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.
