One of the interesting pre-budget recommendations (rather suggestion) to the Union finance ministry was from the apex industry body, the Confederation of Indian Industry (CII). The CII welcomed the significant fiscal stimulus - by way of both tax cuts and enhanced expenditure - which the government had put through during the course of 2008-09. This resulted in the overall government deficit rising some 3.5 percentage points to 6 per cent against the budgeted estimate of 2.5 per cent for fiscal year March 2009.

CII indicated that the government had to persist with fiscal stimulus during FY 2010 also in order to ensure a strong recovery for Indian industry from the demand slowdown of the earlier year. While arguing for continued fiscal stimulus, the industry body went further and suggested that government must be even prepared to 'monetise' the deficit.

Monetisation: not an unmixed blessing

One suspects the CII was not that serious when it suggested monetisation of the government's deficits. For, the ramifications of monetisation of the type the CII suggested go far beyond the transitory relief it may provide in preventing / minimising the pressure on private sector borrowing costs in the face of enhanced government expenditures and borrowing.
To be sure, monetisation has been resorted to in some of the major western economies (though indirectly and in a manner slightly different from what the CII has indicated) in response to the serious economic slowdown facing them. But to argue for monetisation now in India would seem to ignore both the structural characteristics of the Indian economy and also importantly, the historical experience India has had with monetisation - particularly in the period up to 1999 - 2000. Run away inflation would be the last thing anybody would prefer in India and that could be the consequence of outright monetisation of the type the CII has suggested.

(If it can provide any comfort for the CII, it can be pointed out here that the government / RBI have actually been indirectly resorting to some degree of monetisation now - as a means of financing government expenditure in the past several months)!

As recently indicated by the RBI Governor, India continues to be a 'supply-constrained' economy. This is quite at variance with key western economies such as the US, UK or the Euro zone where the economic slowdown has opened up large spare capacity across major sub-segments of their economies. They can, therefore, afford to prime up demand through monetisation without undue fears of such pump-priming spilling over into high inflation. That is not the case in India where deeply entrenched supply constraints mean that outright monetisation carries the large risk of run away inflation. There is not much of an output gap to be exploited here in India.

It is pertinent to note here that the concept of a large output gap is being questioned even in the advanced western economies now. Therefore, how can we exploit a gap (which may not even exist or may not be large at all) so that inflationary pressures do not get aggravated even if fiscal policy / monetary policy were to be very accommodative?

Going farther, there are not only the above cited structural economic reasons arguing against outright monetisation of the type the CII seemed to have in mind. Monetisation of that type and in that scale would be more characteristic of under-developed economies such as a Zimbabwe or some Latin American countries.

Deficits also upset investments sentiment...

Leave alone the larger structural reasons against high deficits and monetisation. A study of the historical data on Indian government deficits and corporate profitability suggests that high and rising budget deficits could be directly negative for corporate profitability too.

Not only could the strains on corporate profitability arise from difficulties in accessing the financial markets for short and long term finance (the 'crowding out' effect in the face of enhanced government borrowing). High budget deficits could also upset sentiments and confidence in the public capital markets - crucial for raising risk capital or equity. The strains may also spill over into accessing external savings in the form of commercial borrowings as overseas creditors may baulk at lending to companies in a country whose sovereign runs deep budget imbalances.

Over and above the difficulties on the financing front, high budget deficits and the demand boost it gives could also create a self-perpetuating loop of high cost goods and services. This could be not only damaging for corporate profitability but also for sentiments and confidence. Economic agents would not then be able to borrow, lend, invest or consume with confidence so that the purchasing power of money would be broadly stable. Such a state of affairs could indeed be a lot more damaging to the private corporate sector.

As Table 1 shows, corporate profitability improved significantly in the post 1999-2000 period. The improvement broadly coincided with a period when the overall government budget deficit was under greater control and declin-ing- relative to the earlier years. Compared to an average annual deficit of 6 per cent in the period between 1990-91 and 1999-00, the average annual deficit was notably lower at around 4.6 per cent in the period from 2000-01 to 2006-07.

This is as per the published government deficit figures which exclude off-budgetary items such as the oil bonds and the fertiliser bonds which are issued to the oil marketing companies / fertiliser companies to compensate them for the under-recoveries (of cost) they have to absorb by selling their end products at government-fixed prices. These bonds, as everybody understands, really form part of the overall budget deficit as a cash outlay would have to be made whey they are redeemed.

These oil bonds / fertiliser bonds have roughly amounted to between 0.5 per cent and 1.5 per cent of GDP over the many years during which they were issued. For instance, in 2008-09, bonds amounting to Rs.98,000 crore were issued to the oil / fertiliser companies, accounting for some 1.8 per cent of GDP. Despite the addition of these off-budget items, the overall deficit figure continued to remain under control and was on a broadly declining trend in the period post 2000. This trend has now been upset by the near trebling of the government deficit between FY 2008 and now - from 2.5 per cent to 6 per cent in FY 2009 and further to 6.8 per cent for FY 2010.

The beneficial feedback or impact of lower government budget deficits on overall corporate profitability is more clearly brought out by the chart above. Corporate profitability here is represented by the overall corporate savings rate - that is, (retained earnings + depreciation) as a per cent of GDP. As can be seen, the negative correlation between government deficits and corporate profits is well established, particularly in the post 2000 period.

One now has to see how the near trebling of the deficit impacts corporate profitability going forward. If the historical data are any indication, corporate profitability is likely to be under quite some strain in this year and next.

Budget deficits do have their place in the overall working of an economy. But economic agents should be aware of their limits and their damage potential.