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The only way out is to monetize the deficit

The only way out is to monetize the deficit
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First Published: Tue, Feb 17 2009. 12 56 AM IST

Updated: Tue, Feb 17 2009. 12 56 AM IST
When does a government go by convention in unconventional times?
When it doesn’t really have a choice. The lack of choice could be political, and the worry about the government being voted out of office if it announced new measures in Parliament, has been mentioned by several political observers.
But the lack of choice is also economic. Consider the manner in which government yields have already shot up as a result of the steep rise in government borrowing.
“The borrowing target for FY10 announced in the interim budget is well above what the market was expecting and the only reason yields haven’t moved up further is because the Reserve Bank of India, or RBI, is dangling the carrot of buying long-term bonds from the open market,” said A. Prasanna, senior economist with ICICI Securities Ltd.
Borrowings are slated to increase substantially in the fiscal year to March 2010 because the fiscal deficit is pegged at a much higher level. While most analysts estimated the FY09 fiscal deficit to be around 6%—the level estimated by the government—their estimates of the fiscal deficit for FY10 were much lower. For instance, Citigroup Inc. pegged it at 4.3% of gross domestic product (GDP), Kotak Mahindra Bank Ltd at 4.4% and Nomura Holdings Inc. at 5.2%. The government’s budgeted estimate of a 5.5% deficit as well as finance minister Pranab Mukherjee’s forecast that the new government would have to add to that deficit is well above what the markets had bargained for. This is bound to exert an upward pressure on interest rates. At the same time, RBI can do its bit by lowering the policy rate. That will lead to lower short-term rates and a steepening of the yield curve. Indranil Pan, chief economist with Kotak Mahindra Bank, says even if RBI cuts its repo and reverse repo rates by 100 basis points, he expects the 10-year bond yield to hover between 5.5% and 6.5%. One basis point is one hundredth of a percentage point.
In other words, putting it bluntly, it’s difficult for interest rates to go down much further. The clamour for a fiscal stimulus is thus misplaced—all that will happen is that interest rates will go up. The crowding out of the private sector is already happening, as seen from the rise in corporate bond yields. There is no free lunch.
The budget estimates for FY10, of course, are not particularly important, as the tax rates may change and so may budgeted expenditure after the new government presents its budget. Moreover, the 10.97% nominal growth in GDP for FY10 over the advance estimates of Central Statistical Organisation, or CSO, is far too high.
More interesting is the manner in which the fiscal deficit has gone up this fiscal year to March. Tax receipts in the revised estimates for the current year are lower by 8%, but the main impact has been on expenditure. Capital expenditure, both Plan and non-Plan, is up by just 5% compared with the budgeted estimates.
So the main item where spending has occurred is revenue expenditure, which is higher by 22% compared with the budgeted estimates. Recall the massive 24% increase in government consumption expenditure estimated by CSO for the second half of the current fiscal in its advance estimates.
The biggest increase, of course, has been in subsidies, which have gone up by 81% compared with budgeted estimates. Clearly, the government has been propping up consumption at the expense of spending on infrastructure.
So all eyes will now be on RBI. As ABN Amro Bank NV senior economist Gaurav Kapur put it: “The only way for interest rates to remain low and for the government to spend more is for the RBI to monetize the deficit, which in effect means printing money. If needed, that’s what the RBI should do—in a crisis of this magnitude, there are no holy cows.”
Manas Chakravarty looks at trends and issues in the financial markets. Your comments are welcome at capitalaccount@livemint.com
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First Published: Tue, Feb 17 2009. 12 56 AM IST