Covid 19: Should Centre be worried about rating downgrade while disbursing fiscal stimulus

In view of increasing costs of managing pandemic, the fiscal slippages are imminent. However, the resultant sovereign rating downgrades can act a deterrent for the government to announce much required big stimulus-cum-relief packages. Is monetisation of deficit is the way forward?

In a recent interview, the chief economic adviser (CEA) to the finance ministry, Krishnamurthy Subramanian defended Indian government on its limited and inadequate covid-19 related fiscal stimulus package; citing concerns over ratings downgrades in case of high fiscal deficits. Earlier in April, Fitch Ratings had said that Indian government has less fiscal room to support the economy than many of its peers and the country’s credit profile would weaken if a wider fiscal deficit increases the debt-GDP ratio. This raises an important question that whether Indian government is in position to disburse much required big stimulus package that can tide over growing woes of economy amid fears of resultant downgrades by the rating agencies as a result of fiscal slippages.

First of all it’s important to find out how reliable these credit ratings are?  Experiences from the past have indicated that rating agencies are probably not prompt enough in alerting investors about any impending risk. Be it’s the case of IL&FS default where rating agencies like ICRA, CARE continued to assign high ratings and deferred plans to downgrade IL&FS group despite their growing financial risk, or the event of Global Financial crisis of 2008 where the “Big Three” — Standard and Poor’s (S&P), Moody’s, and Fitch Ratings misled investors by providing higher estimates for even risky instruments and corporations in lieu of repeat business. Thus, objectivity of the ratings, decisions, policies and transparency and reliability of their rating methodologies, have always remained a cause of concern for the economists.

Having said this, still credit ratings do carry weight and any downgrades can’t be ignored. Any rating downgrade raises the borrowing costs for government and severely impacts governments’ ability to raise debt in the international market. Institutional investors are always bothered about these sovereign ratings and any downgrade generally results in capital flight with stock and bond market in doldrums. Further, the risks of depreciation of rupee and resultant foreign exchange crisis can’t be overlooked. It’s actually a viscous circle, indeed, where higher fiscal deficit (resulting from any big bang stimulus package) leads to rating downgrades and any rating downgrade can push economy into an ugly fiscal environment; thus restricting room for any fiscal stimulus.

The worsening fiscal health of the economy is becoming a cause of concern among economists. The government is facing huge revenue shortfall on account of falling tax revenue and difficulty in realising disinvestment plans due to pandemic outbreak.  As a result of extended lockdown and increased costs associated with corona pandemic, the combined fiscal deficit of the centre and state governments is already expected to increase from 6.5 per cent of the GDP to nearly 12% of GDP in FY2020-21. The government has announced that it will borrow additional Rs 4.2 trillion from the market in this fiscal year; thus pushing estimated gross market borrowing in the financial year 2020-21 from Rs. 7.80 lakh crore as per BE 2020-21  to  Rs. 12 lakh crore. Further, Moody’s expects India’s public debt-to-GDP ratio to worsen from 72% to 84% of GDP in FY21.

Now let’s see the past stimulus measures announced by government. Initially in March, government announced Rs 1.7 lakh crore covid relief package (~0.8% of GDP) for providing free cereals and cooking gas to poor. The government later in May announced a whopping Atmanirbhar Bharat Abhiyan economic package of around 20.97 lakh crore stimuli (~10% of GDP). However, it is worth  noting that the overall package of 20 lakh crore included initial Rs 1.7 lakh crore and various liquidity injecting measures by RBI in last three months’ worth of Rs 8.01 lakh crore. To this end, as many of the government’s proposals are credit based or include liquidity easing measures for the affected sectors, economists have argued that the actual fiscal impact of the announcements made over five tranches is likely to be much less; around Rs 2.5 lakh crore (~1.5% of GDP). Hence, stimulus of around 1.5% of GDP seems completely inadequate and clearly indicates towards weak financial position of the government with limited fiscal space. Thus, there is an urgent need to disburse another round of fiscal stimulus without increasing public debt as any increase in debt to GDP ratio will pose risk for further rating downgrade(Moody has already downgraded India’s sovereign rating from “Baa2” to “Baa3” with negative outlook). It is in this scenario, that the need for monetisation of deficit is widely debated.

Monetisation of deficit happens when Central bank funds the government expenses by buying government securities (Treasury bills) directly from the primary market. It was in practise until 1997; after which it was being gradually phased out with its complete discontinuance in 2006 with the enactment of FRBM Act.

Economists are divided on the issue of monetisation of debt; while some have rebuked against the move, others say limited monetisation can be undertaken, if needed. Although it’s always advisable to avoid monetisation of deficit since it triggers spikes in inflation and compromises independence of monetary policy. It may also lead to currency depreciation and result in macroeconomic imbalance. However, at this point of time, when pandemic has brought economic activity at halt and there is unprecedented increase in government expenditure, monetisation of the deficit looks inevitable.

As high market borrowings can raise the interest rates and can crowd out private investment, its imperative that government should refrain itself from any further additional market borrowings and keep itself confined to already announced 4.2 trillion. Hence, if government deficit shoots further, monetisation of deficit can be undertaken to finance future expenditures in the remaining part of the year, however, there should be a clear commitment on the part of government to keep it a one-time affair.

Having said this, it has to be kept in mind that any monetisation of deficit can lead to inflationary situation unless production increases very sharply. However, presently, amid lockdown and declining incomes scenario, we are in a situation of “deficient” demand. Therefore, the current economic environment in India does not seem to experience inflation consequent to deficit monetisation, at least not in the short run. However, in the long run, government will have to do significant amount of planning to manage supply chains to remove any forthcoming supply side bottlenecks in future; so that monetisation does not prove to be inflationary. Going forward, as long as inflation is kept under control, monetisation is acceptable. Further, RBI is in comfortable position with foreign exchange reserves more than of $500 billion currently to handle any rupee depreciation or macro-economic imbalance, consequent to monetisation of deficit. But of course, if monetisation of deficit is undertaken, it should be done only “once” and to finance only highly relevant and unavoidable expenditures.