Published in l'express of 10 March 2021
Despite the loud and foreceful claims of the proponents of the"unconventional financing measures" that we had no other alternatives , we persisted in highlighting (see - A continuation of populist policies, May 22, 2020) the limitations of the money financing of the budget deficit (printing of money) and its limited applicability in some less advanced open economies like ours because
a) the increase in the money supply associated with monetary financing inevitably leads to higher expected inflation than would be the case with debt-financed fiscal policies.
b) Unlike in advanced economies which issue debt in reserve currencies, other economies do not have this luxury and thus are more likely to face capital flight and excessive depreciation of their currency
c) monetary financing may be more relevant for those economies which are much less open than ours and which have a degree of exchange control and thus on imported inflation
d) the mere provision of liquidity to boost demand may not be of much help because the productive system does not respond as rapidly as in advanced economies. Moreover, the absence of material inputs globally and domestically can clearly make it difficult for the production system to respond rapidly to the increase in demand, resulting in a spike in inflation and an acceleration in the depreciation of the rupee, and
e) foreign investors and Credit Agencies may be apprehensive of such unconventional policies by emerging market central banks and we thus stand the risk of a rating downgrade.
And the latest Moody's report is proving us right ; it notes that “the negative outlook also captures the risks related to some of the pandemic-related policy measures, and in particular the large financing of the 2020-21 budget by the central bank, which raises risks to monetary policy effectiveness. There is a risk that the large expansion of the monetary base increases inflationary pressures that prove hard to contain, leading to a rise in domestic borrowing costs including for the government “
The IMF had also cautioned us that “Direct central bank lending to the government should be a last-resort mechanism, considered only where it is not possible to obtain enough financing from any other source. Moreover, it should be on market terms, restricted in time, and with an explicit repayment plan over the medium term. Otherwise, the monetizing of deficits risks undermining the long-term independence and effectiveness of the central bank, since concerns may arise about its ability to keep inflation under control in the future. This would unanchor inflation expectations and add to pressures on the currency like in Zimbabwe.”
The likely Impact of the MRU downgrade on bank ratings :
1. A Baa1 to Baa2 downgrade for MRU could mean an automatic downgrade from Baa2 to Baa3 for MCB if we keep a notch higher for sovereign MRU. MRU rating has to be higher or as high as MCB.
2. If MCB goes below Baa3 ie Ba1 junk, then MCB financing on the bond market goes dry because no financial Institutions or Institutional investors will invest in junk bond status.
3. There will also be a likely increase in the cost of financing . But transition to junk is the biggest issue for MCB.
Conclusion: Destiny of MRU and MCB are linked!
A rude awakening awaits us as insolvency risks will inevitably materialize in due course. You recall we had recently reiterated the fact that the confidence issues arising from continued BOM's money printing for fiscal purposes, currency depreciation and inflation are likely to intensify, posing disruptive threats to capital inflows and overall financial stability.
Unless there is an effective response to the looming risks and threats, we could be staring at a financial crisis of unprecedented magnitude.
