Monetisation as a preferred option

THE FISCAL Responsibility and Budget Management Bill introduced in December 2000 had set a target for the Centre's fiscal deficit at 2 per cent of GDP and a target of zero revenue deficit to be achieved by 2006. However, the trend in these deficit parameters during the last three years has been quite against the proposed target. The gross fiscal deficit was 5.7 per cent of GDP in 2000-01, increased to 6.14 per cent the next year. The revised estimate for 2002-03 was 5.9 per cent while the deficit has been budgeted at 5.6 per cent for the current year. If the past trend continues the actual gross fiscal deficit will not be less than 6 per cent of GDP for 2003-04. The combined fiscal deficit of the Centre and the States has already hit the double-digit level. If the present fiscal imbalance continues another macro economic crisis looks unavoidable. Foreseeing well in advance the impossibility of achieving the set target for fiscal and revenue deficits, Parliament on July 29 approved the revised bill that seeks to achieve fiscal prudence by eliminating revenue deficits by 2008.

There are two ways of controlling the deficit — by curtailing expenditure and by raising revenue. The Finance Minister has committed to contain the fiscal deficit both ways. He has proposed measures to mop up revenue and also compress unproductive expenditure without scaling down developmental expenditure. The Government has set a target of 19 per cent growth in tax revenues for the current fiscal. The best policy option to attain tax buoyancy is through appropriate tax administration, widening the tax base and growth oriented fiscal and monetary policy measures that will expand revenue potentials. Given the low tax buoyancy and structural as well as administrative rigidities in widening the tax base, the scope for achieving the targeted revenue seems limited.

Expenditure compression involves measures that mainly aim at reducing interest expenditure by prepayment of high cost debt and swapping high cost debt for low cost debt. In this regard, the Finance Minister has pointed out that the Government will pre-pay Rs. 7,500 crores worth of outstanding bilateral aid during the current fiscal year besides swapping Rs. 38,000 crores of high cost debt of State governments. Though debt swapping may reduce the average cost of borrowing, it may not help reduce the growing gap between the assets and liability positions of the Government — a root cause for growing deficits.

There are two pertinent questions. Are these measures appropriate given the present structure of the economy? Do these help achieve the budgetary targets within the proposed time limit? The answer is not in the affirmative if one considers the likely impact of the proposed policy on macro economic variables other than the deficit measures. While formulating fiscal policy or setting budgetary targets it is bizarre not to recognise the current structure of the economy and not base policy on a relevant macro theoretical framework for evaluating the probable impact of the policy package on demand and supply. It is important to take into account the impact of the policy on key macro economic variables rather than assume them as exogenous.

What is needed now is a different strategy to evolve an optimal blend of fiscal and monetary policies that can adequately address the current economic problems and ensure fiscal prudence in the near future. There are symptoms of economic recovery in the first quarter of the current fiscal, but the life span of this recovery is yet to be confirmed. Hence, fiscal deficit reduction as an important policy of the Government seems incredible in the context of demand deficiency coexisting with huge foodgrain stocks, excess capacity in the industrial sector, comfortable foreign exchange reserves, and rural poverty.

In a recent article in a financial daily, Bradford Delong, recalls two instances. First, the American government tried to maintain balanced budgets during the presidency of Herbert Hoover at the outset of the Great Depression. Since then the importance of budget deficit has been recognised in the context of stimulating aggregate demand that finally gives a fillip to recovery. Hence, measures to achieve fiscal discipline should ensure that they do not hurt growth, because government revenue will fall with fall in private income. Second, the commitment of the European Monetary Union (EMU) to the Stability and Growth Pact that mandates member countries to raise taxes and cut spending has put downward pressure on demand and curtailed economic activity. This has resulted in an abysmally low projected growth of 0.7 per cent for the euro zone this year. The adherence to Stability and Growth Pact measures has already pushed Germany into recession and placed Italy in a struggle to revise its growth process.

One of the best policy options to attain fiscal prudence consistent with growth and stability is to monetise some portion of government deficit. However, the Reserve Bank of India is hesitant to monetise the deficit on the ground that it would fuel inflation. The fear of inflation stems from the fact that the consequences of such a policy are evaluated with an explicitly irrelevant macro economic theoretical framework. We still have the hangover of the situation that prevailed prior to 1997 when the deficit was automatically monetised through the issuance of ad hoc treasury bills. Given the current economic situation, the ideal requirement is to set an optimal level of fiscal deficit to be monetised so that it would ensure fiscal prudence as well as aid the growth process. It is essential to avoid confusing optimal with automatic monetisation that resulted in unprecedented growth in money supply during the early 1990s. When the economy has demand deficiency coexisting with larger fiscal deficits, monetary expansion will result in output growth leaving prices unaffected. Even staunch monetarists would agree with this.

Another fear of monetisation stems from the argument that there are certain commodities that the economy cannot produce and that fiscal deficit will expand demand for such commodities leading to inflation. This is an irrelevant argument at present as the economy was till recently passing through a recessionary phase. Moreover, if the proposition that fiscal deficit expands demand that results in inflation is valid then any rise in private investment will also fuel inflation; therefore, the policy of the RBI that aims at maintaining a soft interest rate regime can be blamed as inflationary.

If the policy of expenditure compression is constrained by committed expenditures such as interest payments then monetisation of fiscal deficit can contribute to the reduction in interest payment over time through two channels. First, for a given deficit, the need for market borrowing declines to the extent of monetisation. This will in turn lead to a decline in the cost of borrowing. Second, the growth of outstanding market debt tends to slow down, thereby reducing interest payments. Instead, if we allow the present structure of fiscal imbalance to continue, then the Budget will soon become unviable and when there is a solvency constraint on the public debt, the RBI will have to finance not only the primary deficit but also the interest expenditure, leading to higher inflationary pressures in the future. This argument originated from the well-known proposition of Sargent and Wallace that the growth of money supply that does not keep pace with government borrowing will result in a high interest rate trap. This, apart from crowding out private investment, will create a deficit that will be unviable in the long run.

There is another argument originating from the differential impact of various modes of financing a given amount of deficit on the distribution of investible resources. It is possible that financing the deficit through market borrowing crowds out private investment whereas money financing tends to crowd-in private investment through money and credit multiplier effects.

Even if monetisation results in some amount of inflation it will contribute to the recovery process, given the current inflation being much lower than the threshold rate of 6 to 7 per cent. What is more important in enhancing investment activities is the real cost of capital, not the nominal cost. For instance, a high nominal PLR of 15 per cent and the lowest real interest rate of 2.7 per cent coincided with the boom in investment activities in 1994-95.

There are a few empirical studies in the Indian context that attempt to evaluate the non-inflationary portion of the fiscal deficit to be monetised taking into account its implications on major macro economic variables. A study by Mihir Rakshit proposed one per cent of the GDP. Manohar Rao has estimated an optimal level that works out to 15 per cent of the fiscal deficit. In one of the empirical works, the Madras School of Economics also has estimated an optimal monetisation of deficit, which is closer to the estimates of Manohar Rao.

Thus, monetising fiscal deficit at an optimal level will give demand side fillip that will help in reviving the economy from the recession, which will in turn expand the tax base and increase government revenue. Moreover, this will help contain the growth of public debt in the long run and further ease interest rates. The fall in the size of the debt and the decline in interest rate will eventually help in containing the interest expenditure that will set a path to achieve the target of zero revenue deficit within the stipulated period.

(The author is Associate Professor, Madras School of Economics