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GS Paper: Indian Economy

  • Who is afraid of monetisation of deficit?

    Rating agencies influence the decisions of investors. So, when any economy is downgraded by them, it’s certainly a cause for concern. But to restart the economic engines, governments need to spend more by borrowing. This article suggests the way to achieve both: avoiding downgrade and increasing spending. How? Read to know…

    To worry or not to worry: Issue of downgrading by rating agencies

    • Some economists urged the government amid covid pandemic 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 worry too much about it.
    • 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 downgrade, Moody’s says, has not factored in the economic impact of the pandemic.
    • Any further deterioration in the fundamentals from now on will push India into ‘junk’ status.

    Here is why we should be worried about a downgrade

    •  Whatever the failings of the agencies, in the imperfect world of global finance that we live in, their ratings do carry weight.
    • Institutional investors are largely bound by covenants that require them to exit an economy that falls below investment grade.
    • If India is downgraded to junk status, foreign institutional investors, or FIIs, 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 hands full trying to stave off a foreign exchange crisis.
    • That is the last thing we need at the moment.

    So, what is the way out? Try for an upgrade!

    • We have to put our best foot forward now to prevent a downgrade and bring about an upgrade instead.
    • To do so, we need to note the key concerns that Moody’s has cited in effecting the present downgrade to our rating: slowing growth, rising debt and financial sector weakness.
    • These concerns are legitimate.

    Bleak prospects

    • Many economists as also the Reserve Bank of India (RBI) expect India’s economy to shrink in FY 2020-21.
    • The combined fiscal deficit of the Centre and the States is expected to be in the region of 12% of GDP.
    • Moody’s expects India’s public debt to GDP ratio to rise from 72% of GDP to 84% of GDP in 2020-21.
    • The banking sector had non-performing assets of over 9% of advances before the onset of the pandemic.
    • Weak growth and rising bankruptcies will increase stress in the banking sector.

    Fiscal deficit and growth: two concerns of rating agencies

    • The government’s focus thus far has been on reassuring the financial markets that the fisc will not spin out of control.
    • It has kept the ‘discretionary fiscal stimulus’ down to 1% of GDP.
    • That 1%  figure is most modest in relation to that of many other economies, especially developed economies.
    • ‘Discretionary fiscal stimulus’ refers to an increase in the fiscal deficit caused by government policy as distinct from an increase caused by slowing growth, the latter being called an ‘automatic stabiliser’.
    • Keeping the fiscal deficit on a leash addresses the concerns of rating agencies about a rise in the public debt to GDP ratio.
    • But it does little to address their concerns about growth.
    • The debt to GDP ratio will worsen and financial stress will accentuate if growth fails to recover quickly enough.
    • The government’s stimulus package relies heavily on the banking system to shore up growth.
    • But there is only so much banks can do.
    • More government spending is required, especially for infrastructure.

    So, government need to increase fiscal stimulus without increasing public debt

    • We need to increase the discretionary fiscal stimulus without increasing public debt.
    • The answer is monetisation of the deficit, that is, the central bank providing funds to the government.
    • These fears are based on misconceptions about monetisation of the deficit and its effects.

    What monetisation of debt mean?

    • A common misconception is that it involves ‘printing notes’.
    • But that is not how central banks fund the government.
    • The central bank typically funds the government by buying Treasury bills.
    • As proponents of what is called Modern Monetary Theory point out, even that is not required.
    • The central bank could simply credit the Treasury’s account with itself through an electronic accounting entry.
    • What is base money? When the government spends the extra funds that have come into its account, there is an increase in ‘Base money’, that is, currency plus banks’ reserves.
    • So, yes, monetisation results in an expansion of money supply.
    • But that is not the same as printing currency notes.

    But expansion of money supply leads to inflation, what about that?

    • It could be that the expansion is inflationary.
    • This objection has little substance in a situation where aggregate demand has fallen sharply and there is an increase in unemployment.
    • In such a situation, monetisation of the deficit is more likely to raise actual output closer to potential output without any great increase in inflation.

    No difference in borrowing from banks or RBI directly:MMT

    • Exponents of the Modern Monetary Theory (MMT) make a more striking point.
    • They say there is nothing particularly virtuous about the government incurring expenditure and issuing bonds to banks instead of issuing these to the central bank.
    • The expansion in base money and hence in money supply is the same in either route.
    • The preference for private debt is voluntary.
    • MMT exponents say it has more to do with an ideological preference for limiting government expenditure.
    • Central banks worldwide have resorted to massive purchases of government bonds in the secondary market in recent years, with the RBI joining the party of late.
    • These are carried out under Open Market Operations (OMO).
    • The impact on money supply is the same whether the central bank acquires government bonds in the secondary market or directly from the Treasury.

    So why the shrill clamour against monetisation of public debt?

    • OMO is said to be a lesser evil than direct monetisation because the former is a ‘temporary’ expansion in the central bank’s balance sheet whereas the latter is ‘permanent’.
    • But we know that even so-called ‘temporary’ expansions can last for long periods with identical effects on inflation.
    • What matters, therefore, is not whether the central bank’s balance sheet expansion is temporary or permanent but how it impacts inflation.
    • As long as inflation is kept under control, it is hard to argue against monetisation of the deficit in a situation such as the one we are now confronted with.

    Way forward

    • We now have a way out of the constraints imposed by sovereign ratings.
    • The government must confine itself to the additional borrowing of ₹4.2 trillion which it has announced.
    • Further discretionary fiscal stimulus must happen through monetisation of the deficit.
    • That way, the debt to GDP ratio can be kept under control while also addressing concerns about growth.

    Consider the question “Examine the issues involved in the direct monetisation of the debt by the government to fund the spending in  the wake of covid pandemic.”

    Conclusion

    The rating agencies should be worrying not about monetisation per se but about its impact on inflation. As long as inflation is kept under control, they should not have concerns — and we need not lose sleep over a possible downgrade.

    Back2Basics: Automatic stabiliser

    • Automatic stabilisers refer to how fiscal instruments will influence the rate of growth and help counter swings in the economic cycle.
    • Automatic stabilisers will influence the size of government borrowing.

    Discretionary fiscal policy

    • Keynesian Perspective: Keynes noted that in a recession, confidence falls and the private sector cut back on spending and investment.
    • Therefore, we see a rise in private savings and a fall in aggregate demand. This can worsen the recession.
    • This is why Keynes advocated government borrowing – to make use of these surplus savings.
    • Keynes argued that automatic stabilisers may not be enough, and the government should specifically find public sector projects to inject money into the circular flow.
    • This is known as discretionary fiscal policy.

  • India’s rising Forex Reserves

    India’s foreign exchange reserves are rising and are slated to hit the $500 billion mark soon. In the last month, it jumped by $12.4 billion to an all-time high of $493.48 billion.

    Aspirants must make a note here:

    1.Authority managing FOREX in India

    2.Components of FOREX

    3.IMF’s SDRs

    4.Emergency use of FOREX

    Rising above the 1991 crisis

    • Unlike in 1991, when India had to pledge its gold reserves to stave off a major financial crisis, the country can now depend on its soaring Forex reserves to tackle any crisis on the economic front.
    • The level of Forex reserves has steadily increased by 8,400 per cent from $5.8 billion as of March 1991 to the current level.

    What are Forex Reserves?

    • Reserve Bank of India Act and the Foreign Exchange Management Act, 1999 set the legal provisions for governing the foreign exchange reserves.
    • RBI accumulates foreign currency reserves by purchasing from authorized dealers in open market operations.
    • The Forex reserves of India consist of below four categories:
    1. Foreign Currency Assets
    2. Gold
    3. Special Drawing Rights (SDRs)
    4. Reserve Tranche Position
    • The IMF says official Forex reserves are held in support of a range of objectives like supporting and maintaining confidence in the policies for monetary and exchange rate management including the capacity to intervene in support of the national or union currency.
    • It will also limit external vulnerability by maintaining foreign currency liquidity to absorb shocks during times of crisis or when access to borrowing is curtailed.

    Why is Forex rising despite the slowdown in the economy?

    1.Rise in  FPIand  FII

    • The major reason for the rise in forex reserves is the rise in investment in foreign portfolio investors in Indian stocks and foreign direct investments (FDIs).
    • Foreign investors had acquired stakes in several Indian companies in the last two months.
    • Forex inflows are set to rise further and cross the $500 billion as Reliance Industries subsidiary, Jio Platforms, has witnessed a series of foreign investments totalling Rs 97,000 crore.

    2.Crash in oil prices

    • On the other hand, the fall in crude oil prices has brought down the oil import bill, saving the precious foreign exchange.

    3.Fall in overseas remittances and foreign travel

    • Similarly, overseas remittances and foreign travels have fallen steeply – down 61 per cent in April from $12.87 billion.

    What’s the significance of rising forex reserves?

    • The rising forex reserves give a lot of comfort to the government and the RBI in managing India’s external and internal financial issues at a time when the economic growth is set to contract by 1.5 per cent in 2020-21.
    • Provides Cushion: It’s a big cushion in the event of any crisis on the economic front and enough to cover the import bill of the country for a year.
    • Appreciation of Rupees: The rising reserves have also helped the rupee to strengthen against the dollar.
    • The forex reserves to GDP ratio is around 15 per cent.
    • Provides confidence to Market: Reserves will provide a level of confidence to markets that a country can meet its external obligations, demonstrate the backing of domestic currency by external assets, assist the government in meeting its US dollar needs and external debt obligations and maintain a reserve for national disasters or emergencies.

    What does the RBI do with the forex reserves?

    • The RBI functions as the custodian and manager of forex reserves and operates within the overall policy framework agreed upon with the government.
    • The RBI allocates the dollars for specific purposes. For example, under the Liberalized Remittances Scheme, individuals are allowed to remit up to $250,000 every year.
    • The RBI uses its forex kitty for the orderly movement of the rupee. It sells the dollar when the rupee weakens and buys the dollar when the rupee strengthens.

    Where are India’s forex reserves kept?

    • The RBI Act, 1934 provides the overarching legal framework for the deployment of reserves in different foreign currency assets and gold within the broad parameters of currencies, instruments, issuers and counterparties.
    • As much as 64 per cent of the foreign currency reserves is held in the securities like Treasury bills of foreign countries, mainly the US.
    • 28 per cent is deposited in foreign central banks and 7.4 per cent is also deposited in commercial banks abroad.
    • In value terms, the share of gold in the total foreign exchange reserves increased from about 6.14 per cent as at end-September 2019 to about 6.40 per cent as at end-March 2020.

    Is there a cost involved in maintaining forex reserves?

    • The return on India’s forex reserves kept in foreign central banks and commercial banks is negligible.
    • While the RBI has not divulged the return on forex investment, analysts say it could be around one per cent, or even less than that, considering the fall in interest rates in the US and Eurozone.
    • There was a demand from some quarters that forex reserves should be used for infrastructure development in the country. However, the RBI had opposed the plan.
    • Several analysts argue for giving greater weightage to return on forex assets than on liquidity thus reducing net costs if any, of holding reserves.
    • Another issue is the high ratio of volatile flows (portfolio flows and short-term debt) to reserves which are around 80 per cent. This money can exit at a fast pace.

  • Shapes of Economic Recovery

    Predicting recovery graphs, economists have added cool shapes for our information.

    The types of graphs mentioned here are the possible indicators of macro-economic recovery. They are the potential hotspots for a prelim question. UPSC can puzzle you with the type of graphs and associated macroeconomic situation.

    Try to mirror! How would our economy grow?!

    Types of graphs

    The shape of economic recovery is determined by both the speed and direction of GDP prints. This depends on multiple factors including fiscal and monetary measures, consumer incomes and sentiment.

    • The best scenario is a V-shaped recovery in which the economy quickly recoups lost ground and gets back to the normal growth trend-line.
    • A pipe graph is a V graph with a longer tail — the recovery isn’t one that happens quickly over one quarter but over two-three quarters.
    • The pipe is different from the Swoosh because in the latter the economy bears the pain for longer.
    • A Z–shaped recovery is when a post-lockdown spending surge is so fierce that growth is lifted above the trendline and then after a party settles down to trend. The Z-shaped recovery is the most-optimistic scenario in which the economy quickly rises like a phoenix after a crash.
    • A U-shaped recovery — resembling a bathtub — is a scenario in which the economy, after falling, struggles and muddles around a low growth rate for some time, before rising gradually to usual levels.
    • A W-shaped recovery is a dangerous creature — growth falls and rises, but falls again before recovering yet again, thus forming a W-like chart. The double-dip depicted by a W-shaped recovery is what some economists are predicting if the second wave of COVID comes along and the initial rebound flatters to deceive.
    • The L-shaped recovery is the worst-case scenario, in which growth after falling, stagnates at low levels and does not recover for a long, long time.
    • Then, there is the J-shaped recovery, a somewhat unrealistic scenario, in which growth rises sharply from the lows much higher than the trend-line and stays there.
    • There is also the Swoosh shaped recovery, similar to the Nike logo — in between the V-shape and the U-shape. Here, after falling, growth starts recovering quickly but then, slowed down by obstacles, moves gradually back to the trend-line.
    • Finally, say hello to the Inverted square root shaped In this, there could a rebound from the bottom, the growth slows and settles a step-down.

    Why is it important for India?

    • The Indian economy was slowing down even before COVID hit, and the trouble has now been amplified manifold because of the lockdowns.
    • Experts predict a fall of up to 5 per cent in the GDP in FY-21.
    • This is clearly a crisis situation, and our getting out of the hole will depend a great deal on the shape of the economic recovery that will hopefully follow.
    • A Z- or at least V-shaped recovery would be the most preferable. If not, we should at least have a U-shaped recovery or a Swoosh to get back on our feet in a couple of years.
    • A W-shape will bring in much pain before the eventual gain, while an L-shape or the Inverted-square root will make a wreck of the growth train.

  • Tax Avoidance: case study on Flipkart deal

    Through this story, we will explore how investment fund companies exploit the tax agreements between the two countries. This story involves the famous case of investment by Walmart in Flipkart. So, let’s see what was involved in the case and what argument was made by the investment fund involved in the case.

    Tax avoidance

    Tax avoidance is the use of legal methods to minimize the amount of income tax owed by an individual or a business. This is generally accomplished by claiming as many deductions and credits as is allowable. It may also be achieved by prioritizing investments that have tax advantages, such as buying municipal bonds.

    First, let’s understand why Mauritius is favourite among investors?

    • Mauritius and India do have a tax treaty to start with.
    • Suppose an investment company based out of (why not based in?) Mauritius made a lot of money selling shares of an Indian company.
    • Now, Indian authorities won’t tax the gains you made via the transaction.
    • Instead, you’ll be taxed in Mauritius.
    • But since Mauritius does not tax capital gains, you get away without paying capital gain tax.
    • So you got the answer to why Mauritius.
    • Obviously, foreign corporations lapped up this opportunity until 2016 — when the government finally decided to plug the gaps.
    • They made amendments to the treaty.

    The story of Tiger Global’s investment into Flipkart

    • Tiger Global was one of the earliest investors in Flipkart.
    • They held 22% of the company until 2018 when they sold about 17% to Walmart’s Luxembourg entity FIT Holdings.
    • This transaction was valued at over INR 14,500 Cr.
    • But Tiger Global had made its investments through funds based out of Mauritius.
    • Since Tiger Global had made most of its investments during the first half of the decade (obviously before 2016).
    • So the amendment to the treaty wasn’t really applicable to them.
    • So when they made all that money selling their stake in Flipkart, they figured they wouldn’t have to pay any tax.
    • And at first sight, this argument seems legit.

    Let’s dig deeper into the case by going through 3 arguments

    • The funds were operating out of Mauritius.
    • The directors were discharging their duties in Mauritius.
    • All in all, everything was firmly placed in Mauritius.
    • But if you peel back the layers, you’ll see that these funds are ultimately owned by Tiger Global Management LLC, USA — albeit through a maze of holding companies.
    • So, the tax authorities argued that Tiger Global had in fact set up the Mauritius based entity for the sole purpose of avoiding taxes.
    • And therefore contested that they shouldn’t be exempt from paying tax on gains they made through the Flipkart Transaction.
    • Tiger Global, miffed with the taxmen, took the matter to a quasi-judicial body — The Authority for Advance Rulings (AAR).

    And the case begins.

    Let’s look into three arguments.

    1. Focus on transaction, not on the entity that involved in the transaction

    • Tiger Global investment fund counsel had the following argument to make:
    • “It must be proven that the transaction [the final sale of shares] itself was designed to avoid taxes.”
    • And proving that the structure of the entity undertaking the transaction was designed for the avoidance of income-tax should not be necessary here.
    • So, the Revenue (the Income Tax Department) had failed to discharge its burden of proof. But AAR didn’t agree with this argument.

    2. So, what’s AAR’s argument?

    • AAR said that you don’t just compute taxes by looking at the final transaction.
    • Instead, you look at the transaction as a whole —When were the shares bought? What was the purchase price? What happened in between? Who’s the primary executioner? What’s the appreciation in value? You look at everything.
    • More importantly, the “head and brains” executing the transaction resided elsewhere.
    • Tax authorities had shown rather conclusively that a certain Mr. Charles P. Coleman (operating out of a U.S based entity) was the beneficial owner of the fund.
    • And that “he” was primarily responsible for most management decisions.
    • So the AAR hit back with the following observation:

    In our opinion, it is not the holding structure only that would be relevant. The holding structure coupled with prima facie management and control of the holding structure, including the management and control of the applicants, would be relevant factors for determining the design for avoidance of tax. The applicant companies were only a “see-through entity” to avail the benefits of India-Mauritius DTAA [Double Taxation Avoidance Agreements]

    But wait… what about the past judgements?

    • Tiger Global had another weapon in its arsenal — Past judgements on the matter.
    • Specifically, a particular ruling in the case of Moody’s Analytics Inc.
    • AAR in this case conceded that capital gains accruing to a Mauritius based entity from the transfer of shares of an Indian company shouldn’t ideally be taxed.

    3. Flipkart is a Singaporean company. So, pay the taxes!

    • The AAR said that “In this particular case, gains were made by transferring shares of a Singaporean company. Not an Indian company.”
    • That’s right. Flipkart is based out of Singapore.
    • Flipkart Singapore is the strategic shareholder of Flipkart India.
    • Flipkart India is the entity that owns most of the capital assets.
    • The shares that were sold to Walmart — that’s Flipkart Singapore, not Flipkart India.
    • But the India-Mauritius tax treaty agreement is only applicable to the transfer of shares of Indian companies.

    Is Flipkart Indian?

    Consider the question “Examine the basis used by the Authority for Advance Rulings (AAR) that led it to rule in favour of tax authorities.”

    Conclusion

    AAR concluded that there was no doubt that Tiger Global had set up the Mauritius based entity to avoid paying taxes and therefore should be liable to pay what the Income Tax authorities deem fit.

    Back2Basics: Vodafone tax

    Can India tax the gains made by selling the shares of Singaporean company?

    • According to Section 9(1)(i), (popularly known as the Vodafone tax), any income accruing or arising, whether directly or indirectly (through multiple layers), inter-alia, through the transfer of a capital asset situated in India, shall be deemed to accrue or arise in India.”
    • So Indian tax laws are pretty clear about where the gains ought to be taxed.
    • But the India-Mauritius treaty doesn’t say anything about this matter.
    • That’s why the AAR ruled the way it did.

  • Explained: Gross Value Added (GVA) Method

    The National Statistical Office (NSO) recently released its provisional estimates of national income for the financial year 2019-20. The release also detailed the estimates of the Gross Value Added (GVA).

    Try this question from CSP 2011:

    Q. In the context of Indian economy, consider the following statements

    1. The growth rate of GDP has steadily increased in the last five years.

    2. The growth rate in per capita income has steadily increased in the last five years.

    Which of the statements given above is/are correct?

    (a.) 1 only

    (b.) 2 only

    (c.) Both 1 and 2

    (d.) Neither 1 nor 2

    The GVA method

    • In 2015, in the wake of a comprehensive review of its approach to GDP measurement, India opted to make major changes to its compilation of national accounts.
    • It aims to bring the whole process into conformity with the UN System of National Accounts (SNA) of 2008.

    What is GVA?

    • As per the SNA, GVA is defined as the value of output minus the value of intermediate consumption.
    • GVA is a measure of the contribution to GDP made by an individual producer, industry or sector.
    • At its simplest, it gives the rupee value of goods and services produced in the economy after deducting the cost of inputs and raw materials used.
    • It can be described as the main entry on the income side of the nation’s accounting balance sheet, and from economics, perspective represents the supply side.

    How it has changed income calculation?

    • While India had been measuring GVA earlier, it had done so using ‘factor cost’.
    • GDP at ‘factor cost’ was the main parameter for measuring the country’s overall economic output until the new methodology was adopted.
    • GVA at basic prices became the primary measure of output across the economy’s various sectors and when added to net taxes on products amounts to the GDP.
    • In the new series, the base year was shifted to 2011-12 from the earlier 2004-05.

    GVA estimates by NSO

    • As part of the data on GVA, the NSO provides both quarterly and annual estimates of output — measured by the gross value added — by economic activity.
    • The sectoral classification provides data on eight broad categories that span the gamut of goods produced and services provided in the economy.
    • These are: 1) Agriculture, Forestry and Fishing; 2) Mining and Quarrying; 3) Manufacturing; 4) Electricity, Gas, Water Supply and other Utility Services; 5) Construction; 6) Trade, Hotels, Transport, Communication and Services related to Broadcasting; 7) Financial, Real Estate and Professional Services; 8) Public Administration, Defence and other Services.

    How relevant is the GVA data given that headline growth always refers to GDP?

    • The GVA data is crucial to understand how the various sectors of the real economy are performing.
    • The output or domestic product is essentially a measure of GVA combined with net taxes.
    • However, GDP can be and is also computed as the sum total of the various expenditures incurred in the economy.
    • It includes private consumption spending, government consumption spending and gross fixed capital formation or investment spending; these reflect essentially on the demand conditions in the economy.

    Significance of GVA

    • From a policymaker’s perspective, it is vital to have the GVA data to be able to make policy interventions, where needed.
    • Also, from global data standards and uniformity perspective, GVA is an integral and necessary parameter in measuring a nation’s economic performance.

    Issues with GVA

    • As with all economic statistics, the accuracy of GVA as a measure of overall national output is heavily dependent on the sourcing of data and the fidelity of the various data sources.
    • To that extent, GVA is as susceptible to vulnerabilities from the use of inappropriate or flawed methodologies as any other measure.
    • Economists argue that India’s switch of its base year to 2011-12 had led to a significant overestimation of growth.
    • They argued that the value-based approach instead of the earlier volume-based tack in GVA estimation had affected the measurement of the formal manufacturing sector and thus distorted the outcome.

  • The contours of economic recovery

    This article analyses the various aspects of the stimulus package announced by the government. It gives a broad idea about the borrowing and fiscal deficit of the government. Where the fiscal deficit should be spent? Which area the announced reforms should focus on? You’ll be able to answer these questions after reading the article.

    Contraction of the Indian economy

    •  Many analysts have recently predicted a contraction for the Indian economy.
    • Goldman Sachs/ICRA and Nomura, in their recent assessments, have forecasted India’s growth to contract by (-)5.0 per cent and (-)5.2 per cent, respectively.
    • Even the RBI assesses that growth in the current year may be in the negative zone although it has not given a specific number.
    • The World Bank has predicted growth in the range of 1.5 to 2.8 per cent.
    • In order to relate budgetary magnitudes to GDP, we also need an idea of the magnitude of nominal GDP growth.
    • In the current year, this is expected to be at least 4 per cent points less than the rate of growth at 10 per cent as assumed in the 2020-21 budget.

    Let’s clear the misunderstanding about the stimulus

    • One misunderstanding about the “stimulus” must also be cleared.
    • Any increase in government expenditure over and above the base level acts as stimulus.
    • This is the traditional Keynesian approach.
    • It made no distinction between different types of expenditures.
    • It is only later studies that made a distinction based on the size of fiscal multipliers.

    How much will be the gross borrowing and fiscal deficit?

    • The Centre has already announced an increase in gross borrowing for 2020-21 from INR 7.8 lakh crore to Rs. 12 lakh crore.
    • This may lead to a fiscal deficit of about 5.7 to 5.8 per cent of GDP.
    • This may only be enough to provide for the considerable shortfall in the budgeted tax and non-tax revenues and non-debt capital receipts, which is also being estimated by a number of analysts to be in the range of Rs 18 lakh crore, implying a shortfall of Rs 4.45 lakh crore.
    • This shortfall is 2.08 per cent of GDP.
    • The Centre’s fiscal deficit will have to be further increased to accommodate the additional burden on the 2020-21 budget arising on account of the stimulus package.

    Let’s divide stimulus package into budgetary and non-budgetary part

    • The series of measures announced by the FM are a mix of i) already budgeted expenditure,ii) additional expenditure, iii) extension of credit facility with government guarantee for certain select sectors and a host of reform measures.
    • Analytically, the overall stimulus package of Rs 20.97 lakh crore can be divided into a budgetary and a non-budgetary part.

    1) Non-budgetary part

    • The non-budgetary part, accounting for nearly 85 per cent of the overall package.
    • Non-budgetary part consists mainly of liquidity enhancing measures for banks and NBFCs which may facilitate the financial sector in playing a key role to kickstart the economy.
    • The credit guarantee provided by the government under the various schemes announced recently is of central importance in this context.
    • In fact, for certain schemes, the government has come forward to provide 100 per cent guarantee, which should quicken the pace of credit sanction and delivery by banks.
    • Production of goods and services is inter-related in an economic system.
    • Once production starts, different sectors will be mutually supporting since different industries and service providers are locked in an input-output system.

    2) Budgetary part and fiscal deficits

    • The budgetary part amounts only to about 15 per cent of the overall package.
    • This can be further divided into government expenditure which was already budgeted in the 2020-21 budget and expenditures constituting genuine additionality.
    • The genuine additionality component is only 10 per cent of the package equivalent to 1 per cent of GDP.
    • Adding this to the enhanced level of 5.7 per cent of GDP, the Centre’s fiscal deficit may be close to 6.7-7 per cent of GDP.
    • This will maintain the level of budgeted expenditure while providing for the additional cost of the announced fiscal stimulus.
    • In fact, the fiscal deficit will be even higher if the current year’s GDP is lower than that of the previous year.

    Composition of government expenditure matters

    • With this high fiscal deficit, the composition of government expenditure becomes critical.
    • Some of the establishment expenditures and subsidies, especially those linked to petroleum prices like fertiliser and petroleum subsidies, may be reduced.
    • While expenditure on health-related items may be increased.
    • The central government has announced freezing of increments of DA and dearness relief components in the case of salaries and pensions respectively.
    • In fact, the government should be doing much more to relieve the plight of migrant workers.

    What is budgetary contribution for infrastructure?

    • According to the National Infrastructure Pipeline, the Centre’s budgetary contribution to infrastructure is estimated at 1.25 per cent of GDP on an annual basis.
    • This is less than 18 per cent of the estimated fiscal deficit of the Centre in 2020-21, indicating a very poor quality of fiscal deficit.
    • One dimension of expenditure restructuring should be to frontload infrastructure spending, including that on health infrastructure
    • Which will be helpful in taking advantage of the higher multiplier effects associated with capital expenditures.
    • Investment augmentation is also demand supporting and employment and income generating.

    Support to demand

    • Support to demand will come not only from the Centre but also from the states and the public sector undertakings.
    • States have been allowed to borrow an additional 2 per cent of their respective GSDPs subject to certain conditions.
    • In fact, at the present juncture, these conditions are not required since the enhancement of the borrowing limit is for one time while the reforms linked to conditions are permanent in nature.
    • In any case, states should be encouraged to support demand by going up to the full extent of the enhanced limit.

    Why the monetisation of debt is unavoidable?

    •  The combined fiscal deficit of the Centre and states alone may amount to close to 12 per cent of GDP in 2020-21.
    • Besides, the total public sector borrowing also includes the borrowing by central and state public sector undertakings.
    • Thus, the total Public Sector Borrowing Requirement may well exceed available sources of financing consisting of i) the financial savings of the household sector, ii) savings of the public sector iii) net capital inflows.
    • In this context, monetising debt has become unavoidable.
    • The Centre must be forthcoming on these issues while recognising that extraordinary situations call for extraordinary solutions.

    Reforms should be sector-specific

    • In the case of reforms, we have reached a new stage.
    • General reforms cutting across industries and sectors have been critical in the early stages.
    • The earlier regime of controls and permits had to be brought to a close.
    • But now reforms have to focus on specific sectors.
    • Applying the general principles of liberalisation to sectors such as agriculture and, more particularly, agricultural marketing, power sector, and telecom have assumed importance.
    • Labour market reforms are needed across all the states.
    • But labour reforms are introduced better when the economy is in the upswing.
    • Consensus building is critical before introducing labour reforms.
    • Land markets need to be freed up consistent with the concerns of small and marginal farmers.

    Consider the question “The fiscal stimulus and the promise of reforms announced by the government would be instrumental in bringing the Indian economy devastated by the Covid-19 pandemic back on track. Comment.”

    Conclusion

    Fiscal deficit should be used to create infrastructure ensuring that the quality of fiscal deficit is not poor. At the same time, reforms announced should be sector-specific and consensus-based in case of labour laws.

    Back2Basics: AT&C losses

    • Distribution loss consists of two parts: a. Technical loss and b. Commercial loss.
    • It is also called AT&C loss.
    • AT&C loss is nothing but the sum total of technical and commercial losses and shortage due to non-realization of billed amount.
    • AT&C Loss = (Energy input – Energy billed) * 100 / Energy input.

  • Moody’s downgrade India’s Ratings

    The Moody’s Investors Service downgraded the Government of India’s foreign-currency and local-currency long-term issuer ratings to “Baa3” from “Baa2”. It stated that the outlook remained “negative”.

    Practice question for mains:

    Q. Why India’s GDP growth rate is being labelled an overestimate yet again by the global credit rating agencies? Discuss this in context to the latest downgrade of Indian Economy as highlighted by the Moody’s.

    Why this matters?

    • The Moody’s is historically the most optimistic rating agency about India.
    • This downgrade challenges India’s policymaking institutions.
    • They will be challenged in enacting and implementing policies which effectively mitigate the risks of a sustained period of relatively low growth.

    What is the reason for this downgrade?

    There are four main reasons why Moody’s has taken the decision:

    • Weak implementation of economic reforms since 2017
    • Relatively low economic growth over a sustained period
    • A significant deterioration in the fiscal position of governments (central and state)
    • And the rising stress in India’s financial sector

    What does “negative” outlook mean?

    • The negative outlook reflects dominant, mutually-reinforcing, downside risks from deeper stresses in the economy and financial system.
    • These could lead to more severe and prolonged erosion in fiscal strength than Moody’s current projections.
    • The ratings have highlighted persistent structural challenges to fast economic growth such as “weak infrastructure, rigidities in labour, land and product markets, and rising financial sector risks”.
    • In other words, a “negative” implies India could be rated down further.

    Is the downgrade because of Covid-19 impact?

    No. The pandemic has amplified vulnerabilities in India’s credit profile that were present and building prior to the shock, and which motivated the assignment of a negative outlook last year.

    Then why did the downgrade happen?

    • More than two years ago, in November 2017, Moody’s had upgraded India’s rating to “Baa2” with a “stable” outlook.
    • At that time, it expected that effective implementation of key reforms would strengthen the sovereign’s credit profile through gradual but persistent measures.
    • But those hopes were belied. Since that upgrade in 2017, implementation of reforms has been relatively weak and has not resulted in material credit improvements, indicating limited policy effectiveness.
    • Each year, the central government has failed to meet its fiscal deficit (essentially the total borrowings from the market) target.
    • This has led to a steady accretion of total government debt.

    What will be the implications of this downgrade?

    • Ratings are based on the overall health of the economy and the state of government finances.
    • When India’s sovereign rating is downgraded, it becomes costlier for the Indian government as well as all Indian companies to raise funds because now the world sees such debt as a riskier proposition.
    • A rating downgrade means that bonds issued by the Indian governments are now “riskier” than before.
    • The weaker economic growth and worsening fiscal health undermine a government’s ability to pay back.
    • Lower risk is better because it allows governments and companies of that country to raise debts at a lower rate of interest.

  • Problem of interest rate differential in India

    Do you remember Operation Twist by the RBI? what was being twisted there? It was the yield curve that was sought to be twisted. It had been aimed at reducing the gap between long term interest rates and short term policy rates. This article explains the impact such gap could have on the economy.

    Why long term loans come with a higher interest rate?

    • Long term loans equate to long repayment periods.
    • More uncertainty during these long periods can translate to higher risks.
    • And to compensate for the high risks involved, banks quote higher interest rates when corporates borrow from them to build and operate stuff.
    • However, when banks borrow from the RBI they are borrowing over short intervals.
    • And so they get charged lower interest rates.

    So, why banks are keeping interest rates high despite borrowing at low rates from the RBI?

    • Ever so often, the RBI cuts rates in the hopes of making loans more accessible to banks.
    • They are hoping banks will also extend this benevolence to their customers by cutting long term interest rates.
    • But right now, banks are scared.
    • They don’t think the corporates can pay back.
    • So they are keeping long term rates at elevated levels despite borrowing at consistently low rates from the RBI.

    What happens when gap between long-term and short term interest rates widen?

    •  Capital wasn’t cheap to begin with for corporate borrowers, and it’s getting more expensive.
    • This comes just as migrant rural workers have been driven out of urban production centers because of shuttered factories.
    • Even if this labor is safely put back on, say, road construction, concessionaires [think private road contractors] might still go bankrupt before completing any projects.
    • That’s because their annuity payments from the government are linked to falling short-term policy rates, whereas their long-term borrowing costs are both high and sticky

    To understand the issue of annuity payment and its relation with interest rates, let’s dig deeper into 3 types of models-

    1. Build-Operate-Transfer (BOT) Model

    • So, NHAI is the National Highways Authority of India and is largely responsible for building and maintaining roads.
    • Its preferred method to get the job done is to deploy what is called the BOT model.
    • The Build-Operate-Transfer (BOT) model, as the name suggests is a way for NHAI to offload its responsibilities of road building to private contractors.
    • Under BOT model, private contractors build the road, operate it, make money off of collecting toll, and after about 10–15 years, they hand over the road back to NHAI.
    • There aren’t enough private contractors willing to bid for such projects because — hey, maintaining and operating a road is a pain.
    • Why pain?  You have to wait 15 years to recoup all the money you had to pour in to build the damn thing. That’s the pain.

    2. Engineering, procurement and Construction (EPC) model

    • Under the EPC (Engineering, Procurement & Construction) model, NHAI pays private contractors first, so that they can help NHAI build the road.
    • The contractor does not operate or collect tolls here.
    • Instead, it can walk away scot-free with money in its coffers once it’s done building the road.
    • But it’s hard for the government to shore up all the resources required upfront.

    3. Hybrid Annuity Model (HAM)- The middle path

    •  It’s a nice little mix of both EPC and BOT.
    • Under it, NHAI pays some money upfront in fixed installments usually, 40% of the project cost.
    • And the private contractor does his bit by putting up the rest and finishing the project.
    • However, once the construction is complete, the contractor does not make money off of collecting toll.
    • Instead, he transfers the assets over to NHAI.
    • So its incumbent on the government to pay the rest of the money once the project takes off.
    • And the payments are dependent on the asset created, the performance of the developer, and a few other things.
    • However, since the payouts usually last 15–20 years we need to find a way to determine what kind of money the government pays the contractor every 6 months.
    • And here’s the best way to think about this — So when the government pays the 40% upfront, it’s promising to pay the 60% sometime in the future.
    • It’s money they owe the contractor.

    And, here is the crux of the matter

    • So when the repayments, are made, they’ll have to pay the principal and the interest.
    • The interest involves a fixed component (3%) and a variable component.
    • What is varible component? The variable component is effectively the short term policy rates.
    • So if the RBI keeps cutting these short term rates, private contractors get less money per instalment even if their roads are all nice and shiny.
    • And this can’t bode well for them because they probably put up the 60% back in the day by borrowing from another bank.
    • A bank that’s charging them long term interest rates that refuse to come down.

    Conclusion

    The widening gap between the short term policy rates and long term interest could easily spell the disaster for the entrepreneurs and in turn for the economy as a whole. The government should consider a special package for such entities given the unprecedented situations we found ourselves in.

  • Using COVID crisis to reorient India towards reforms

    Following the announcement of relief and stimulus package, the debate began over its various aspects. This article assesses the various aspects of the package and draws comparison with the package announced by the other countries. So, how does India fare compared with other countries?

    Fiscal component of  stimulus package

    • According to the IMF-PT (policy tracker), the fiscal component of the Indian package is estimated to be at least 3.5 per cent of GDP as expenditure for poor households, migrant workers and agriculture.
    • There is an additional 0.5 per cent of GDP for states to spend unconditionally, bringing the fiscal package excluding loans to businesses to at least 4 per cent of GDP.
    • The support for businesses (MSMEs) is estimated to be 2.7 per cent of GDP.
    • Of this, at least 2 per cent of GDP is in the form of 100 per cent credit guarantees and equity infusion.

    Comparison with major emerging economies

    • Among major developing economies, only Brazil -8 per cent of GDP– and Peru -7 per cent of GDP– have a fiscal stimulus higher than the 5 per cent level for India.
    • The Brazil estimate includes about 3 per cent of GDP as working capital loans to businesses and households.
    • The fiscal support level for some important emerging economies is — China 2.5 per cent of GDP and Indonesia 3.5 per cent.

    Why it is difficult to segregate the stimulus package?

    • While comparing the fiscal stimulus packages across countries, it is important to understand that such packages are in the nature of additional spending and tax reliefs.
    • Which can work directly through aggregate demand or indirectly by mitigating risk and enhancing access to fund.
    • Access to fund is ensured in the nature of credit guarantees to financial institutions and non-financial enterprises
    • A large number of fiscal stimulus packages announced by different countries contain credit guarantees to financial institutions, SMEs, and agriculture.
    • Hence, it is difficult to segregate fiscal stimulus into its pure and impure components.
    • Most economists, and international organisations, recognise that fiscal stimulus consists of both the pure and impure.
    • And includes three broad items — a direct “above-the-line” component, a “below-the-line” component and guarantees of various forms primarily credit.
    • The choice of using only one component of the fiscal stimulus is selective and highly inappropriate.

    India as a positive fiscal stimulus outlier

    • To put the packages into perspective, the average of all fiscal measures in the G24 developing economies is equal to 3.6 per cent.
    • No matter how the calculation is done, India is a positive fiscal stimulus outlier; by IMF-PT calculations.
    • The stimulus is close to the largest among major emerging market economies.

    So, how much rich countries are spending?

    • The rich nations are spending more — they can afford to. Japan announced what may be the upper limit to the expansion — 21.1 per cent of GDP.
    • However, this does include large elements of loans and credit guarantees.
    • Through a combination of several fiscal measures (tax deferrals, credit guarantees, etc.) the US has pledged close to 13 per cent of GDP.
    • The European Union, on average, has pledged 4 per cent of GDP.
    • The average for advanced countries is around 6 per cent of GDP.

    Significance of monetary policy change made by RBI

    • The monetary policy change in India is quite significant.
    • The change paves the way for internationally competitive monetary policy.
    •  That is, real interest rates comparable to those prevalent in competitor economies.
    • The repo rate now stands at 4 per cent, with inflation well contained.
    • This is substantially a much different, and much-improved RBI response than that what occurred in 2008-09.
    • At that time, as a monetary counter to the financial crisis, the RBI reduced the repo rate by 425 basis points to 4.75 per cent.
    • This was done over seven months and the prevailing CPI inflation rate was 10 per cent.

    Economic reforms as a part of stimulus package

    • India has announced several economic reforms as a part of the stimulus package.
    • These are long-awaited — freeing up of the labour market, allowing farmers to sell their produce and land to who they choose, removal of archaic laws like the Essential Commodities Act, with the promise of more to come.
    • This is not an empty promise — the Centre will advance another 1.5 per cent of GDP to states to expand spending.
    • This advance will be conditional on them for undertaking long-pending reforms.
    • The Indian fiscal package is reformist, well-disciplined and provides focused support; and if needed, there is still room for additional measures.

    Conclusion

    The Indian fiscal package is reformist, well-disciplined and provides focused support; and if needed, there is still room for additional measures. We should use the crisis to re-orient India towards its long-awaited destiny.

  • Understanding the monetisation of deficit

    The RBI could finance the government debt by buying bonds from the secondary market. Or it could directly finance the debt. And both could stoke inflation. But, do they carry the same inflation risk. The answer is an unambiguous ‘No’. So, how monetisation of debt is different from Open Market Operation by the RBI? Read the article to know…

    What is Monetised deficit?

    • The Monetised Deficit is the extent to which the RBI helps the central government in its borrowing programme.
    • In other words, monetised deficit means the increase in the net RBI credit to the central government, such that the monetary needs of the government could be met easily.

    What monetisation of deficit mean (and doesn’t mean)

    • 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.

    So, is the RBI monetising the debt?

    • It is not as if the RBI is not monetising the deficit now; it is doing so.
    • It is doing so 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.

    Historical context of the monetisation of debt: An agreement

    • 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.
    • So, the RBI uses OMO as liquidity instrument to manage the balance between the policy objectives of supporting growth, checking inflation and preserving financial stability.

    So, what were the outcomes of the agreement?

    • The outcomes of that agreement were historic.
    • Since the government started borrowing in the open market, interest rates went up.
    • HIgh interest rates 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.

    What is the reasoning for jeopardising the hard-won gains of agreement?

    • The Fiscal Responsibility and Budget Management Act as amended in 2017 contains an escape clause.
    • Escape clause permits monetisation of the deficit under special circumstances.
    • What is the case for invoking this escape clause?
    • 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.

    No, the situation is not so grim-Look at the bond yields

    • There is no reason to believe that we are anywhere close to the above-mentioned 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.

    Why worry about monetisation if OMO also leads to inflation?

    The following four issues make clear the difference in OMO and monetisation

    1. Issue of RBI’s control over monetary policy

    • 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.

    2. Credibility of RBI on curbing inflation

    • 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 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.

    3. Yield on bond could shoot up anyway

    • If, in spite of above problems, the government decides to cross the line, markets will fear that the constraints on fiscal policy are being abandoned.
    • Perception in the market will be 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.

    4. Monetisation is not inevitable yet

    • 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.

    Consider the question asked in 2019, “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 argument.”

    Conclusion

    Though OMO and monetisation both leads to inflation, the issues with monetisation have far-reaching consequences. Also, the situation we are in doesn’t yet warrant monetisation which should be seen as a last resort.

    Back2Basics:  Open Market operation

    • OMOs are conducted by the RBI by way of sale and purchase of G-Secs to and from the market with an objective to adjust the rupee liquidity conditions in the market on a durable basis.
    • When the RBI feels that there is excess liquidity in the market, it resorts to sale of securities thereby sucking out the rupee liquidity.
    • Similarly, when the liquidity conditions are tight, RBI may buy securities from the market, thereby releasing liquidity into the market.