not was because they were afraid of the bond prices falling, which would offset the gains from higher rates.
    • The increase in the Hold-To-Maturity limits by the RBI  by one year to March 2022, has assured the banks that they need not fear booking interim losses if bond prices are volatile.
    • The announcement that the RBI would purchase state and central government bonds on the market (even if in small sizes) would provide further comfort.
    • The change in assessment of inflation should help buyers of government bonds take the risk.
    • Banks or other bond investors that refrained from purchasing government bonds because they felt the RBI would increase interest rates at some point to comply with its legal mandate, would be reassured by this clear communication.
    • The targeted refinancing operations (TLTRO) should help bring down borrowing rates in the targeted industries.

    Conclusion

    Economic challenges may persist for the foreseeable future. The economic scars of the last six months are likely to take time to heal. The RBI and the MPC, which have been proactive, creative and accommodative so far, may have to stay so for a while longer.

  • Growth compulsion, fiscal arithmetic

    The government faces the challenge of high fiscal deficit and declining revenue. This article discusses the challenge and suggests the way forward to deal with the situation.

    Dismal growth prospects

    • At (-)23.9% contraction for the first quarter of 2020-21, India’s growth showed one of the highest contraction globally.
    • What is most surprising in the Q1 data is that the sector ‘Public Administration, Defence and other Services’ contracted at (-) 10.3%.
    • This means that there was no fiscal stimulus.
    • The 2020-21 real GDP growth for India is forecast in the range of (-) 5.8% (RBI) to (-) 14.8% (Goldman Sachs).
    • The OECD in its September 2020 Interim Economic Outlook has projected a contraction of (-) 10.2% in FY21 for India.

    Challenge of decline in revenue

    • Due to a sharp contraction in nominal GDP growth, central and State tax revenue, both may contract.
    • . In the first quarter of 2020-21, the Centre’s gross tax revenues contracted by (-) 32.6%.
    • The CAG-based data pertaining to 19 States show a contraction of (-) 45% in their own tax revenues.
    • Given the adverse impact of the lockdown, even the budgeted non-tax revenues are not likely to be realised.
    • The revenue calculations of the Budget were made on the assumption that the nominal income of the country would grow at 10%.
    • Some estimates indicate that the tax and non-tax revenue and non-debt capital receipts in the current fiscal may fall well short of the budget estimates by an amount higher than ₹5-lakh crore.
    • The combined fiscal deficit of the Centre and the States will have to make up for the shortfall in tax and non-tax revenues, if the level of budgeted expenditures is to be maintained.

    Challenge of widening of fiscal deficit

    • In order for the central government to maintain the level of budgeted expenditure and also provide for additional stimulus, its fiscal deficit may have to be increased to close to an estimated 8.8% of GDP.
    • If one adds the Centre’s and States’ fiscal deficit, the combined fiscal deficit amounts to 13.8% of GDP.
    • If the nominal GDP actually contracts in 2020-21, the fiscal deficit as the percent of GDP would go up further.

    Role of the RBI

    • The International Monetary Fund, in its June 2020 update of the World Economic Outlook, estimated the fiscal deficit of India and China at 12.1% of GDP.
    • India doesn’t have adequate resources to support a fiscal deficit of nearly 14% of GDP.
    • All this will therefore require substantial support from the Reserve Bank of India which will have to take on itself, either directly or indirectly, a part of the central government debt.
    • In the direct mode, the RBI takes on the debt directly from government at an agreed rate.
    • It took India long to move away from the automatic monetisation of debt.
    • Even if the RBI wants to support the borrowing programmes, it should not do so directly.
    • The indirect method is preferable as the market still sends out the signals on interest rate.
    • In both cases, the RBI is the provider of liquidity.
    • The question ultimately relates to the extent of debt monetisation that may be undertaken.
    • The country has also to guard against high inflation.

    Role of government

    • The economic situation warrants enhanced government expenditure.
    • It appears that governments are withholding expenditure. That is not the right approach.
    • At the same time, there is a limit to monetisation of debt.

    Conclusion

    Perhaps the best course of action would be to keep the combined fiscal deficit at around 14% of GDP in the current year and find ways to finance it. This will have to be brought down gradually. It may take several years of normalisation.

  • New umbrella entities (NUEs) for retail payments.

    Context

    • Last week the Reserve Bank of India (RBI) released a document setting out the framework it plans to adopt to authorize the establishment of new umbrella entities (NUEs) for retail payments.

    What are NUEs

    • Once established, these newly authorized entities will be able to operate their own clearing and settlement systems.
    • establish new standards and technologies; and develop innovative new payment systems that enhance customer access, convenience and safety.
    • All NUEs will have to be interoperable with the National Payments Corporation of India (NPCI).
    • NPCI would also be allowed to set themselves up as for-profit entities, and they will themselves be able to participate in RBI’s payment and settlement systems.
    • The NPCI is at the epicentre of the digital payments in the country.

    If NPCI is doing its job well, then why NUE?

    • Between the UPI, IMPS, Aadhaar-enabled payments, Bharat BillPay, and all the other payment systems that it manages, 48% of all electronic retail payments in the country pass through the NPCI infrastructure.
    • NPCI is the fulcrum around which everything digital revolves.
    • Perhaps RBI’s concern stems from having the operations of so much of the country’s payment system concentrated in one entity.

    Are the concerns of RBI valid?

    • There is nothing wrong with having all digital transactions flow through a single entity—so long as that entity is neutral.
    • If RBI’s concern is technical, we could build sufficient redundancy into NPCI’s technical architecture to ensure that there is no single point of failure in the system.
    • Creating multiple umbrella entities is not the answer to this problem, as NUEs would be allowed to establish themselves as profit-oriented entities.
    • There is also the question of whether the trade-off is even worth it as replicating the NPCI infrastructure will require heavy investments to make participants in one NUE can seamlessly interact with those in every other.
    • Ensuring interoperability while still maintaining the security of the underlying infrastructure is going to be difficult and expensive.
    • There is the cost of the additional regulatory burden that RBI will have to shoulder, now that the banking-sector regulator will have to manage not just one but multiple umbrella entity.

    Issues with NPCI

    • There would be consequences to letting NPCI only entity in handling the payment system.
    • Any sort of monopoly results in market inefficiencies.
    • Of we have just one umbrella regulator, we will never be sure if transaction costs are as low as they could be, or if the variety of product offerings available to us could be better.
    • Problem is that the NPCI is expected to both manage the digital payments industry as well as come up with the frameworks necessary to foster innovation.
    • When NPCI had just small products in its portfolio it was able to perform both functions efficiently.
    • The effort of just keeping the system working seems to be taking a toll on NPCI’s ability to develop the protocols and standards that are needed to encourage innovation in this boom sector.

    What is the solution to issues faced by NPCI

    • One possible solution might be to create a separate and independent standards-setting body.
    • Such body would come up with the protocols and standards required to foster innovation in the digital payments space.
    • This is how most successful digital infrastructure systems work. Take the World Wide Web, for example.
    •  Any new standard that this body creates will have to first be approved by the NPCI, but then it can be rolled out throughout the digital payments ecosystem.

    Consider the question “Examine the role played by the NPCI in revolutionising the payment system in India.”

    Conclusion

    By establishing a neutral and independent standards-setting body, we can make sure that the system as a whole in our country evolves in the best traditions of digital infrastructure adopted anywhere in the world.

  • Where the “fiscal space” debate should focus?

    The article focuses on the “fiscal space” debate in India. So, what is this debate? This debate is focuses upon the size of the fiscal deficit this year in India, ways that could be used to finance it and upper limit of this deficit etc. But the author argues that we should focus on debt/GDP trajectory in the subsequent years. Besides this, he suggests what our policy intervention comprise.

    Monetary policy and fiscal policy: Efficacy Vs. Space debate

    • In response to the economic disruption caused by Covid-19, monetary policy has moved swiftly and aggressively in many economies.
    • But questions remain on its incremental efficacy.
    • With a high level of uncertainty around, risk-averseness is evident in the financial systems.
    • This risk-averse tendency reduces the efficacy of lower rates and higher liquidity.
    • So, while monetary policy may have space, how much efficacy will it have?
    • Fiscal policy i.e. spending by the governments can have much efficacy.
    • But how much space does it have? Therein lies the debate.

    Focus on Debt/GDP trajectory, not on level

    • The “fiscal space” debate in India has centred exclusively on this year’s deficit and how it will be financed.
    •  But a more holistic assessment of fiscal space should focus on two factors 1) the government’s inter-temporal budget constraint 2)  how India’s debt/GDP evolves in the coming years.
    • These two are the factors that rating agencies and foreign investors will eventually focus on.
    • Following are the question that debate should focus on.
    • How much will India’s debt/GDP jump up this year?
    • More importantly, what happens thereafter?
    • Will debt/GDP keep rising year after year? Or will it start declining?
    • As research has found, it’s typically the trajectory of debt/GDP — more than the level — that impacts future growth.

    Evolution of debt

    • The evolution of debt is essentially a function of three variables:
    • 1) The primary deficit.
    • 2) Nominal GDP growth
    • 3) The government’s cost of borrowing.
    • The higher is the difference between growth and cost of borrowing, the greater is the depreciation of the existing debt stock.
    • High growth allows countries to “grow out” of their debts.
    • In contrast, high primary deficits worsen the debt burden.

    Where does India stand?

    • India comes into COVID-19 with a debt/GDP of about 70 per cent.
    • A primary deficit across the Centre and states of about 2.5 per cent of GDP including the Centre’s extra-budgetary resources. — based on the Revised Estimates for 2019-20.
    • A weighted average sovereign borrowing cost of about 7.5 per cent (on the stock of debt) and an estimated pre-COVID nominal GDP growth of 7.5 per cent in 2019-20.
    • In other words, the favourable gap between growth and borrowing costs had closed.
    • With this backdrop, one can simulate what happens to debt/GDP in the coming years under different growth, fiscal and interest-rate scenarios.
    • What do we find?
    • Even under relatively benign scenarios –nominal GDP growth of 4 per cent and a fiscal expansion of 3 per cent of GDP this year- India’s debt/GDP will balloon towards 80 per cent by the end of the year.
    • But India will not be alone. Public debt is expected to balloon all over the world.
    • Instead, what will matter for sustainability is the trajectory of debt thereafter.
    • Does debt/GDP come down or keep going up in subsequent years?

     Fiscal space depends on potential growth in coming years

    • The subsequent trajectory of Debt/GDP depends overwhelmingly on medium-term growth.
    • Consider the following two scenarios and refer to the figure given below-
    • 1. Fiscal Deficit 6%
    • Consider that this year’s combined fiscal deficit widens by 6 per cent of GDP.
    • But the primary deficit is then consolidated back to 2 per cent of GDP in the next 3 years.
    • And as long as nominal GDP is 10 per cent in the medium term which corresponds to real GDP growth of 7 per cent.
    • Debt/GDP gets on to a constantly declining path after the third year.
    • This suggests a bigger fiscal intervention is sustainable but only if medium-term growth prospects are lifted in tandem.
    • 2. Fiscal Deficit 3%
    • Consider that this year’s deficit widens by “just” 3 per cent of GDP.
    •  But medium-term nominal GDP growth settles at 8 per cent that is, real GDP growth of 5 per cent.
    • Debt/GDP rises relentlessly for the next decade towards 90 per cent of GDP.

    Key takeaway: focus on medium-term growth

    • This suggests even a relatively-conservative fiscal response this year becomes unsustainable if medium-term growth prospects are diminished.
    • Small changes in medium-term growth have large implications for fiscal sustainability.
    •  How much fiscal space India has to respond in the crisis year will depend crucially on what potential growth is likely to be in the coming years.
    • The more that India’s policy response can preserve, protect and boost medium-term growth — both through the nature of the policy intervention this year and the accompanying reforms — the larger the fiscal response India can mount.
    • Put more starkly, the fiscal debate between “need” and “affordability” is endogenous.
    • The medium-term sustainability of any fiscal package this year will depend on the nature of growth-enhancing interventions and reforms that accompany it.

    So, what could the interventions comprise?

    1. Keep small business afloat

    • Policy must ensure that all viable enterprises can survive the pandemic.
    • If economically-viable but illiquid small and medium enterprises go under, the implications both for unemployment and India’s underlying production capacity could be severe.
    • The government’s credit-guarantee scheme is, therefore, very important and should hopefully induce banks to provide much-need working capital to keep small businesses afloat.

    2. Reforms in the finance sector

    • It is important to jump-start a risk-averse financial sector into funding an economic recovery, more broadly.
    • Last week’s bond market interventions which involved special liquidity and partial guarantee funds are important to ease conditions at the financial periphery.
    • Over time, however, liquidity must give way to capital and reform.
    • Following steps will be crucial to strengthening the financial sector-
    • 1)Pre-emptively recapitalising public sector banks for growth and resolution capital.
    • 2) Conducting an AQR for the NBFC sector after pandemic.
    • 3) Then converting well-run NBFCs into banks to avail of a stable deposit franchise.
    • 4) Modifying the incentives under which public sector banks operate.
    • Higher potential growth is only feasible if the financial sector is able to fund it.

    3. Reforms in the other sectors

    • Real reforms must accompany those in the financial sector.
    • The government’s announcement on unshackling agriculture — if carried through to its logical conclusion — is potentially game-changing for farmers and will be a landmark reform for the sector.
    • As COVID-19 hastens the reorganisation of supply-chains within Asia, India must seize the moment to integrate into the Asian supply chain.
    • Revisit a Special Export Zone (SEZ) model with the appropriate regulatory environment to avoid the pitfalls of the past.
    • Path dependence will be key. If the first one or two SEZs succeed, it would create a powerful demonstration effect both externally to help attract more firms into India.
    • And internally inducing different states to compete to create their own SEZs to drive jobs and investment.

    4. Social infrastructure and ways to pay for it

    • If the virus has taught the world anything, it’s the criticality of social infrastructure.
    • India will not be able to fundamentally alter its growth potential without crucial investments in health and education.
    • The government’s announcement to boost health spending is, therefore, very welcome.
    • But how will this be paid for? This is where policy must get creative.
    • Existing assets on the public sector balance sheet must be aggressively monetised to fund growth-enhancing investments in physical and social infrastructure.
    • This will simultaneously take the pressure off the fiscal and financial sectors, and deliver a productivity-enhancing swap on the public sector balance sheet.

    The article is helpful to consolidate the basic understanding of the macroeconomic parameters of economy. Consider the question asked by UPSC last year “Do you agree with the view that steady GDP growth and low inflation have left the Indian economy in good shape? Give reasons in support of your arguments”

    Conclusion

    Higher potential growth is the antidote to many pressures, from incomes to jobs to debt sustainability. To the extent this unprecedented crisis creates political space and capital to reform, the opportunity must be seized.

    Back2Basics: Nominal GDP

    • Nominal gross domestic product is gross domestic product (GDP) evaluated at current market prices. 
    • GDP is the monetary value of all the goods and services produced in a country.
    • Nominal differs from real GDP in that it includes changes in prices due to inflation, which reflects the rate of price increases in an economy.

    Primary Deficit

    • Primary deficit refers to the difference between the current year’s fiscal deficit and interest payment on previous borrowings.
    • It indicates the borrowing requirements of the government, excluding interest.
    • It also shows how much of the government’s expenses, other than interest payment, can be met through borrowings.

    Debt/GDP ratio

    • The debt-to-GDP ratio is the metric comparing a country’s public debt to its gross domestic product (GDP).
    • By comparing what a country owes with what it produces, the debt-to-GDP ratio reliably indicates that particular country’s ability to pay back its debts.
    • Often expressed as a percentage, this ratio can also be interpreted as the number of years needed to pay back debt if GDP is dedicated entirely to debt repayment.

    AQR- Asset Quality Rating

    • An asset quality rating refers to the assessment of credit risk associated with a particular asset, such as a bond or stock portfolio.
    • The level of efficiency in which an investment manager controls and monitors credit risk heavily influences the rating bestowed.
    • And because asset quality is an important determinant of risk that profoundly impacts liquidity and costs, analysts go to great lengths to make sure they issue the most accurate evaluations possible.
    • After all, their pronouncements can greatly affect the overall condition of a business, bank, or portfolio for years to come.

  • Is the perpetual bond a suitable option to raise money?

    The government is exploring ways to raise money to deal with the destruction caused by COVID pandemic. One of the suggestion is the monetisation of fiscal deficit. But this article looks into an alternative approach of issuing bonds based on the idea of Consol bond issued by the British government during WW 2. So, how much amount needs to be raised? and why a perpetual bond like Consol bond is a suitable option for India? Read to know!

    A gathering financial storm

    • India projected a deficit of ₹7.96-lakh crore in the Budget before the pandemic.
    • Adding to the above concern: 1) Off-balance sheet borrowings of 1% of GDP. 2) The overly excessive target of ₹2.1 lakh crore through disinvestments.
    • Thus, financial deficit number is set to grow by a wide margin owing to corona crisis.
    • There will be revenue shrinkage from the coming depression that will most certainly be accompanied by a lack of appetite for disinvestment.

    Need for stimulus package and measures taken by the RBI

    • In addition to the expenditure that was planned, the government has to spend anywhere between ₹5-lakh crore and ₹6-lakh crore as a stimulus package.
    • The stimulus provided by the government so far and recent announcements by the Reserve Bank of India (RBI) achieved little.
    • All the RBI’s schemes are contingent on the availability of risk capital, the market for which has completely collapsed.
    • The government and the RBI have tried several times to increase lending to below investment grade micro, small and medium enterprises, but have come up short each time.
    • Furthermore, while the 60% increase in ways and means limits for States is a welcome move, many States have already asked for doubling the limits due to the shortages in indirect taxation collections from Goods and Services Tax, fuel and liquor.
    • The government and the central bank need to understand that half measures will do more harm than good.

    What is the Consol Bond?

    • Consol bond is a form of British government bond that has no maturity and that pays a fixed coupon.
    • Consols are basically rare examples of actual perpetual bonds.
    • The bonds were issued in 1917 as the government sought to raise more money to finance the ongoing cost of the First World War.

    So, why bond like Consol Bonds is a good option for India?

    • There is no denying the fact that the traditional option of monetising the deficit by having the central bank buy government bonds is one worth pursuing.
    • Citizens’ active participation is ensured in Consol Bond type alternative.
    • Furthermore, with the fall of real estate and given the lack of safe havens outside of gold, the bond would offer a dual benefit as a risk-free investment for retail investors.
    • When instrumented, it would be issued by the central government on a perpetual basis with a right to call it back when it seems fit.
    • An attractive coupon rate for the bond or tax rebates could also be an incentive for investors.
    • The government can consider a phased redemption of these bonds after the economy is put back on a path of high growth.

    The solution of bond offered here could be a valuable addition in points to the answer to the question which asks about the ways to raise money. Consider the question, “Economic devastation caused by the COVID pandemic has forced the government to explore the various ways to raise the money. Discuss the options available with the government and issues associated with the options.”

    Conclusion

    Politicians and epidemiologists across the world have used the word “war” to describe the situation the world is currently in. So, to raise the money to fight this war against Covid-19, we can take the cue from past and issue bond based on the Consol bond.

    Back2Basics: What is fiscal deficit?

    • A fiscal deficit is a shortfall in a government’s income compared with its spending.
    • The government that has a fiscal deficit is spending beyond its means.
    • A fiscal deficit is calculated as a percentage of gross domestic product (GDP).
    • There can be different types of deficit in a budget depending upon the types of receipts and expenditure we take into consideration. Accordingly, there are three concepts of the deficit, namely-
    • Revenue deficit = Total revenue expenditure – Total revenue receipts.
    • Fiscal deficit = Total expenditure – Total receipts excluding borrowings.
    • Primary deficit = Fiscal deficit-Interest payments.
    • Primary deficit shows how much government borrowing is going to meet expenses other than interest payments.
    • Thus, zero primary deficits mean that the government has to resort to borrowing only to make interest payments.
    • To know the amount of borrowing on account of current expenditure over revenue, we need to calculate the primary deficit.
    • Thus, the primary deficit is equal to fiscal deficit less interest payments.

    Perpetual Bonds

    • A perpetual bond, also known as a “consol bond” or “prep,” is fixed income security with no maturity date.
    • This type of bond is often considered a type of equity, rather than debt. One major drawback to these types of bonds is that they are not redeemable.
    • However, the major benefit of them is that they pay a steady stream of interest payments forever.
    • Perpetual bonds exist within a small niche of the bond market.
    • This is mainly due to the fact that there are very few entities that are safe enough for investors to invest in a bond where the principal will never be repaid.
    • AT-1 bonds which were recently in news due to YES bank failure is an example of a perpetual bond.