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GS Paper: Indian Economy

  • Ease legal constraints on fiscal expenditure

    The article discusses the two legal provisions that need to be changed in order to provide a fiscal stimulus of the size that could save the economy from collapse. Other major concern after the package would be the inflationary pressure resulting from government spending.

    The urgency of the fiscal package by the Centre

    • The longer the Centre dithers over a big-bang fiscal package to counter the adverse economic fallout of covid-19, the closer it risks pushing India’s economy to the precipice of disaster.
    • The nationwide lockdown has more or less paralysed commercial activity, our exit path looks dreadfully long-winded, and the distress being seen right now could just be an early sign of what is to come.
    • The suffering of citizens will likely expand once the shutdown’s second-order effects, which operate with a lag, begin to kick in.
    • Estimates of ₹10 trillion needed by way of fiscal relief, once seen as too much by some, could yet turn out to be too little.
    • Either way, preparatory work in terms of legal enablers should be done alongside the arithmetic

    Legal constraints in the way of the stimulus programme

    • There are two major constraints that we need to be relieved of—if only temporarily—for a stimulus programme to take shape.
    • The first is the Fiscal Responsibility and Budget Management (FRBM) Act of 2003.
    • And the second is the amendment done in 2016 of the Reserve Bank of India Act to give legislative cover to a flexible inflation-targeting framework that set our central bank the task of keeping India’s retail price index within a certain band.
    • Both of these were aimed at long-term economic stability but made no allowance for a robust fiscal response to the kind of crisis we now face.
    • It would be best if these were tweaked appropriately by a special session of Parliament.
    • If not, then ordinances should be issued to suspend specific restrictions for a while.

    Projections of fiscal deficit

    • Under the budget presented in February, the Centre’s fiscal deficit for 2020-21 was projected at 3.5% of gross domestic product (GDP).
    • This included a half percentage point deviation from the FRBM glide path allowed by the law’s contingency clause.
    • Total expenditure was placed at a little over ₹30.4 trillion, and receipts at ₹22.4 trillion-plus.
    • With tax revenues and asset-sale realizations expected to fall short, the fiscal gap could widen to about ₹10 trillion even without any extra spending.
    • Drastic cuts in expenditure could save some money, but even if a heavy axe is wielded on expenses, the government’s deficit this year would have to exceed twice the legal limit for a stimulus that saves the economy from collapse.
    • If this turns out to be a year of negative growth, as some fear, effecting a revival will only get harder.
    • For pre-emptive action, the government should use its parliamentary clout to permit a limitless deficit for 2020-21.

    A question based on the limits placed by the FRBM Act and the changes brought by the amendment to the RBI Act which mandated RBI with managing the inflation could be asked by the UPSC.

    Prospects of inflationary pressure and RBI’s mandate

    • An effort to spend our way out of an economic morass could prove inflationary if too much cash ends up chasing too few goods and services.
    • As we have undergone both demand and supply shocks, opinion is divided on whether prices will go haywire.
    • This risk would depend on how much cash gets pumped around at what point in time and the pace at which supplies are restored.
    • In other words, the inflation outlook is highly uncertain.
    • But should prices threaten to rise, it would be counterproductive of the central bank to tamp them down by tightening credit.
    • As of now, RBI’s mandate is to keep inflation at 4%, with a tolerance band of 2% on either side.
    • This target is valid till March 2021, but needs to be reviewed right away to let the central bank focus on growth.
    • The acceptable range could be widened and the time limit to achieve the goal lengthened as a special reprieve.

    Conclusion

    A few tweaks of the law must go alongside calculations of a stimulus package designed to relieve economic distress. The government should act on these quickly to save the day.

  • Recovery from COVID-19 is an opportunity to create economies that are more resilient and fair

    This article discusses the three principles which could form the basis for recreation of the economy devastated by the Covid-19. The first is adopting the economies of “scope” instead of economies of scale. The second is about governance and focus on bottom-up approach. And third is about empowering the people.

    Impact of Covid-19 on the ideology of globalisation

    • The history of the globalisation has turned out to be very brief.
    • In 2020, the global COVID-19 pandemic has forced millions of Indians to return to their villages.
    • Jetsetters have been locked in their gated communities.
    • Global supply chains have been broken apart.
    • People are scrambling for essentials from local suppliers.
    • The ideology of globalisation has hit realities on the ground.

    Recovery from COVID-19 is an opportunity to create economies that are more resilient and fair. The following three architectural principles must apply.

    1. Replace economies of scale by the economies of scope

    • COVID-19 has settled, for now, the debate between free-trade evangelists and advocates of industrial policy.
    • The vulnerability of global supply chains: A complex global economy in which local producers obtain scale (and lower costs) by supplying products for global markets is vulnerable to shutdowns anywhere.
    • The resilience of local economies: Local economies that have a variety of capabilities within them, albeit on smaller scales, are more resilient.
    • Therefore, local economic webs must be strengthened, in preference to global supply-chains.
    • “Make in India,” which was dismissed by free traders as a reversion to pre-1991 economic policies, has become a necessity.
    • Make in India is necessary to maintain supplies of essentials and to create employment for the hundreds of millions of Indians with fragile incomes who have been badly shaken by the lock-down of the Indian economy.

    2. Local systems solution to global problems

    • Local systems solutions are essential for global systemic problems.
    • Privatisation: Garrett Hardin had coined the expression, “The Tragedy of the Commons”, in 1968.
    • The Tragedy of the Commons is a term for the proposition that a resource that belongs to everybody will not be cared for by anybody.
    • This supported policies to privatise public property, ostensibly for the benefit of everybody and became the dominant school of economics from the 1970s onwards.
    • A different explanation: Elinor Ostrom, who was awarded the Nobel Prize for economics in offered a different explanation for the tragedy of the commons.
    • She argued that common resources are well-managed when those who benefit from such resources the most are in close proximity to them.
    • For her, the tragedy occurred when external groups exerted their power (politically, economically or socially) to gain a personal advantage.
    • Bottom-up approach: She was greatly supportive of the “bottom-up” approach to issues: Government intervention could not be effective unless supported by individuals and communities.
    • The world is facing challenges of ecological sustainability and persistent inequalities, which seem to get worse with the prevailing paradigm of economic growth.
    • These challenges are described in the 17 Sustainable Development Goals (SDGs).
    • They cut across national boundaries.
    • They also span several domains of expertise and institutional mandates.
    • The final, 17th goal states the principle by which all the goals will be achieved — “partnerships”.

    Actions theory Vs. Systems thinking

    • Action theory: The prevalent action theory, used by governments, businesses and philanthropic organisations to solve complex problems, focuses on breaking complex problems into components and then tackling the components in separate silos.
    • Problems caused by the actions theory: This widely prevalent theory of action has contributed greatly to causing the systemic, interconnected problems the SDGs now aim to address.
    • What is systems thinking: Effective action to address multiple challenges together requires “systems thinking” — that is, a systemic vision spanning across the problems.
    • Systems thinking is essential, amongst experts at the top and amongst partners on the ground.
    • Several organisations are promoting collaborative action with systems thinking on the ground in India.
    • Kudumbashree in Kerala has proven the power of community action.
    • The Foundation for Ecological Security, guided by Elinor Ostrom’s ideas, is working in many Indian states.
    • Dainik Bhaskar is promoting “SDG chaupals” in Indian villages.

    3.  Empowering the people

    • The third principle for the new economy is, empower the people, the fundamental requirement for genuine democracy.
    • India’s Constitution seeks self-governance in India’s towns and villages.
    • These are not being implemented by governments and policy experts who do not want to give up power to the people.
    • India lives in its villages, Mahatma Gandhi had said. Most of India still does.
    • And many, who had migrated to cities looking for jobs, are returning, shaken by the pandemic.
    • Gandhi was a systems thinker. For Gandhi, the global village was an abstract concept.
    • This cannot be realised until local villages and towns become harmonious communities, where people live in harmony with each other and with nature around them.

    The corona crisis has laid bare some of the problems associated with globalisation. It has forced a rethink of the economic policies and model adopted by the world. Against this backdrop, a question can be asked by the UPSC that demands the analysis of problems that have surfaced and solutions. For ex. “Covid-19 pandemic has brought into a sharp focus some inherent problems associated with the globalisation. In this context suggest the ways to make the Indian economy resilient to such shocks and fair to all the sections of society”

    Conclusion

    COVID-19 marks the end of the economics’ paradigm of the Washington Consensus. New models of economies, and new rules of global governance, must be bottom-up, not top-down. That’s how the whole world can move from relief, to recovery, and into resilience.

    Back2Basics: What was the Washington Consensus?

    • The Washington Consensus refers to a set of free-market economic policies supported by prominent financial institutions such as the International Monetary Fund, the World Bank, and the U.S. Treasury.
    • A British economist named John Williamson coined the term Washington Consensus in 1989.
    • The ideas were intended to help developing countries that faced economic crises.
    • In summary, The Washington Consensus recommended structural reforms that increased the role of market forces in exchange for immediate financial help.
    • Some examples include free-floating exchange rates and free trade.

  • It will take fiscal boldness now to relieve financial distress

    The article discusses the fiscal response of the government to deal with the corona crisis. Fiscal response to the 2008 financial crisis was higher in terms of GDP percentage. Also, a comparison with emerging peer economic indicates that India might be running the tighter fiscal policy in the time of crisis. The article suggests higher spending by going beyond the traditional fiscal space.

    A possible explanation for moderate fiscal response by the government

    • The Indian government has till now come up with an insipid fiscal response to the ongoing economic crisis.
    • Long battle: One view is that the government does not want to fire all its bullets in what threatens to be a long battle. It wants to time its interventions.
    • Weak public finances: The other possible explanation for this fiscal timidity is that India has entered this crisis with weak public finances.

    Comparison with finances at the 2008 financial crisis

    • The combined official fiscal deficit of the Union plus state governments was at its lowest level in many decades.
    • The economic boom of the preceding four years had led to higher tax collections pouring into the treasury.
    • The massive increase in spending announced in the budget of February 2008 was with an eye on the national election scheduled a year later, rather than in anticipation of a coming storm.
    • Then followed the second wave of fiscal expansion after the North Atlantic financial crisis hit Indian shores seven months later.
    • Back then, India’s effective fiscal stimulus over two years was a substantial 4.3% of gross domestic product (GDP).
    • In 2020, the crisis-driven spending plan announced by the government so far is less than 1% of GDP.
    • There could yet be a big fiscal push in the coming days.

    Tighter fiscal policy in crisis compared to other emerging economies

    • Some of the budget estimates released a few days ago by the International Monetary Fund are telling.
    • In 2018, the total fiscal deficit of the Indian government as a proportion of GDP was 2.4 percentage points higher than the average for Asian emerging markets.
    • India is expected to end 2020 with a total fiscal deficit that will be 2.5 percentage points lower than Asia’s average.
    • In other words, India ran a looser fiscal policy compared to the rest of Asia in normal times, but is likely to run a tighter fiscal policy than its regional peers in a crisis year.
    • Something similar can be seen in estimates for public debt.
    • Asian public debt as a proportion of GDP is expected to go up by nine percentage points in 2020.
    • The comparable figure for India is 2.9 percentage points. (These estimates are being cited with full knowledge that forecasting models break down during extreme events.)

    Funding extra expenditure through money creation

    • Lack of traditional fiscal space should not hold the government back in a crisis situation.
    • There are many options outside the consensus macro playbook.
    • Money creation: A commonly cited option right now is funding extra expenditure through money creation rather than borrowing.
    • The size of the Reserve Bank of India (RBI) balance sheet as a percentage of nominal GDP is close to its 35-year average.
    • There is scope for printing more money right now.
    • Lower inflationary pressure: And the inflationary consequences are likely to be muted because of the lower velocity of money amid a demand collapse.
    • Public finances in the future: Getting public finances back on track is a battle that lies in the future.
    • A rapid recovery in economic activity would be the best solution.
    • Otherwise, history tells us that countries have brought down their public debt numbers through some combination of financial repression, austerity, higher taxes and inflation.
    • Some element of capital controls could also be back in play.

    Need for increasing discretionary government spending

    • The collapse in tax revenues as the economy is shut down will automatically lead to a rise in India’s fiscal deficit.
    • However, there is a need for an increase in discretionary government spending as well.
    • Economists have shown that spending multipliers are higher than tax multipliers in India.
    • In other words, the increase in economic output for every unit increase in the fiscal deficit is higher when the government spends rather than changes tax rates.
    • State’s spending Vs. Union spending: Spending by states gives more bang for the buck than equivalent spending by the Union government.

    “Below the line measures” to support the economy

    • Also, there are options other than direct spending to support the economy.
    • Countries such as Germany, the UK, Italy, France and South Korea have complemented traditional fiscal expansions with “below the line” measures such as loans and guarantees to companies.
    • In an excellent recent study, analysts estimate that more than half of Indian corporate balances sheets will be unable to meet expenses with zero revenues.
    • They are careful to point out that their analysis is based on extreme assumptions that there is no fall in their wage bills, no revenues, and no access to fresh credit.

    One of the common suggestions we have been coming across is the spending by the government by printing money. In this article, the second important suggestion is below the line measures. Take note of these measures and options available with the government.

    Way forward

    • The poor need income support for their very survival. That should be at the top of any democratic government’s list of
    • However, protecting Indian companies from a financial collapse also matters, because otherwise, the economy will see a reduction in its capital stock, which will be needed both for a rapid recovery as well as job creation once the worst is over.
    • There are contagion risks in financial markets as well, going by what has happened to some mutual funds that were invested in bonds.

    Conclusion

    These are extraordinary times that require extraordinary measures. The danger from a delayed fiscal programme is that hysteresis may set in, as companies run out of money and supply chains are broken, damaging our economic prospects in the medium term.

     

     

  • RBI should preserve its inflation credibility

    This article by Urjit Patel elaborates on the recent actions of the RBI which are likely to result in making the role of MPC redundant. Some of the moves cited are injection of liquidity by the RBI and reduction of reverse repo rate by the RBI. Implications such actions could have for the macroeconomic stability are also discussed.

    Stimulus package after the 2008 financial crisis and problems created by it

    • Following the global financial crisis of 2007-08, India, like many other countries, embarked on a stimulus.
    • The pump-priming did not end too well.
    • Inflation and bad loans: By 2013, India crossed or approached double-digit figures in inflation and the national fiscal deficit, in addition to looming bad loans.
    • Taper tantrum: In summer 2013, when the Federal Reserve indicated a possible reversal of its ultra-accommodative policy, macroeconomic parameters for India were so weak that it got caught up in the “taper tantrum” and experienced external sector fragility.

    Inflation targeting and the role of MPC

    • While fiscal excesses and financial sector stress remain issues today, India has improved significantly on at least one dimension — namely, inflation — which has also stabilised the external sector.
    • How was this beneficial progress achieved?
    • Starting in September 2013, the Reserve Bank of India (RBI) initiated an effort to build credibility with domestic savers and international investors on maintaining inflation at prudent levels.
    • Three years thereafter, the RBI Act was amended to put in place a flexible inflation targeting framework.
    • A Monetary Policy Committee (MPC), comprising of RBI representatives and external members appointed by the Government of India, was enjoined with the legal mandate of managing the policy (repo) rate.
    • MPC was mandated to keep consumer price inflation at a target level of 4 per cent, while keeping in mind economic growth.

    Assessment of MPC’s performance

    • By objective measures, the MPC framework until recently worked rather well.
    • It lent transparency and democratic accountability to the process of interest-rate setting.
    • Combined with efforts on managing food inflation, it has brought inflation closer to the target.
    • It has contributed to tempering household inflation expectations.
    • It has kept borrowing costs in the economy at reasonable levels in spite of the high level of government borrowing and several other distortions.
    • Appreciation by the rating agencies: Indeed, rating agencies and multilateral institutions repeatedly mention the MPC and the inflation targeting framework as a landmark structural reform towards sound macroeconomic management.

    Latest monetary actions by RBI that reduced MPC’s role

    • Since last year, a series of monetary actions by the RBI have left the MPC’s decision on the policy rate partly redundant, diluted the accountable process of monetary decision-making.
    • This has put at stake the sanctity of the MPC framework.
    • With a stated intention to improve the transmission of monetary policy to households and corporations, the RBI has pumped unprecedented levels of money (close to Rs 7 trillion) into the banking system.
    • It has done so mostly by purchasing government bonds but partly also by purchasing dollars.
    • No desired results: Given impaired financial sector balance-sheets, transmission to economic growth has been at best muted; liquidity is no silver bullet to durably address financial sector stress.
    • The primary effect of excessive liquidity has, instead, been to monetise the government’s expenditures and keep its borrowing costs low.
    • With its declared aim not being met satisfactorily, the RBI has doubled down on liquidity supply, with the same outcome.
    • An important casualty has been the MPC framework.
    • Contradictory actions: At times, even when the MPC has kept the policy rate unchanged, the RBI has injected yet more liquidity to move medium-term interest rates down.
    • The two actions have been noted to be in direct contradiction of each other.
    • If the objective is to move medium-term rates, why not build consensus within the MPC to cut the policy rate more aggressively and communicate the rationale?
    • Change in reverse repo by the RBI: Further, given the enormous liquidity glut, every night banks park liquidity with the RBI at a (reverse repo) rate lower than the policy rate and which is not set by the MPC; nevertheless, this rate used to be changed only as part of the MPC Resolution.
    • Lately, the RBI has moved reverse repo rate progressively lower than the policy rate; recently.
    • It has done so outside of the MPC meeting cycle and not as part of the MPC Resolution.
    • There are straightforward tools in liquidity management to ensure that in surplus conditions also, the central bank transacts with banks at the policy rate — technically, by switching from “deficit” to “floor” system of liquidity management.
    • Such a switch is routinely adopted by central banks when they provide excess liquidity; the RBI has chosen not to do so.

    What are the implications?

    • The net effect is that market interest rates are being increasingly controlled by the RBI rather than the MPC.
    • Indeed, there is a proposal that the rate at which the RBI absorbs liquidity be still lower, likely divorced from the policy rate set by the MPC.
    • The spirit of the MPC framework enshrined in the RBI Act is being violated.
    • It is unclear how the MPC can be expected to satisfy its legal mandate if what it seeks to achieve via the setting of the policy rate is in conflict with, or compromised by, the RBI’s liquidity management.
    • These developments have the potential to pose risks for India’s macroeconomic stability going forward.
    • The implicit monetisation of fiscal expenditures through government bond purchases by the RBI in the secondary market has postponed the recognition of the untenable fiscal reality.
    • The delay has meant the government has had limited policy space since the onset of COVID.
    • Supply-chain disruptions due to measures taken to contain the pandemic raise the possibility of cost-push inflationary pressures, especially given the excessively easy fiscal and monetary conditions.
    • This can abruptly raise economy-wide borrowing rates, inflict losses on banks, and imperil financial stability.
    • If the gains in inflation credibility built by the MPC framework are dissipated by ineffective policies and operations, both household and investor expectations for inflation in India could unhinge.
    • Worse, it could instigate turmoil in the external sector.
    • Excessively low bank deposit rates may induce some non-resident deposits to exit the country.

    A question based on the issue of RBI’s action and its implication for MPC and overall economy can be asked by the UPSC, for ex- “The MPC framework has performed well in delivering on its mandate. Yet, there were some actions by the RBI recently which could be perceived as inimical to the functions of the MPC. Discuss.”

    Conclusion

    In a highly unpredictable time such as this, the RBI should preserve its inflation credibility. The decision on monetary policy actions based on voting by committee members, provision of inflation and growth forecasts in the resolution statement, and coordination of rate-setting and liquidity management, need to be adhered to.

    Back2Basics: What is MPC?

    • The Reserve Bank of India Act, 1934 (RBI Act) was amended by the Finance Act, 2016,  to provide for a statutory and institutionalised framework for a Monetary Policy Committee, for maintaining price stability, while keeping in mind the objective of growth.
    • The Monetary Policy Committee is entrusted with the task of fixing the benchmark policy rate (repo rate) required to contain inflation within the specified target level.
    • The meetings of the Monetary Policy Committee are held at least 4 times a year and it publishes its decisions after each such meeting.
    • As per the provisions of the RBI Act, out of the six Members of Monetary Policy Committee, three Members are from the RBI and the other three Members of MPC are appointed by the Central Government.
    • Governor of the RBI is ex officio Chairman of the committee.

  • East India will require heavy investment to tide over the post-Covid loss of livelihood

    The article discusses the issue of migrant labourers and the problems eastern states could face due to the return of labourers and the lack of employment opportunities in these states. The return of migrant labourers may lead to the mechanisation in the states where they worked. A relief-cum-stimulus package at least 5% of the GDP is suggested by the author.

    IMF’s projections for the economy

    • The IMF’s projections for GDP growth for this year seem to be either in the negative or below 2 per cent for almost all major countries of the G-20 group.
    • India could do a little better compared to the other BRICS nations, but its growth will most likely be below 2 per cent.
    • This, of course, is under an optimistic scenario.
    • Many experts reckon that India could also go into negative GDP growth this year if it does not reboot the economy properly and in time.

    The problem of collapse in demand

    • The Centre and the Reserve Bank of India are trying to remove all roadblocks so that factories and farms can resume operations.
    • The focus is largely on the supply side — how to ease restrictions and how to increase liquidity in the system for resuming production.
    • It may not take too long as the real problem is the collapse in demand.
    • And that demand may not pick up easily as the virus is likely to stay with us for quite some time.
    • We could have lockdowns again if there is a surge in infection.
    • This will surely limit our travel and restrict our shopping for non-essentials.
    • However, there is one demand that can easily revive — that of food.

    Why food demand matters?

    • The NSSO survey of consumption expenditures for 2011-12 revealed that about 45 per cent of the total expenditure of an Indian household is on food.
    • For the poor, the NSSO reckoned, this figure was about 60 per cent.
    • We do not have information about the consumption patterns in 2020, guess is that about 35-40 per cent of the expenditure of an Indian household is on food and for a poor household, this figure is around 50 per cent.
    • Herein, lies the scope to reboot the economy.

    Labour shortage and mechanisation

    • The sudden announcement of the nationwide lockdown gave labours no time to go back to their families.
    • They lost their jobs and incomes and having spent whatever little savings they had, these workers have been reduced to penury.
    • The Centre and states, despite their best efforts, have not managed to address the problem of hunger of these workers.
    • Even civil society has not managed to bridge the gap.
    • The migrant labourers may well have lost their trust in the state, and once the lockdown is lifted, most of them are likely to rush back to their families in villages.
    • And, it could be some time before they are back in the cities — that is, if they return at all.
    • So, farms and factories, especially the MSMEs in the relatively developed states of western, southern and north-western India are likely to face labour shortages for many months, perhaps years.
    • This could lead to more mechanisation of farms and factories in these states.
    • In Punjab, for example, most of the wheat harvesting is already done by combined harvesters.
    • Now even paddy harvesting could be done by mechanised harvesters.

    The double challenge for states which are home to migrants

    • However, eastern Uttar Pradesh, Bihar, Jharkhand, West Bengal, and Odisha, from where much of the migrant labour comes, will face a double challenge.
    • Their agriculture, with tiny farm holdings, is already saddled with a large labour force — this comprises 45 to 55 per cent of the total labour force of these states.
    • Non-farm income from wages and salaries, through migrant labour, was an important source of income for households in these states.
    • This is now severely hit. In all probability, the per capita rural incomes of these states could shrink, at least in the short run.
    • This could lead to poverty and increase hunger and malnutrition.
    • How does one then reboot the economy and also address hunger and malnutrition?

    The lockdown and the subsequent plight of the migrant labourers brought to the fore uneven development in the country. The points mentioned below suggest the ways to address this problem. A question based on this issue could be asked by the UPSC, for ex- “The issue of migrant labourers amid Covid-19 pandemic highlighted the uneven development in the country. In this context, state the reasons which led to the uneven development of various regions of the country. Suggest ways to address the problem”.

    The requirement of a special investment package for eastern states

    • A special investment package — like the Marshall Plan of USA in 1948 — for the eastern belt of India is required.
    • Investment should be used to build better infrastructure, agri-markets and godowns, rural housing, primary health centres, schools and enhances people’s skills.
    • The package will go a long way to revive the economy and augment the incomes of the migrant workers.
    • Rising incomes will generate more demand for food as well as manufactured products, giving a fillip to the growth engines of agriculture as well as the MSME sector.
    • Building better supply chains for food directly from farm-to-fork, led by the private sector, will enhance the export competitiveness of agriculture.
    • It will also ensure a higher share of farmers in the consumers’ rupee.
    • Long-term demand-driven growth: Such broad-based development in a relatively underdeveloped region of the country will lay the foundations of a long-term, demand-driven, growth of the industry in India.
    • The all India relief package of Rs 1.7 lakh crore announced by the central government earlier, which is about 0.8 per cent of the country’s GDP, is too small to reboot the economy.

    Conclusion

    If India has to bounce back quickly, it needs a much bigger relief cum stimulus package — certainly not below 5 per cent of GDP. And, it should focus more on the eastern belt, where the issue is that of survival.

    Back2Basics: Marshall Plan, 1948

    • The Marshall Plan, also known as the European Recovery Program, was a U.S. program providing aid to Western Europe following the devastation of World War II.
    • It was enacted in 1948 and provided more than $15 billion to help finance rebuilding efforts on the continent.
    • The brainchild of U.S. Secretary of State George C. Marshall, for whom it was named, it was crafted as a four-year plan to reconstruct cities, industries and infrastructure heavily damaged during the war and to remove trade barriers between European neighbours – as well as foster commerce between those countries and the United States.

  • Lockdown with a human face: Immediate focus should be on alleviating hardships of poor, vulnerable groups

    The article deals with the policy response to the crisis. Reducing the pain inflicted on the poor and vulnerable section should be the priority. The size and nature of the stimulus package is also discussed in the article.

    The dilemma of lives Vs. livelihood

    • As the coronavirus spreads, severe dilemmas haunt policymakers.
    • Testing of lockdown? Even the scientific community is confused and does not seem to know whether the South Korean model of more intensive testing is preferable to the European model of a complete lockdown.
    • The economic crisis that we are facing today is very different from any crisis that we have encountered recently.
    • This is the first economic crisis in recent memory to have been triggered by a non-economic factor — a pandemic.
    • A lockdown essentially amounts to limited economic activity and this results in throwing temporary workers and daily wage earners out of employment.
    • Migrant labour falls in this category.
    • According to the 2011 census, the number of migrant workers under the category, “migrants for work/employment” was 41.42 million.
    • This number must have grown substantially by now.
    • The impact of the lockdown has fallen very heavily on the poor and vulnerable groups.
    • We need to bear this in mind while evolving the strategy to combat the virus.

    Expenditure during the pandemic

    • First, medical and healthcare expenditure, which includes the money spent on extension of hospital facilities, employment of additional medical and healthcare workers, costs of testing on a much wider scale and the purchase of accessories like personal protection equipment, ventilators and testing kits.
    • The expenditure under this category is a “must” and there can be no compromise on it.
    • The length of the battle will decide the cost.
    • Second, the expenditure involved in taking care of the people thrown out of employment, and other vulnerable sections of the population.
    • Third, stimulation expenditure aimed at restarting the economy. Here, the financial system presided over by the RBI will play an important role. But the government also has a role.

    Two issues to consider while deciding on the lockdown

    • The “life” versus “livelihood” dilemma pertains to the lockdown policy.
    • A tight lockdown over an extended period may save lives by curtailing the progress of the virus.
    • But at the same time, it places several segments of society under severe hardship.
    • With the lack of economic activity, many will go hungry.
    • In this context, the government must look at two issues.
    • First, it must consider to the extent to which the lockdown can be relaxed while keeping in mind the priority of restricting the spread of the virus.
    • The government has recently announced some relaxations.
    • This is a welcome step. However, it must keep this concern under continuous consideration. It must explore other options on the medical front as well.
    • For example, will more testing make it possible to reduce restrictions?
    • Second, if the lockdown is a “compulsion”, we need to pay adequate attention to the plight of people who have been affected adversely.
    • The government had earlier announced certain measures to help some segments of society.
    • With the lockdown being extended, it is necessary to raise the levels of relief, and also cover segments of society not covered earlier — migrant labour, for example.

    The following points about the stimulus package are appearing repeatedly in most of the article on economic damage to the economy. They are also relevant from the UPSC perspective. A question based on it,  like “What steps were taken by the government to revive the Indian economy in the aftermath of the corona crisis?” can be asked.

    What should be the nature of the stimulus package?

    • There is much talk about a “stimulation package” to revive the economy.
    • The financial system will have to lead the charge.
    • Additional expenditure: Expectations regarding additional expenditures by the government vary from 2 per cent of the GDP to 5 per cent of the GDP.
    • Normal sources of financing will not be adequate to meet this order of expenditure.
    • Many analysts felt that the figure of 3.5 per cent of the GDP as the fiscal deficit, indicated in the budget for 2020-21, would be exceeded.
    • The pandemic will necessitate an increase in expenditure.
    • Moreover, with the decline in economic activity, revenues will also go down.
    • The revenue projections were made on the assumption that the nominal income growth would be 10 per cent.
    • But this is unlikely to be achieved. The nominal income growth is likely to be 7 per cent, at best.
    • Given the increase in expenditures and the slowdown in revenue collection, the borrowing programme will exceed significantly over what was indicated in the budget.
    • The monetisation of debt is inevitable and it will have its own consequences.
    • Provisions for states: The brunt of the expenditures will be borne by the state governments and therefore, the Centre must allocate additional resources to them.
    • They may also be allowed additional borrowing above 3 per cent of the state domestic product.

    What will be the overall growth rate for India?

    • In the first quarter of 2020-21, the GDP growth rate will be negative.
    • Agricultural performance during the year could be the same as in 2019-20 as the rainfall is expected to be normal.
    • The developed world may go through a recession over the year.
    • Thus the external sector may not be of much help.
    • It is quite possible for the economy to have a V-type recovery from the second quarter of 2020-21.
    • On that assumption, the overall growth rate for the year can be 3 per cent. This is an optimistic estimate.

    Conclusion

    To return to the present, the focus of the government has to be two-fold. It must act vigorously to contain the virus, explore the possible alternatives to complete lockdown. Second, it must take all actions to provide adequate help to the poor and the needy including the migrant workers. Lockdown, as necessary, must be with a human face.

     

  • What is “Direct” Monetization of Deficit?

    With the economy stalled, there isn’t enough money in the market for the government to borrow. Can it ask the RBI to print more money? How does this process work, and what are the arguments against it? Let us see:

    Discuss the scope and feasiblity of “Direct” Monetization by the government for Deficit Financing as an option of the last resort.

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    What is “direct” monetisation of the deficit?

    • Imagine a scenario where the government deals with the RBI directly — bypassing the financial system — and asks it to print new currency in return for new bonds that the government gives to the RBI.
    • Now, the government would have the cash to spend and alleviate the stress in the economy — via DBT to the poor or starting social and capital expenditure etc.
    • In lieu of printing this cash, which is a liability for the RBI (recall that every currency note has the RBI Governor promising to pay the bearer the designated sum of rupees), it gets government bonds.
    • Such bonds are an asset for the RBI since such bonds carry the government’s promise to pay back the designated sum at a specified date.
    • And since the government is not expected to default, the RBI is sorted on its balance sheet even as the government can carry on rebooting the economy.

    What triggers a demand for direct monetization?

    1) Decline of Demand

    • With a nationwide lockdown, incomes have fallen and so have consumption levels.
    • In other words, the demand for consumer goods and services (say a haircut) in the economy has gone down.
    • What can be done to boost demand? People need to have money. But, of course, who will give them money.
    • From the highest-ranking CEOs to stranded workers, incomes have taken a huge hit, if not completely dried up.

    2) Moving ahead for a fiscal deficit

    • For its part, the RBI has been trying to boost the liquidity in the financial system. It has bought government bonds from the financial system and left it with money.
    • Most banks, however, are unwilling to extend new loans as they are risk-averse. Moreover, this process could take time.
    • The government’s finances were already overextended going into this crisis, with its fiscal deficit way over the permissible limit.
    • On top of that, if the government was to provide some kind of a bailout or relief package, it would have to borrow a huge amount. The fiscal deficit will go through the roof.

    3) No money in the market

    • There isn’t enough money in the market for the government to borrow.
    • Moreover, as the government borrows more from the market, it pushes up the interest rate.
    • Hence, the govt. is left with the only solution — the “direct” monetisation of government deficit.

    How is DM different form OMOs?

    • Direct monetization is different from the “indirect” monetizing that RBI does when it conducts the so-called Open Market Operations (OMOs) and/ or purchases bonds in the secondary market.

    Global examples

    • Other countries are doing it to counter the economic crisis related to COVID-19.
    • In the UK on April 9, the Bank of England extended direct monetisation facility to the UK government even though the Governor of the Bank opposed the move till the last moment.

    Has India ever done this in the past?

    • Yes, until 1997, the RBI “automatically” monetized the government’s deficit.
    • In 1994, Manmohan Singh (former RBI Governor and then Finance Minister) and C Rangarajan, then RBI Governor, decided to end this facility by 1997.
    • Now, though, even Rangarajan believes that India would have to resort to monetising the deficit.

    Issues with Direct monetisation

    • Direct monetisation of the deficit is a highly contested issue.
    • Another former RBI Governor D Subbarao has said that there is no question that India must borrow and spend more in this crisis.
    • He regarded this as a moral and a political imperative.

    Issues: Inflationary practice

    • Ideally, this tool provides an opportunity for the government to boost overall demand at the time when private demand has fallen — like it has today.
    • But if governments do not exit soon enough, this tool also sows the seeds for another crisis. Here’s how:
    • Government expenditure using this new money boosts incomes and raises private demand in the economy. Thus, it fuels inflation.
    • A little increase in inflation is healthy as it encourages business activity. But if the government doesn’t stop in time, more and more money floods the market and creates high inflation.

    To what level should government debt be ideally limited?

    • While no ideal level of debt is set in stone, most economists believe developing economies like India should not have debt higher than 80%-90% of the GDP. At present, it is around 70% of GDP in India.
    • It should commit to a pre-determined amount of additional borrowing and to reversing the action once the crisis is over.
    • Only such explicitly affirmed fiscal restraint can retain market confidence in an emerging economy.
    • The other argument against direct monetizing is that governments are considered inefficient and corrupt in their spending choices — for example, whom to bail out and to what extent.

  •  Indian Debt market, that never was

    India’s bond market suffers from several issues. This article discusses such issues, and also highlights the recent positive trends seen in the debt market owing to several steps taken by the government.

    The Indian debt market, primarily of the fixed-income variety, can be broadly classified into:

    • 1. Money Market
    • Where the borrowing is for a tenor of less than a year.
    • Different types of money market instruments: Inter-Bank Term Money, repo transactions, Certificate of Deposits, Commercial Papers, T-Bills, etc. are some of the money market instruments.
    • Through these instruments, short term requirement of funds is met by banks, institutions and the state and central governments.
    • 2. Bank and Corporate Deposits
    • Bank fixed deposits (FDs) have been popular and widely subscribed to, as the feeling of no-default-risk.
    • Corporate deposits are FDs issued by a company (non-bank).
    • 3. Government Securities
    • G-Secs are sovereign-rated debt papers, issued by the government with a face value of a fixed denomination.
    • 4. Corporate & PSU Bond Market
    • Corporate bonds are issued by public sector undertakings (PSUs) and private firms.
    • These bonds are issued for a wide tenor between 1 year – 15 years.
    • These bonds carry a different risk profile and hence will have associated rating.

    Debt market plays a significant role in the economy of a country. But India’s debt market suffers from shallowness. Some of the steps taken by the government to improve the situation have been showing positive trends. In the light of this development, the UPSC can frame a direct question, for ex. “What are the factors responsible for the shallowness of the debt market in India? Suggest ways to increase the depth of the debt market in India.”

    What are the problems of India’s debt market?

    • Wholesale market: The Indian debt market is largely a wholesale market.
    • It is a wholesale market in a sense that a majority of institutional investors comprises of mainly banks, financial institutions, mutual funds, EPFO, insurance companies and corporates.
    • The concentration of these large players has resulted in the debt markets being fairly skewed, evolving into a wholesale & bilaterally-priced trades.
    • Lack of retail sell and transparency: It also lacks the retailness and the contractual transparency that the Indian capital markets have been able to build in the past 2 decades.
    • Skewed towards G-secs: Structurally, the debt market remains firmly skewed towards government securities (G-secs).
    • Also, the largest investor group in the G-secs market are the banks, due to their regulatory requirement to invest in SLR.
    • Low and unstable trading in the corporate bond market: The Indian corporate bond market has low & unstable trading volumes.
    • Sadly, the corporate bond market remains largely about top-rated financial and public sector issuances.
    • The domestic debt managers have forgotten that the logic of the business of finance is “to price the risk”.

    Regulation and comparison with other countries

    • RBI regulates money markets & G-secs.
    • SEBI regulates the Corporate debt market & bond markets.
    • The domestic debt market in India amounts to about 67% of GDP.
    • The size of India’s corporate bond market is a mere 16% of GDP — compared with 46% in Malaysia, and 73% in South Korea.

    The recent positive trend in the debt market

    • In the past few years, the domestic corporate bond market had seen increasing volumes, largely due to financial investments going into it, including retail participation.
    • Also, the banks had ceded space to NBFCs over past many years.
    • This is because banks found it easier to buy securitisation pools to achieve their PSL targets rather than develop competencies that NBFCs had built-in serving affinity groups, in smaller cities & towns.
    • And post the ILFS crisis, the markets have started shunning non-banks again.
    • Policy initiative by the government: The various policy initiatives undertaken in the last few years would take time to fructify and to stabilise.
    • These include the IBC, SEBI’s bond market policies, RBI’s large borrower framework for enhancing credit supply.
    • Some of these have already seen changes/addendums to the original draft, with the intent being to course-correct, for the stability of the markets.

    Roll over of debt papers in India

    • We have seen liquidity problems in our markets every few years.
    • The concept of “roll-over” of debt paper was usual as our markets did not build long term papers.
    • With the ILFS slowdown, it was easy for name-calling on “ALM mismatch” concept.
    • Not much had been anyways done before and later to address the availability of debt to reduce the Asset-to-Liability mismatches.
    • Also, we have played it safe so far by even lending for large infra projects with shorter paper and hoped to roll it over at the end of the debt term.

    Conclusion

    This is the time that our regulators need to work along with the various governments, especially the states, for smoother ironing of fiscal hiccups and use this to redress any structural glitches. It’s time that there is actual intent to deepen the domestic debt market and to listen to the industry about their requirements.

    Back2Basics: What is ASM?

    • Banks’ primary source of funds is deposits, which typically have short- to medium-term maturities.
    • They need to be paid back to the investor in 3-5 years.
    • In contrast, banks usually provide loans for a longer period to borrowers.
    • Home loans, for instance, can have a tenure of up to 20 years.
    • Providing such loans from much shorter maturity funds is called an asset-liability mismatch.
    • It creates risks for banks that need to be managed.
    • The most serious consequences of asset-liability mismatch are interest rate risk and liquidity risk.
    • Because deposits are of shorter maturity they are repriced faster than loans.
    • Every time a deposit matures and is rebooked if the interest rates have moved up the bank will have to pay a higher rate on them.
    • But the loans cannot be repriced that easily. Because of this faster adjusting of deposits to interest rates asset-liability mismatch affects net interest margin or the spread banks earn.

    Priority Sector Lending (PSL)

    • Priority Sector Lending is an important role given by the (RBI) to the banks for providing a specified portion of the bank lending to few specific sectors like agriculture and allied activities, micro and small enterprises, poor people for housing, students for education and other low-income groups and weaker sections etc.

    Roll over of debt

    • When debt becomes due there is a need to either repay the principal or alternatively, to enter into a new agreement.
    • Structurally, funds from the second debt are used to repay the first debt.
    • Then you repay the second debt as required. Quite often these new terms will be agreed with the initial lender.
    • In essence, you’re ‘rolling’ the repayment obligation from one period into the next.
    • This all leads to rollover risk, which is the risk you that you won’t be able to find anyone willing to lend the value of the outstanding debt and/or offer a comparable rate as the first principle repayment obligation approaches.
    • This may be due to either movement in the borrowers perceived credit status and/or changes to the broader credit environment.
    • This was a key theme during the financial crisis of 2007 – 2008.
    • The reasons for refinancing may include the above, but also other themes such as debt consolidation (which doesn’t directly imply a change to the debt term).

  • Don’t waste the oil crisis

    This article discusses the factors that contributed to oil prices falling below zero, and where the prices are headed in the near future. There are suggestions for India to make the most of this oil crisis. In the last week, we covered the same topic but its focus was on increasing the storage capacity. This article also covers the geopolitical implications of oil prices remaining low for long.

    What negative price of the benchmark US crude WTI mean?

    • The collapse in the price of WTI reflected a technical peculiarity of futures trading.
    • Paper traders would normally have had two options- 1) To let their contract expire and take physical delivery 2) To pass on the contract to someone else.
    • The US was running out of crude oil storage capacity and traders knew they could not “risk” taking delivery.
    • There was no physical space to hold the product.
    • So their only option was to sell the contract.
    • On the last day before the contracts expired, the traders in desperation “paid” to offload their risk.
    • There was no physical transaction of oil.
    • The current future price is back in positive territory.

    The world running out of oil storage capacity

    • The world and not just the US was fast running out of storage capacity.
    • Production in excess of demand: This was because oil production was way in excess of demand.
    • The latter had crashed by almost 30 million barrels a day or mbd (the equivalent of OPEC’s entire production) because of the COVID-induced lockdown of transportation and industry.
    • The price of the other crude benchmarks had also dropped but not the same extent — the North Sea Brent fell, for instance, to $15/bbl, a level not seen since 1999.
    • The reason was that unlike the WTI, which is traded in the US and therefore dependent on US inland storage capacity, the other crudes have access to seaborne storage (oil tankers).
    • This latter capacity is, however, fast filling up and the price of these crudes may also hit historic lows.

    So, where the oil prices are headed?

    • Oil prices will be volatile downwards until demand picks up and/or supply is further cut.
    • Demand will depend on the curve of post-COVID economic recovery.
    • Supply will rest on the outcome of further discussions amongst OPEC, Russia and, ironically, the US.
    • OPEC and Russia had earlier this month agreed to cut production by 10 mbd.
    • But clearly, this is not enough and further cutbacks have to be agreed on.
    • Whatever the scenario for economic recovery or supply constraints, there is a slim likelihood of crude oil prices reaching the average price levels of 2019 ($64) over the next 12 months or so.
    • More likely, they will be volatile downwards with $50 as the ceiling and with no floor.
    • This “low for longer” price outlook raises two issues for India’s policy-makers.

    As India depends on imports for over 80% of its oil requirements, oil prices have wide implications for the financial health of India. Safe oil supply lines are essential for its energy security. Both these points are important from the UPSC point of view. Following two points deal with these two factors.

    Two issues that India’s policy-makers need to consider-

    1. Disruption of oil supply lines and problems of diaspora

    • Every oil producer with no exception will face a budgetary crisis.
    • Some, like Saudi Arabia, the UAE and Kuwait will finance their social and economic commitments by cutting costs, increasing debt and drawing down on their sovereign reserves.
    • Others like Iran, Iraq, Nigeria and Venezuela, who have no such cushion and whose credit ratings are junk, will confront deepening political and social crises.
    • Economic plan: India should build into its economic plans the possibility that its traditional oil supply routes could get disrupted.
    • And that its diaspora, whose remittances are of significance, could face disproportionate hardship as these economies retrench.

    India has the largest diaspora in the world and sends as much as $80 billion back home as remittances. So, any impact on diaspora in oil economies has implication for India from this perspective as well.

    2. Empower the oil traders and remove bureaucratic control

    • On the day prices hit negative territory, it is unclear whether the trading experts in our oil PSUs had the flexibility to even contemplate “buying” the WTI futures contract for June, taking delivery, shipping it to India and storing it someplace.
    • It is also not clear whether they had the authority to lock in low prices through forward contracts.
    • Storage capacity and WTI quality mismatch: There is a shortage of storage capacity in India and a mismatch between the quality of WTI and the requirements of our refineries.
    • India cannot leverage the current market conditions of low and volatile oil prices to our national advantage unless we empower the traders and leave them unencumbered from bureaucratic control.
    • Most importantly, protect them from the three Cs ( CVC, CBI and CAG) in case their trade goes awry.

    Conclusion

    This oil market crisis could be made to work to our advantage. We must not waste this opportunity. There is a need to remove the bureaucratic hurdles in our PSUs, increasing storage capacity and sound financial planning by the government to make the most of this oil crisis.

    Back2Basics: What is WTI  and Brent crude benchmark?

    • West Texas Intermediate (WTI), also known as Texas light sweet, is a grade of crude oil used as a benchmark in oil pricing.
    • This grade is described as light crude oil because of its relatively low density, and sweet because of its low sulfur content.

    Brent Crude

    • Brent Crude is a trading classification of sweet light crude oil that serves as one of the two main benchmark prices for purchases of oil worldwide.
    • This grade is described as light because of its relatively low density, and sweet because of its low sulphur content.

    Futures contract

    • In finance, a futures contract is a standardized legal agreement to buy or sell something at a predetermined price at a specified time in the future, between parties not known to each other.
    • The asset transacted is usually a commodity or financial instrument.

  • What is Operation Twist?

    The Reserve Bank of India (RBI) has announced simultaneous purchase and sale of government bonds in a bid to soften long-term yields under its Operation Twist.

    Operation Twist

    • Operation Twist is a move taken by U.S. Federal Reserve in 2011-12 to make long-term borrowing cheaper.
    • It first appeared in 1961 as a way to strengthen the U.S. dollar and stimulate cash flow into the economy.
    • It is the name given to a Federal Reserve monetary policy operation that involves the purchase and sale of bonds.
    • The operation describes a form of monetary policy where the bank buys and sells short-term and long-term bonds depending on their objective.

    Its genesis

    • The name “Operation Twist” was given by the mainstream media due to the visual effect that the monetary policy action was expected to have on the shape of the yield curve.
    • If we visualize a linear upward sloping yield curve, this monetary action effectively “twists” the ends of the yield curve, hence, the name Operation Twist.
    • To put another way, the yield curve twists when short-term yields go up and long-term interest rates drop at the same time.

     Back2Basics: Open Market Operations

    • Open market operations are the sale and purchase of government securities and treasury bills by RBI or the central bank of the country.
    • The objective of OMO is to regulate the money supply in the economy.
    • When the RBI wants to increase the money supply in the economy, it purchases the government securities from the market and it sells government securities to suck out liquidity from the system.
    • OMO is one of the tools that RBI uses to smoothen the liquidity conditions through the year and minimise its impact on the interest rate and inflation rate levels.