Is government printing away the deficit?

Suyash Choudhary, Head of Fixed Income at IDFC AMC on Thursday raised the possibility that monetisation of the fiscal deficit may already be underway at the Reserve Bank of India (RBI).

To put it in layman’s terms, monetisation of the deficit is the printing of money to finance government spending. This process is usually not carried out in normal circumstances as it can lead to inflation. However, the extraordinary demands placed on the government due to the Covid-induced lockdown leaves the central bank with few alternatives.

The fiscal deficit is the government’s total revenue minus its total expenditure. Before the crisis, the central government had estimated a fiscal deficit of 3.5% of GDP for FY21. The combined state government deficit, albeit for FY20, was estimated at 2.6% by RBI, placing the total deficit at around 5.6% of GDP. However, the actual deficit for FY21 may turn out to be substantially higher due to the Covid-19 crisis, which would result in below estimated tax revenue and higher than projected expenditure.

“Basis an anticipated sharp revenue slowdown and the need for a discretionary expenditure expansion, we are looking for a deficit expansion of 4-6% of GDP at the combined Centre and the state level," said Choudhary in a note. “This throws up a big ask for financing, a majority of which has to be financed by the central bank. Indeed this is the template that seems to have evolved, in some form or fashion, in most major economies across the world," he added.

Choudhary explained that RBI seems to be following a two-step process to monetise the fiscal deficit. In the first step, it is buying very short-term government debt (treasury bills) and in the second, it is selling these papers to buy longer dated government bonds. Both these steps together are called ‘Operation Twist’. Although this program has been conducted before, the market expert highlighted the deficit monetisation characteristic of the current one.

A direct result of this type of deficit monetisation is that long-term bond yields may fall, helping investors in longer duration debt mutual funds. However Arvind Chari, Head of Fixed Income and Alternatives at Quantum Advisors urged investors not to get into this tactical trade.

“There is an indirect monetisation of the fiscal deficit. However, we need to see how much RBI will carry out and what the government's borrowing program will be. There may be a tactical opportunity for institutions at the long end, but I don't think individual investors should try to play this move," said Chari.

A second concern that investors may have is whether this will stoke inflation. Experts did not rule out this possibility, but pointed out that this can only happen once demand comes back in the economy. “In the very short term, the risk of deflation is greater than the risk of inflation globally. This should change as demand comes back after the lockdowns start getting lifted. In case demand comes back strongly then inflation can pick up due to huge domestic and global liquidity. Moderate inflation is good for financial assets," said Gaurav Awasthi, Senior Partner at IIFL Wealth Management.

According to the expert, investors should buy into these assets in a staggered manner. “Getting extremely overweight or bullish on assets such as equity and gold before we know the pace of the recovery would be premature," Awasthi added.

Experts also warn that deficit monetisation could pose a risk to inflation over the medium to long term. Assets such as equity and gold are traditionally better at beating inflation than debt. However they carry their own risks such as companies not being able to survive the downturn. Investors should keep an eye out for more data on deficit monetisation, and then gradually move into these assets.

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