Should India Print Money To Fight Covid-19?

The COVID-19 crisis has caused a collapse in global GDP and staggering increases in public deficits and debt. In India, we expect the central government deficit to deteriorate to -6.9% of GDP in calendar 2020 and no profound recovery in the subsequent years (Figure 1). Against the backdrop of a crippled economy and rising debt metrics, policymakers around the globe are adopting or considering unconventional monetary policy to solve the current state of emergency. Examples are the adoption of yield curve control by conservative central banks such as the Reserve Bank of Australia; partial monetization of the fiscal deficit by the Bank of England; Quantitative Easing (QE) in emerging markets such as Colombia, Poland, and Romania; and even planned outright partial monetization of fiscal deficits by Indonesia. In India too, voices are becoming louder over whether the country should resort to debt monetization: see, for instance here, here and here. In this op-ed, therefore, we ask ourselves the question: should India resort to debt monetization, or is the cure worse than the disease?

Debt monetization or monetary finance has been gained much attention under the flag of Modern Monetary Theory, MMT for short. MMT seems to generate some consternation among economists, and indeed people in general. They seem unable to grasp that governments, unlike households or businesses, are not balance-sheet constrained. They can just print money; there is a magic money tree. Indeed, the mechanism by which MMT works is very simple (Figure 2). The government spends money into the economy – which in a sovereign-currency issuer comes before taxation. If there is not enough tax revenue to cover the required spending (either because the economy is weak or because the government does not want to tax too much), then bonds are issued to make up the difference. This is the same as in normal economic ‘theory’.

All that then changes is that the central bank either buys the bonds directly from the government (which is debt monetization), or if investors buy the bonds it buys them from that secondary market. The latter is what we already see in QE - unless one believes that central banks will start running down their balance sheets again. Once the government has spent the money, the normal ‘money-multiplier’ effect works.

But there are huge risks involved. According to MMT academics, inflation is the only constraint to government spending. But does a country have the power to control its own worst instincts once it does start to print that money, and keep inflation in check? We argue that a country is eligible to adopt MMT without causing side effects in case it meets three criteria:

1. Currency: a countries needs its own free-floating currency
2. Institutional quality: countries need to have the policy discipline to turn off the fiscal taps and raise rates if inflation is too high. Therefore, we also add a filter for the World Bank’s measure of institutional quality[1], with the metric that the country must be above the median for this global measure
3. Current account (CA) balance: in order to create money domestically and to have it accepted on a stable basis internationally, a country needs to run a structural current account surplus.

[1] We have based institutional quality on the World Bank’s government effectiveness index. This index captures the independence of the public services from political pressures and the quality of policy formulation.

Current account metrics

The CA principle in particular needs more explanation. If a country runs a large fiscal deficit, but still runs larger combined household and business (private sector) surpluses, then internationally the country is a netlender, not a borrower: this is the case when a country runs a current account surplus (see Figure 3). In doing so, one can keep control of both (low) interest rates - as long as it faces no inflation problems domestically - and the exchange rate. After all, in traditional economic theory, and practice, a CA surplus, the tendency is for the currency to appreciate, or at least hold its value over time.

But if a country runs a structural current account deficit (as India is doing[2], see Figure 1), things become problematic. Why? Because the government is spending - with printed money - while households and businesses, collectively, are dis-saving too. An economy that is dis-saving overall (Figure 4) runs an external deficit; that makes it a net borrower from abroad; and that often sees currencies come under downwards pressure anyway. This trend is exacerbated in the case of MMT. Inflation may already be too high, as aggregate demand is running ahead of supply: if so, printing more to spend more simply raises inflation higher. Moreover, from the trade perspective, MMT pushes twin deficit countries deeper into the red. This puts extra stress on the exchange rate as importers convert newly-minted money into foreign currency – and the supply-demand imbalance pushes the exchange rate lower.

The same supply-demand imbalance kicks in when capital flows into the country on the other side of the balance of payments. If money is being printed and inflation is going up, a higher interest rate premium is demanded: if that is not delivered then a lower currency will result instead – unless the currency is pegged, but that precludes running MMT in the first place! Even if a foreign investor does not directly demand a lower exchange rate, the supply-demand imbalance in the currency market still comes to bear eventually. In short, the exchange rate will depreciate – and in time lead to imported inflation. Of course, the central bank could step in and intervene using its forex reserves. However, running down on forex reserves can ultimately result in a balance of payments crisis - much more so when the government is printing money to cover a fiscal deficit.

[2] The CA balance was positive for India in Q2 but has been negative for more than a decade. The small surplus was driving by low oil prices and a steep drop in imports due to the COVID-19 crisis. With oil prices on the rise and the economy returning pre-COVID conditions sooner or later, we forecast the CA balance to push into negative territory again soon (see figure 1).

In the end, we argue that only seven(!) countries are eligible to apply MMT in a sustained, responsible manner. These are China, Japan, Malaysia, Thailand, Uruguay, Israel and the US (see Figure 5). The US is a special case, as it runs a structural current account deficit, but at the same time has the global reserve currency: the US dollar. Since almost all global transactions are made in US dollars, America can rely on financing and production from abroad, without this leading to a strong depreciation of the dollar, rising inflation and domestic interest rates.

And while the euro area as a whole also has a slight current account surplus, monetary financing is explicitly prohibited by European treaties. Given the large economic differences between the Eurozone member states, the question is whether MMT is sensible at all, especially when certain institutions (such as a common debt security, banking union or budget) have not yet been settled. So for the time being it seems that the T in MMT will continue to dominate in Europe.

Despite the warnings above, policymakers in many EMs seem to think of MMT as the golden ticket from ‘Charlie and the Chocolate Factory’, especially since inflation and currencies in countries that have adopted QE (which is basically MMT light) have not yet run into serious trouble… yet.

Short-term: no accidents

In the short term, debt monetization[3] in India would not have too many negative repercussions because of massive risk-off sentiment, a point which has been raised by former RBI governor Raghuram Rajan. Banks are still reluctant to lend, as they prefer to park excess liquidity at the central bank against the reverse repo of 3.35% instead of receiving a yield of approximately 6% on corporate lending or government bonds. So even if the RBI started buying bonds on the primary market and this cash was spent in the real economy, it would ultimately end up on deposits by banks, which would channel those excess funds again to the RBI. In a low-interest rate environment, nobody believes inflation could be a problem. In fact, we wouldn’t be surprised if most young traders have never witnessed a high inflation regime to begin with and, therefore do not keep an eye on that old-fashioned relic from the past: CPI.

Medium-term risk

However, all of this involves a major medium-term risk, especially since the Indian economy does not meet the conditions for MMT. There is always a lag, similar to an eventual inflationary impact of a demand shift when supply is fixed. To gauge what could be the side effects, we ran a scenario analysis using a system of equations which we integrally solve (see the appendix in this report for all technical details).

Scenario: a second 20 lakh crore package using printed rupees

We have drawn up a scenario to gauge the economic impact of another government stimulus package financed by freshly printed INR, starting from 2020Q3 onward and spread out over multiple years. We assume a package similar in magnitude to the USD 270bn stimulus package announced in May this year, which is equal to 10% of GDP. The major difference is that we assume that this second package is fully financed by freshly printed rupees.

Such a spending boost would certainly have positive effects on the economy. In this report, we have argued that the local equivalent of a 20 lakh crore package could raise GDP growth by 1.8ppts in fiscal year 2020/21. We assume that a second package of this magnitude would result in cumulative economic growth of an additional 2ppts vis-à-vis the baseline over the coming years, and an increase of India’s structural growth capacity by 6ppts.

However, it comes as no surprise that there are some serious side effects, even though the fiscal impulse is short-lived. As a first side effect, our model simulation shows that inflation might spike to 12% on average in calendar 2021, which is more than twice the inflation rate in the baseline and well above the upper band of the RBI’s target range (Figure 6). These are inflation figures we have not witnessed in India for over three decades.

[3] After numerous shifts in the monetary policy regime (see here), the Fiscal Responsibility and Budget Management Act (FRBM) now explicitly forbids the RBI from buying bonds on the primary market. However, there is an escape clause saying that a national calamity or a decline in real quarterly output by at least three percentage points below the average of the previous four quarters would allow debt monetization. So in theory, India could resort to MMT.

As a second side effect, our simulation shows that the rupee will be crushed: INR would depreciate by 16% against the USD in 2021 compared to 2020 levels and almost 25% against 2019 levels. Investors seeing their yield being eroded by high inflation would shift their portfolios away from Indian assets. Consequently, the INR would plunge, which would raise inflation even more, as imports become more expensive.

Fast-rising inflation in combination with a freefall of the currency does not bode well for economic performance. Although we have not calculated the second-order impact on the economy, such as a price-wage-price spiral, we are certain that MMT will ultimately be more damaging to the Indian economy than any short-term prosperity it brings.

Or to put it differently: for India, as for most other economies, the MMT cure is arguably worse than the disease.

Also published on Bloomberg/Quint - July 28, 2020