VIEW: Should government be thinking of a Corona bond to fund fiscal deficit?

Sharply lower tax collections coupled with increased relief and recovery spending amid the raging COVID pandemic leave the government with no choice but to run large fiscal deficits for some time.

There may a case for the the government to fund some of this deficit by directly borrowing from savers through special bonds, rather than from banks.

Such an instrument--let us call it Corona bond--would help financial stability, by offering a reasonable alternative to savers, and by curbing the possibility of unwelcome inflation down the road.

Even as the economy has taken a body blow from the pandemic, our money supply is registering robust growth.

To recap,money supply “M1” is the sum of currency in circulation and demand deposits in banks. Adding time deposits to this M1 gets us broad money supply “M3”. In a sense, money supply indicates the capacity of the system to consume, invest, or trade in assets.

While the economy itself has been slowing considerably through the COVID outbreak, our money supply growth is quite robust. As of August, India’s M3 was growing at 12.6 percent, whereas M1 was growing at 19.2 percent annually. Ignoring blips post demonetization, we last saw this quantum of M1 growth in 2010. There is a lot of money in the system, sitting idle as of now.

Where has all this money come from? There are primarily three sources of money supply.

First, when banks give loans, they credit the account of borrowers and create money that can then circulate in the system. At the moment though, with bank credit growth barely at 5.5 percent per annum, credit growth does not explain the robust growth in money supply.

Second, when banks lend money to the government by buying government bonds, the eventual government spending net adds to the money supply. In FY21 so far, commercial banks have already purchased a record Rs 5.5 lakh crore of government debt.

Note that when the government sidesteps the banks and raises equity or debt directly from others – from retail or from non-bank institutions – no net money supply is created. In such cases, money supply first dips as savers fund the government, and then is replenished when the government spends the funds.

In summary, bank funding of government expenditure net adds to money supply, while non-bank funding shifts existing money from savers to recipients of government spending.

Finally, when net foreign currency inflows enter the banking system, beneficiary accounts are credited, and money supply is created. With our imports dropping sharply through COVID-19, we are seeing large net foreign exchange inflows, adding to money supply.

For now, therefore, despite very poor credit growth, bank funding of government spending and net foreign exchange inflows is causing a sharp rise in money supply.

The current sharp rise in near money M1 is particularly notable. Currency in circulation has grown by over 23 percent year-on-year, as people likely keep precautionary funds close at hand. Likewise, Jan Dhan Yojana account balances have grown by over 25 percent year-on-year, following government relief measures. In addition, very low real interest rates have likely reduced the demand for term deposits. Instead, savers may be eyeing riskier avenues such as equity markets, contributing to the significant wedge between economics and asset market outcomes.

Normally, when money supply – particularly M1 – grows sharply, economic activity should follow. These are however anything but normal times. The pandemic has sharply reduced the velocity of money. Much of the money is sitting idle, waiting for the pandemic to subside, or for better long-term savings opportunities to appear.

While there may be little risk of any monetary-led inflation for now, we have to look ahead. Eventually, when the pandemic recedes, credit growth will hopefully pickup and the government may follow through with an infrastructure push. Despite imports picking up again, we could continue to enjoy balance of payments surpluses via capital inflows. All this should be very welcome, but could lead to even more growth in money supply, and spur consumption.

Consumption sounds very welcome in today’s barren context, but past experience suggests otherwise. We have struggled to meet any sharp rise in domestic consumption with an adequate increase in domestic output, particularly in proteins and manufactured products. Already, supply-side issues have kept retail inflation and inflation expectations elevated. Any eventual money-led inflation would severely complicate policymaking through our recovery.

We would be well advised to create room for more growth in productive money supply later, via credit growth, government infrastructure spending, and capital inflows. Besides disinvestment, which could be constrained in today’s context, one way to create such monetary room would be the issuance of a Corona bond targeted at savers.

As described earlier, if the government were to fund its expenditure during these extraordinary times by raising funds directly from depositors, rather than from banks, no net money supply would be created. Money would instead move from savers to the recipients of government spending.

To attract investors, the Corona bond would have to offer appropriate post-tax returns. This would offer a low-risk term savings alternative to savers, hopefully with less-repressed negative real rates, and away from risky asset markets.

In summary, Corona bonds would offer significant financial stability benefits of curbing current growth in money supply, creating space for healthy monetary expansion later, and offering reasonable alternatives to savers away from risky asset markets. It would be one way for the government to fund its much-need relief and recovery expenditures with lower risks than a conventionally funded deficit.