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Union finance minister Nirmala Sitharaman and minister of state for finance Anurag Thakur leaving a news conference in New Delhi last week.  (Photo: Bloomberg)
Union finance minister Nirmala Sitharaman and minister of state for finance Anurag Thakur leaving a news conference in New Delhi last week. (Photo: Bloomberg)

Why India needs more than liquidity dreams

  • By focusing on access to easy loans, the government has missed the bus to revive consumer demand
  • Instead, much more money could have been put in the hands of people. One way of doing that would have been depositing money into all Jan Dhan accounts

MUMBAI : Liquidity is the latest elixir in town. Finance minister Nirmala Sitharaman used the term about 40 times in the five presentations she made to the media between May 13-17 to lay out the 20-trillion economic package. Not surprisingly, a significant portion of the package ( 20.97-trillion to be exact) served up liquidity—and not fiscal stimulus as businesses and investors were expecting.

A fiscal stimulus is essentially a scenario where the government cuts taxes or increases spending in trying to revive the economy. The idea is to put more money in the hands of people, so that they can spend it. In the process, consumer demand and economic growth can be revived. Without consumer demand, who do businesses really produce for?

Instead, the government by and large focused on liquidity. What is it? The idea behind liquidity is that people and businesses borrow more and then spend. As they do this, consumer demand will get revived, and businesses and the overall economy will benefit. Of course, unlike a fiscal stimulus which puts money in the hands of people, loans need to be repaid.

At a primal level, liquidity could be the Reserve Bank of India’s (RBI) attempt to pump in money into the economy and drive down interest rates, in the hope that banks will lend. It also means persuading public sector banks (PSBs) to give out loans quickly, as well as serving up a few government guarantees.

The problem with this approach is that recent experience shows us that expecting banks to lend and the country to borrow hasn’t really worked. RBI has cut the repo rate (the rate of interest at which RBI lends to banks, typically for the short-term) from 6.5% in January 2019 to 4.4% now. But banks haven’t been able to lend more (and in the process create liquidity). The failure of this can be seen in the fact that non-food credit growth in 2019-20 was at 7.6%, the lowest in nearly a decade and a half.

Expecting bank loans to grow rapidly now is at best a pipe-dream.

The other path

Some economists are of the view that putting more money in the hands of people, in the hope that they go out and spend it, wouldn’t really have worked during a lockdown. This is true. Having said that, what are the chances of people going out and taking a bank loan, during a lockdown? All the economics starts to work only once the lockdown ends.

Also, the chances of people borrowing during these tough economic times, where they aren’t really confident about their economic future, are rather low. That might be true for small businesses which are in trouble, if they don’t get stuck in the bureaucratic rigmarole of public sector banks, but it’s difficult to see individuals lining up for loans.

Indeed, this is precisely why the British economist John Maynard Keynes, after studying the Great Depression of 1929, had suggested that in times of economic upheaval, like the current situation is, governments should become spenders of the last resort. He even rhetorically suggested that governments should give people money to dig holes and fill them up. The money thus earned and spent would help reviving the economy.

In the Indian context, the idea should have been to get urban consumer demand going, given that agriculture is expected to grow by more than 2% this year and rural demand should not be that badly impacted, once the economy starts to open up.

On this front, the government’s 20.97-trillion package falls flat. The value of the fiscal stimulus ranges from as low as 0.7% of the gross domestic product (GDP) to as high as 1.3% of the GDP, depending on which economist one chooses to believe. But the broader range of the fiscal stimulus is around 1% of the GDP. This is significantly lower than the stimuli announced by developed countries across the world.

At least for now, the government has clearly missed the bus to revive consumer demand.

The liquidity tools

The RBI measures amount to 8.02 trillion or a little over 38% in the government’s economic package. This includes the central bank cutting the cash reserve ratio by 100 basis points to 3% and in the process releasing 1.37 trillion into the financial system. One basis point is one hundredth of a percentage. Banks need to maintain a certain proportion of their demand and time liabilities with RBI as a reserve. When this ratio is cut, money is released into the financial system.

Also, between February 24 and April 23, RBI launched different schemes and lent 2.38 trillion to banks at the repo rate in order to encourage them to lend further, under certain conditions. Other than these schemes, there are a whole host of other things that RBI has done in order to pump money into the financial system. But is it working?

In the last two months, banks on an average have deposited 4.59 trillion with RBI. This is excess money that they have been unable to lend. As of May 17, this number stood at 5.21 trillion. Hence, instead of pumping money into the financial system, RBI has been taking money out of it.

What about other liquidity measures?

The government expects a 70,000 crore boost to the housing sector through the extension of credit linked subsidy scheme (CLSS) for the middle-income group (income of 6 lakh to 18 lakh).

Under CLSS, the government pays a part of the interest paid by the borrower on a home loan. The government expects people to take the benefit of this subsidy, take on home loans, spend their own money to make a down-payment and in the process spend a total of 70,000 crore to buy homes (the liquidity). But what are the chances of people buying homes currently?

The scheme has benefited about 330,000 people since May 2017 when it was launched. The government expects the scheme to benefit 250,000 people this year. This is a bit of stretch given that in better economic circumstances people bought 330,000 homes over three years and now they are expected to buy 250,000 homes in a year where jobs are being lost and incomes are falling. This is a great example of why more liquidity may really not be a solution to the current problem.

The 3-trillion automatic and collateral free loans for businesses including micro, small and medium enterprises, are expected to be another big liquidity generator. These loans come with a government guarantee. This is something that the PSBs are likely to fulfil.

The collateral-free loans are available to businesses with borrowings of up to 25 crore and turnover of up to 100 crore. Also, these loans are limited to up to 20% of the outstanding loans of a business. This basically means that the maximum loan that can be given to any businesses in this case is 5 crore.

The thinking behind this move may have come from what happened in the aftermath of the 2008 financial crisis, where PSBs went easy on lending to big business and ended up accumulating a huge amount of bad loans. Bad loans are loans which haven’t been repaid for a period of 90 days or more. This ultimately led to accusations of crony capitalism. With loan size limited to a maximum of 5 crore, the government will not get into an image management problem even if there are large scale defaults on these loans.

The fiscal stimulus

The disappointment on the fiscal stimulus front notwithstanding, the government has taken some such measures.

In the part of the package announced in late March, the government decided to deposit 500 each into 204 million female Jan Dhan accounts. The cost for this will work out to 30,600 crore. There were several indirect measures as well. Under the Pradhan Mantri Garib Kalyan Ann Yojana, people would get five kgs of rice or wheat and one kg of pulses free, for three months, over and above their current allocation. This was expected to cost the government 32,700 crore.

In the announcements made this month, the big measure under fiscal stimulus has been the increase in allocation towards the Mahatma Gandhi National Rural Employment Guarantee Scheme, the government’s work guarantee scheme.

The government had originally budgeted to spend 61,500 crore under the scheme. This has been increased to about 1.01 trillion. The idea is to help create more work for labourers returning home having lost their jobs in cities.

In fact, much more money could have been put in the hands of people. One way of doing that would have been putting money into all Jan Dhan accounts (384.1 million). At 1,000 per month for a period of three months this would have cost the government around 1.15 trillion. This would have been a proper fiscal stimulus instead of the ghuma firake stimulus, as industrialist Rajiv Bajaj called the economic package in a recent interview to journalist Barkha Dutt.

In fact, cutting income tax rates still remains a good way to revive urban demand, given that the upper-middle class which pays a bulk of the income tax, and has the best purchasing power in the country. But all this hasn’t happened primarily because the government’s fiscal situation was already in a mess before covid-19 struck.

Tax revenues

In 2019-20, the government had hoped to earn a gross tax revenue of 24.6 trillion. This was later revised downwards to 21.6 trillion. By the looks of it, it seems highly unlikely that the government would have ended up earning this much as well. The government tax revenues had dried up big-time even before March when the lockdown was introduced to prevent the spread of covid-19.

In fact, the government was expected to borrow 7.80 trillion to finance the fiscal deficit this year. Fiscal deficit is the difference between what a government earns and what it spends. Since then, the number has been revised to 12 trillion.

Even this borrowing might be just enough to make up for the shortfall in taxes that the government faces this year. The fall in tax collections along with the cost of the fiscal stimulus is likely to push the fiscal deficit of the central government to 7-8% of the GDP, against the budgeted 3.5%.

One suggestion that is constantly being made is that the central bank should print money and directly hand it over to the government to help meet its spending. Also, money printing is unlikely to cause inflation given the huge demand destruction that has happened over the past two months.

The Indian industry currently has a lot of free capacity which can be utilized as soon as demand picks up. Hence, the chances of demand outpacing supply and that leading to higher inflation, are very low.

The money printing suggestion has gained a lot of traction because Western central banks are printing a lot of money. One of the questions being asked is that if the US Federal Reserve, the central bank of the country, can print $2.77 trillion over a period of last two-and-a-half months, why can’t RBI print money as well?

The US dollar is deemed to be the global safe haven. Hence, there is perpetual demand for the US dollar globally. This allows the US Federal Reserve to print money without having to face any negative repercussions for the same. The same cannot be said to be true for India.

Hence, money printing can lead to negative consequences like foreign investors leaving India, a dramatic fall in the value of the rupee, an increase in long term interest rates, instability of financial institutions and general macroeconomic instability. Clearly, this is a risk that the government is unwilling to take.

Vivek Kaul is the author of the Easy Money trilogy.

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