RBI may Resort to Direct Financing after India’s Budget Blowout

Square

India’s government is running out of options to fund its budget and may soon have to knock on the central bank’s door once again for support.

The administration can get the Reserve Bank of India to buy sovereign bonds directly or boost dividends to help supplement revenue, which has been hit by an economy-crippling lockdown to contain the virus’s spread. The government is facing a budget deficit of as high as 7% of gross domestic product, the widest in more than two decades, according to some estimates.

For now, banks are amassing sovereign bonds on optimism the central bank will soak up the debt supply. Lenders awash with cash, given poor demand for loans in the economy, have raised their holdings of sovereign notes to 41.4 trillion rupees as of June 19, up 13% from end-March.

“We still think it is feasible to finance a deficit of around 11% of GDP — center and states — without resorting to large amounts of RBI financing,” said Sergi Lanau, deputy chief economist at the International Institute of Finance in Washington. “Banks have already bought many bonds and with an economy in recession, they may not have many opportunities to lend to firms anyway.”

Ratings Overhang

A possible credit rating downgrade is another risk for India, which is heading for its first economic contraction in more than four decades this year. The credit score of Asia’s third-largest economy is only a step away from junk at Fitch Ratings and Moody’s Investors Service, both of which have kept the sovereign on negative watch citing deteriorating fiscal strength.

Economists in a Bloomberg survey expect the nation’s fiscal deficit this year to hit 7% of GDP — a level last seen in 1994 — against a target of 3.5%. The International Monetary Fund sees the country’s public debt rising to 85.7% of GDP next year from around 70% now.

Precarious Position

India’s public finances set to deteriorate as economy contracts

While the threat of a rating downgrade may reduce the likelihood of the central bank buying bonds directly from the government, there is room for the RBI to rescue the government by way of a dividend payout in August.

The “RBI would be required to partially bail out the government by allowing its revaluation reserves to be utilized,” said Kunal Kundu, an economist with Societe Generale GSC Pvt., adding there is also the possibility that the government could issue a special “Covid bond” to tide over the expenses or the shortfall caused by the virus.

The government has budgeted 600 billion rupees as dividends from the central bank this year, while it received a record 1.76 trillion rupees in payout last year. The RBI pays dividends to the government every year, based on the profits from its investments and printing of currency notes.

Forbidden Fruit

The government has so far limited actual fiscal stimulus to 1%-1.5% of GDP. Of late, it has scaled back on spending, which Bloomberg Economics’ Abhishek Gupta says will deepen the recession worries. He is projecting a GDP contraction of 10.6% in the current financial year.

For policymakers, it’s a tightrope walk with no easy solution. While inflation has more or less been under control since a Monetary Policy Committee headed by the central bank governor was set up four years ago, those gains could easily evaporate.

The experiences of the 1980s when India used to resort to deficit financing and which led to double-digit inflation is probably a reason why the central bank would be reluctant to step in, according to Hugo Erken, a senior economist at Rabobank International in Utrecht in the Netherlands.

“There is a risk in all of this,” said Erken. “Once you start using the money printer and touch the ‘forbidden fruit,’ it is hard to go back.”