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Why no Cheques for us?

In this week's FinMail we are going to understand the reason why the Indian Government can't replicate the US Government in sending all of us a cheque. We look at the repercussions of the same.



The Story:

President Joe Biden, on the 11th of March, signed the Rescue Plan in an attempt to stimulate the US economy that has been locked in due to the pandemic. On Monday he addressed a press conference in which he remarked that the IRS, Treasury Department, and the Bureau of Fiscal Service would soon start disbursing 100 Million Cheques which will provide a $1400 check to every eligible American. This is the third stimulus cheque that is being made and is included in the $1.9 Trillion Coronavirus Relief Package.


You might have wondered, Why the Indian Government can't do the same and send every one of us a cheque. So, today we bring you the discussion on why the government can't do this while also looking at the repercussions if done.


So let us deep-dive right into exploring the reasons why the Indian Government can't do this.



Why India can't pull it off?

For understanding the reason why the Indian Government can't do this, consider or assume India as a 'Company' and the central government as 'Board Members' of the company. Now for you to have a profitable interest in a company like India, you need to either own the shares of the company or else you need to lend money to the company by purchasing the company's bonds. Now can a country have its own shares? No, but instead, the government of the country can borrow money from the public, companies, or other countries by issuing bonds which are generally called Sovereign Bonds.


So, if you purchase sovereign bonds of India or some other country as well, does it mean that you have a profitable interest in the country that you are invested in? Yes so if you hold Sovereign Bonds of any country it means that you have a profitable interest to some extent.


Now, you might be aware of the credit ratings of the bonds/debentures. So, if a company issues its bonds/debentures, a credit rating is assigned to depict the credit-worthiness of the borrower. As sovereign bonds contain sovereign guarantees i.e. the guarantee of the government (regardless of any ruling party) the credit rating is highest in these bonds on a country level. But if you were to look from an international level or perhaps as a Foreign Institutional Investor, you would consider the credit rating of the country as a whole. The credit rating of countries that differ from each other like India would have a higher credit rating as compared to Mongolia or Pakistan while it will be lower as compared to Japan or USA.


So assume that you are a bondholder of Mexico and you have a profitable interest in Mexico's future, how would you feel if a company (Mexico) that you are invested in starts distributing money to everyone, even to those who have no profitable interest in the company. Would you as an investor be concerned about the company's profitability? Of course, yes! So in the same way, consider India's situation from its bond holder's perspective, assume that you are a Foreign Institutional Investor and you hold Indian Sovereign Bonds. How would you feel about the safety of your capital when India decides to distribute free money?


When India already has a fiscal deficit (the gap between Income and Expenses) and distributing free money to the people of India will mean it will widen up more Fiscal Deficit and thus as an Investor you would be concerned about the profitability of the company. The creditworthiness of the company will be affected which in turn would mean that the rating of the bonds would be downgraded. And a downgrade of a bond means that the risk of the bond has increased. If the risk has increased, either you would ask for more interest, or either you would be concerned about your money and might also think of exiting the bonds by selling those bonds.


You would also be concerned about the financing aspect of the distribution. As in how would the Reserve Bank make arrangements for such a huge amount. For financing the amount, either more money is to be printed which can endanger the inflation rates in the country and would also devalue the currency, more loans are to be borrowed from people, companies, or other countries which would add to India's debt or the Reserve Bank would need to reduce the interest rates in the country. Reducing Interest Rates will effectively mean that banks will start paying out lesser interests to the investors and the loan rates would also essentially come down. But lower interest rates would demotivate investors as they will start looking for other Investment Options. But let us consider that reducing the interest rates is the safest option as of now. Now how would this decision pan out?



The Effect:

The decision of the government to distribute free money would create panic among Investors who are just holding these bonds for their profitable interest. Economic times in May last year reported that Foreign Investors hold about 2% of India's total outstanding debt. 2% would seem a small portion but in amount terms it is about ₹11 Lakh Crores. Now that is huge! Imagine what panic would turn out to be.


First of all, as the government has decided, it will now have to raise money for the same or make arrangements for it. Because this is a huge task for the government to do, to execute this step in a way that doesn't affect the economy. In most cases, the credit rating of Indian bonds will suffer a downgrade (reduction in rating). As you may know, if a Bond's credit rating downgrades, it signifies that the risk involved has been increased and two of either thing could happen

1) Investors would require more rate of interest as a premium for the increase in risk and because that is not possible

2) Investors would be left with no other options but to sell.



Now, what if this happens at a scale?

The panic that has been created will trigger a huge selling streak of Indian Bonds in the market. Investors in an attempt to exit these bonds would also be ready to sell the bonds at a discounted rate to what they had purchased at. This will mean there are more bonds in supply while the demand is the same or low. As we all know, as supply increases, the price decreases. Investors would ask for more rate of interest or more discounts because there is ample supply of these bonds in the market.


This means that the cost of borrowing has gone up. Because borrowers have now need to pay more interest or suffer a discount in the amount received as a result of lack of interest in buying the bonds. So on one hand, Interest Rates were to be reduced to provide easy access to money to people and to make arrangements for the money. But due to this decision, the interest rates have now shot up. This is totally the opposite of what was expected from the situation.


This reason alone is the larger risk factor that the government can't take the step. If this reason was not in the picture, there are some other challenges as well that would be a hindrance to the government's step to distribute free money.


India's Large Population - Distributing free money in a country with a population of ₹130 Crores would require a huge sum.


Low Tax Filing Population - Creating an eligibility criterion based on the information of the citizens would be difficult as there are only a small fraction of people who pay taxes in India. Less than 3% of the population file taxes.


Lack of Infrastructure - Even if the government decides to distribute free money, we just lack a proper infrastructure in place whereby we can assure that every deserving individual gets the money without someone hijacking it.



But why does US can pull it off?

The answer is the trust of the Investors. USA has the level of Institutional Trust which India simply doesn't. Comparative to US, India has a lack of trust of investors that makes the difference. This is like the rest of the world banks on US to pull it off. Also, USA's currency is a widely accepted currency even so that the rate at which US is printing new currency, it is not concerning the Investors much.

Also, the demand for US Federal Bonds won't decrease much, and Investors would still keep buying US Bonds. Just because of the same reason - Trust!


That is it for this week's FinMail.

Shoutout to FinForAll for bringing the subject of this FinMail to the limelight.

 

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