Context: India faces a “guns, germs and steel” crisis. There are Chinese “guns” on the borders. There are coronavirus “germs” in our bodies. There are “steel” makers and other businesses on the verge of bankruptcy.
Tragedy of military, health and economic crises
- Military crisis: The Chinese military threat warrants immediate and strategic action by our defence and foreign affairs establishments.
- Health crisis: The COVID-19 health epidemic is going to be a long battle until a vaccine arrives.
- Economic crisis: Even prior to COVID-19, India’s trade levels had fallen from 55% of nominal GDP in 2014 to 40% in 2020. Now, with the global economic crisis, India’s economy is in severe crisis.
Extent of Funding Required:
Cost to the military crisis: The Chinese conflict will need central government funds by an additional 1-2% of GDP.
- Kargil parallel: India’s defence expenditure in the Kargil war year increased by nearly 20% from the previous year. It also forced the then government to increase India’s defence budget for the next financial year to 2.7% of nominal GDP.
- Constraints: India’s defence budget is just 2% of GDP for the financial year 2021. China’s defence budget is nearly four times larger.
Cost to the health crisis: The central government will need additional government funds equal to at least 1% of GDP to continue the fight against COVID-19.
- Constraints: The combined public health expenditure of States and the central government in India is a mere 1.5% of GDP, compared to China’s at 3% and America’s at 9%.
Cost to the economic crisis: Based on estimates of loss of consumption, incomes and its multiplier impact, the government will need to inject additional funds of 5% of GDP to absorb the economic shock and kick start the spending cycle again.
- Lockdown effect: The lockdown shut off people from spending for two full months, which will contract India’s economy for the first time in nearly five decades, regardless of a strong agriculture performance.
- Spending by people is the largest contributor to India’s GDP. For every Rs.100 in incremental GDP, Rs. 60 to 70 comes from people’s consumption spending.
- India’s economy has four major drivers
- People’s spending on consumption
- Government spending
- Investment and
- External trade
Incremental funds needed: In sum, the government needs to spend an additional 8% of GDP while revenues will be lower by 2% of GDP, a combined gap of 10% of GDP.
Potential Sources of Revenue and associated challenges:
- Govt. revenue: Central government revenues for this year were budgeted at 10% of GDP but it will likely fall short by 2% of GDP.
- Trade: Already the global trade has contracted so trade is not a viable alternative to offset the loss from consumption.
- Falling GDP: The government had expected a nominal GDP growth of 10% this year. It is clear now that GDP will not grow but shrink.
- Investment is also not a viable option at this stage since the demand for goods and services has fallen dramatically.
- Wealth tax: Potential new sources of revenue such as a wealth tax or a large capital gains tax can be of help for the medium term but will not be of much immediate help.
- Printing money: The Reserve Bank of India can just create money at will and transfer them to government coffers electronically.
- But if money is printed at will, it can lead to a massive jump in prices and inflation. Indian Rupee is not a global reserve currency like the Dollar whose printing did not lead to inflation in the past.
- Borrowings: Whether money is printed or borrowed from others, it will still be counted as government debt.
- With rising government debt levels, international ratings agencies will likely downgrade India’s investment rating to “junk”, which will then trigger panic among foreign investors.
- Moody’s reduced the long-term foreign-currency credit rating of India to Baa3 from Baa2.
- Government borrowing: A balanced course of action for the govt. is to borrow heavily to pull India out of the “guns, germs and steel” crisis and deal with the consequences of a potential “junk” sovereign rating later.
- Direct transfers: Putting money directly in the hands of the needy can stimulate immediate consumption.
- Fiscal stimulus: It should be similar to the “New Deal” which was a series of programmes and projects instituted by U.S. President Franklin D. Roosevelt during the Great Depression of the 1930s.
India is currently facing a significant dilemma — save the country’s borders, citizens and economy or prevent a “junk” rating.
Image Source: India Today
About Bond Ratings
- The bond credit rating represents the creditworthiness of corporate or government bonds.
- Gilt-edged bonds refer to high-grade bonds that some national governments and private organizations issue in an effort to generate revenue.
- Investment grade bonds: Risk-averse investors looking for safe bond investments to avoid the risk of losing their principal investments may opt for government bonds or for investment grade corporate bonds with AAA to Baa3/BBB- ratings.
- Junk bonds: Bonds that carry a higher risk than investment grade bonds are referred to as junk bonds.
- Investors demand a higher yield for purchasing these bonds as compensation for taking on a high level of risk. Hence, these bonds are also referred to as high yield bonds.
- The bond yield is the annual return on investment which depends on the purchase price of the bond and the interest promised..
- Ratings: Non-investment grade bonds are typically given a credit rating of Ba3/BB- by credit rating agencies Moody's, Standard & Poor's, and Fitch Ratings.
- A Ba3/BB- rating indicates a higher level of concern with respect to the deteriorating economic conditions.