Where to find the INR 20 lakh crores? A prediction and a recommendation
Jyoti Prasad Deka
Mitigating climate change through research / strategy in sustainability and energy transition
Introduction
On 12 May 2020, Tuesday, in his address to the nation, India’s Prime Minister Mr. Narendra Modi announced a special economic package worth INR 20 lakh crores (US$ 266 billion) in order to revive the COVID 19 hit Indian economy. PM Modi announced that INR 20 lakh crores package included liquidity infusion by RBI in recent past – on February 26, RBI injected INR 2.8 lakh crores and on March 27, an additional amount of INR 3.75 lakh crores – as well as the INR 1.7 lakh crores package announced by Finance Minister Mrs. Nirmala Sitharaman on 27 March. The combined monetary value of these stimulus comes at around INR 9.75 lakh crores, which means the balance of PM Modi’s special package, an amount of INR 10.25 lakh crores will be new money and has to come from either external borrowing, increased taxation or by breaking into some reserve. The India Today, on 13 May, commented that “Modi’s INR 20 lakh crores package may actually be repackaging, in parts, but can pull back India’s economy…and put it on the path of revival. All depends on how government plans to provision money equivalent to 10% of its (India’s) GDP.”
On this monetary provisioning background, on 13 May 2020, Wednesday, the Business Standard published an article – “Why RBI shouldn’t finance govt borrowing” by Professor Errol D Souza (Director, IIM Ahmedabad) and Professor Astha Agarwalla (Associate Professor at Adani Institute of Infrastructure Management) that raised an alarm stating fiscal expansion by Indian Government could exceed deficit by more than 5.5 percent causing severe harm to the country’s credit worthiness and debt profiles. The article advised prudence in monetary policy and against direct financing of Government’s fiscal expansion (read INR 20 lakh crores package) by RBI (through means like open market operations or simply, by printing money).
This article is written with a perspective build on above two published views. It contains one prediction – that US dollar as a currency is likely to devalue or depreciate and one recommendation for provisioning the INR 20 lakh crores– that RBI should support government’s fiscal expansion by liquidating part of its huge dollar term foreign reserve.
Explaining the “Prediction”
Figure 1: Evolution of US Fed money supply, interest rate and CPI inflation rate, YoY, of the US economy
In order to understand the current stress on US dollar, let us look at few data on US Federal Reserve’s interest rate, monetary base (i.e. base money supply or Mo) and the YoY CPI inflation in US economy (all depicted together in Figure 1). As Figure 1 shows, the US Federal Reserve have been undertaking extraordinary liquidity injection since the 2008 global financial crises. The liquidity measures counted roughly around US$800 billion during 2008 and has increased steadily to approximately US$4.8 trillion by April 2020, on the backdrop of US Government’s latest COVID 19 rescue package. This trend has direct correlation to Fed’s interest rate, which have been kept below 0.5% till year 2017 and raised to around 2-2.5% during year 2018-19 before revising down again to near zero in February 2020. Printing money of such magnitude to support expansionary measures generally leads to expectation of inflation or real inflation down the lane. But the US economy has been an exception, in fact it faced two deflationary events during the course of 2008 till 2020.
So, what is causing this exception? And, what will happen if this exception ceases to exist?
Figure 2: Illustration of interaction between Aggregate Demand and Supply in Price levels and Real GDP terms (AD – aggregate demand, LRAS – Long Run Aggregate Supply, SRAS – Short Run Aggregate Supply, Source: OpenStaxCollege via Khan Academy)
The first question can be explained by an understanding of Keynesian view of macro-economics and its mandate to governments and central banks on what to do during recessions. The reason that most economies took the road of economic expansion and monetary stimulus since the 2008 crisis is the view that during a recession in short run of a few months to a few years, firms and production facilities experience drop in aggregate demand. So, if the government as third party becomes the host and put money into economic expansion, things may get rolling back to normalcy. In other words, raising "demand will create its own supply”. The other fact of 2008 financial crisis was that it was viewed as a liquidity crisis in the global financial system caused by insolvency of toxic financial assets such as MBS, CDOs. Therefore, central banks around the world took swift measures to lower interest rate and inject billions of monies into the system. When such steps are taken, according to the Keynesian views, aggregate demand (as shown in Figure 2, the AD curves) shifts to right and raises real GDP of the economy. Keynes also supports the inflation argument by stating that supply meanwhile experiences a short term pricing stickiness and as a result, price level does not rise as much (as shown in Figure 2, Keynesian zone remains between Pk and Pi levels in the short run). In our opinion, pricing stickiness on supply side is the reason behind the exception of low inflationary expectation in the US economy all this while.
Now let us move to the second question – what will happen if this exception ceases to exist?
The Keynesian approach, with its focus on aggregate demand and sticky prices, has proved useful in understanding how the economy fluctuates in the short run and why recessions and business cycles occur (illustrated by Short Run Aggregate Supply and Aggregate Demand curves in Figure 2). But, in the long run, macro-economic analysis tends to shift to the neo-classical view that “it is the supply that creates its own demand”. So, as shown in Figure 2, in long run the economy operates into the Long Run Aggregate Supply zone where prices may rise steadily. Over periods of some years or decades, productive power of an economy to supply goods and services increases and aggregate demand follows this supply potential with inflationary expectation. In our opinion, 12 years of liquidity provisioning has led to long run shift in US economy’s fundamental demand drivers in a way that it is losing areas to expand. Now it all boils down to the technological prowess and productivity that will lead the US economy in its next quest for larger growth. Having said that, such transition to neo-classical macroeconomic zone will not arrive without pain and the resultant will be a great inflationary pressure on the US economy.
Such inflationary pressure will have a direct impact on US dollar as a currency. In fact, the status of the reserve currency that the dollar enjoyed for last few decades will have to face some tests. Whether the US economy and its currency come out of these tests successfully or how fast that will happen, only time can tell. Nonetheless, above analysis makes one thing clear – that in the short run to next 5 years, US dollar is going to depreciate in value.
Explaining the “Recommendation”
Figure 3: India’s foreign reserve accumulation between 2001 and 2020
The foreign reserve in dollar terms held by RBI has risen from roughly US$300 billion in 2008 to US$450 billion in May 2020. This figure in May 2020 represents 15.6% of India’s GDP in the FY 2019.
Countries use foreign currency reserves to keep a fixed rate value for domestic currency versus a reserve, maintain competitively priced exports, remain liquid in case of crisis, and provide confidence for external investors. But reserve can also be used, under exceptional circumstances, to pay external debt and to afford capital to fund sectors of the economy. In our opinion, the fiscal deficit of India’s current year budget has landed in one of such exceptional situation. One other parameter to monitor is India’s debt to national GDP ratio which in current year stands at 68.52%. If the debt to GDP ratio approaches 70%-80%, the external borrowing cost the country faces could be monumental. Noting these circumstances, the INR 20 lakh crores fiscal stimulus could well be funded by liquidating some of the foreign reserve by RBI in stead of any more external borrowing. In nominal current rates, the stimulus of INR 20 lakh crores represents 60% of India’s foreign reserve. Also, the argument strengthens itself based on the prediction this article made on devaluation of dollar as a currency.
Figure 4: Comparison of India’s foreign reserve and recently announced COVID 19 relief package
But such a move by RBI can also invite other challenges and these need to be studied for their impacts on Rupee and Indian economy in general. The most obvious challenge is an appreciating Rupee that can hurt exports that is already fragile following COVID 19 demand shock worldwide. On the other side of the coin, imports may become cheaper, and economy might end up losing a right balance. A more volatile exchange rate could also hurt medium to long term planning of firms and businesses. How currency matter impacts trade relations on broader terms between India and US can be another area to investigate in order to understand the repercussion of “dumping dollars”.
References
[3] https://www.khanacademy.org/economics-finance-domain/macroeconomics/
[4] Data for graphs taken from U.S. Federal Reserve and RBI websites
Data Governance | nbn? Australia
4 年Nice to see that a prediction you made more than 3 months back is coming true! Looking forward to the next article, keep sharing the insights :)
Strategy Consultant
4 年I am somewhat confused. Deploying huge forex reserves can disadvantage exports sector thus shrinking aggregate demand. Also the pandemic is not expected to impact LRAS..shouldn't government start looking inside and start austerity measures in non critical areas instead to finance short term liquidity issues
Head of Security at Razorpay
4 年Well written.