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Deficit Monetisation by the RBI

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May 28, 2020

What is the issue?

  • The Union Finance Minister recently remarked that she was keeping her options open on monetisation of the deficit by the RBI.
  • How the government and the RBI decide on this will have significant implications for India’s economic prospects, and here is an overview on that.

What is the present deficit scenario?

  • Indian economy is passing through an unprecedented phase, and so is the fiscal health of the country.
  • Apparently, the government will not be able to achieve its FY21 fiscal deficit target of 3.5% of GDP.
  • The exchequer is facing a revenue crunch due to falling tax revenue post the lockdown.
  • There is also difficulty in realising the disinvestment target in an uncertain market.
  • Adding to it, the RBI has projected a negative GDP growth rate for the Indian economy in FY21.
  • The Government has even raised its gross market borrowing for FY21 by 54% (Rs 7.8 - 12 lakh crore).
  • Given these, the fiscal deficit as a percentage of GDP may even cross the double-digit mark.
  • The government stimulus package of Rs 20 lakh crore also seems to be inadequate to revive the economy.
  • As is seen, a large part of it accounts for liquidity-boosting measures by the RBI.
  • Because, the weak fiscal position has forced the government to restrict the stimulus.
  • It is in this scenario, that the need for monetisation of deficit has been widely felt.

What is monetisation of deficit?

  • In simple terms, monetising the deficit is equal to the central bank creating money to help the government meet its expenditure.
  • In layman’s language, this means printing more money ('monetisation'), which is direct monetisation.
  • In other way, deficit monetisation happens when the RBI buys government securities directly from the primary market to fund government’s expenses.
  • This is a kind of implicit monetisation.

How have the modes evolved?

  • Monetisation of deficit was in practice in India till 1997.
  • Back then, the central bank automatically monetised government deficit.
  • It does it through the issuance of ad-hoc treasury bills.
  • However, two agreements were signed between the government and RBI in 1994 and 1997.
  • This was to completely phase-out funding through ad-hoc treasury bills.
  • Later on, with the enactment of FRBM Act, 2003, RBI was completely barred from subscribing to the primary issuances of the government from April 1, 2006.
  • It was agreed that henceforth, the RBI would operate only in the secondary market through the OMO (open market operations) route.
  • [OMOs involve the sale and purchase of government securities to and from the market by the RBI to adjust the rupee liquidity conditions.]
  • The implied understanding was that the RBI would use the OMO route not so much to support government borrowing.
  • Instead, it would be used as a liquidity instrument.
  • This was to manage the balance between the policy objectives of supporting growth, checking inflation and preserving financial stability.

How does it work?

  • Direct monetisation (or simply 'monetisation') of the deficit does not mean the government is getting free money from the RBI.
  • It has to be worked out through the combined balance sheet of the government and the RBI.
  • In that case, it will turn out that the government gets it not free, but in heavily subsidised manner.
  • That subsidy is forced out of the banks.
  • And, as in the case of all invisible subsidies, banks do not even visibly know.
  • In the other way, now, the RBI is monetising the deficit indirectly by buying government bonds through open market operations (OMOs).
  • Notably, both monetisation and OMOs involve printing of money by the RBI.
  • But there are important differences between the two options that make shifting over to monetisation a risky decision.

How is OMO better to direct monetisation?

  • Both monetisation and OMOs involve expansion of money supply that can potentially result in inflation.
  • However, the inflation risk that both carry is different.
  • OMOs are a monetary policy tool with the RBI deciding on the amount of liquidity to be injected in and when to.
  • In contrast, in monetisation, the quantum and timing of money supply is determined by the government’s borrowing rather than the RBI’s monetary policy, to fund the fiscal deficit.
  • If RBI is seen as losing control over monetary policy, it will raise concerns about inflation.
  • That can be a more serious problem than it seems.
  • More importantly, India is inflation prone unlike many other economies.
  • Notably, after the global financial crisis when inflation “died” everywhere, India was hit with a high and stubborn inflation period.
  • As is said by some, the RBI back then failed to tighten policy at the right time.
  • But since then, India has embraced a monetary policy framework.
  • The RBI has indeed earned credibility for delivering on inflation within the target in this period.
  • Now, forsaking that credibility can be costly, with wider implications for the economy both in the short- and long-terms.
  • If, despite these, the government decides to go ahead, markets will fear that the constraints on fiscal policy are being abandoned.
  • They may see the government as planning to solve its fiscal problems by inflating away its debt.
  • If that occurs, yields on government bonds will shoot up, which is the opposite of what is sought to be achieved.
  • If in fact bond yields shoot up in real terms, there might be a case for monetisation, strictly as a one-time measure. India has not reached that point yet.
  • In sum, monetisation has few advantages but it carries a large cost in credibility.

 

Source: Indian Express, Economic Times

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