India Tests the Limits of Public Finance in Emerging Markets

Who exactly is going to fund India’s stimulus?

By guest author Mike Bird from Wall Street Journal

The Indian government promised a blockbuster economic stimulus Tuesday that lifted the country’s stocks. But the country’s economic circumstances looked bleak even before the pandemic began, and it’s unclear who the buyers for all this debt will be. The central bank may eventually need to step into the breach.

India is relaxing some lockdown restrictions as the brutal impact of the economic seizure becomes clear: unemployment rose to 27.1 % in the week to May 3, and many low-income workers have or are at risk of running out of money for basic necessities.

The government touts the total size of the new rescue package at 10 % of GDP—but some of this spending has already been announced—and the figure includes various operations by the Reserve Bank of India, so some isn’t fiscal at all. But the new component of actual spending could still run to 12 trillion Rupees (USD 159 billion) or 6 % of GDP, according to Nomura economists.

The announcement pushes India from one of the smallest fiscal packages among major developing economies to one of the largest. Credit ratings firm Fitch had already projected a 6.2 % central government deficit this year, driven by both falling revenues and increased spending, before Tuesday’s announcement (May 12, 2020).

Who exactly is going to fund the stimulus? The country’s financial system was already troubled, so the commercial banks that hold the largest share of government bonds are less likely to pick up the tab. Foreign investors have also reduced their holdings, in common with a general retreat from emerging market debt this year, and the country runs the risk of having its credit rating downgraded.

That may leave the RBI holding the bag in one way or another. The central bank is legally barred from buying bonds directly from the government, except in exceptional circumstances. And these circumstances are undoubtedly exceptional.

The main fear critics have when central banks buy bonds from their own governments is inflation. But inflation has been low in India in recent years, and given the collapse in demand there is little reason to expect a sudden surge in prices domestically.

Though direct monetary financing is often presented as a road to ruin for economies of all stripes, it may actually be the best option at this juncture. But that shows just how parlous the options available are.

The real risk is a further depreciation of the rupee, which reached its weakest point on record against the dollar in March as emerging market currencies were sold off. India began the crisis with the largest foreign exchange reserves on record and a minimal current-account deficit, both of which have helped avert a steeper selloff so far. The country is a major importer of oil and crashing commodity prices also lend its balance of payments some support for now.

But the Indian economy already looked weak going into the crisis. Investors should be on the lookout for consequences down the line particularly in currency markets, and especially if oil prices eventually begin to rise.