Context:

Recently, finance minister said that she is keeping her options open on monetisation of the deficit by the Reserve Bank of India (RBI).

How the government and the RBI decide on this will have significant implications for India’s economic prospects in the short-term, and indeed in the long-term.

The International Monetary Fund has christened the ongoing economic crisis due to Covid-19 as “The Great Lockdown” and reckons it to be the worst recession that the world would have faced since the Great Depression that happened in the first half of the 20th Century.

The total estimated loss to global economic growth is pegged at $9 trillion — more than three times India’s GDP.

However, while the rest of the world is certain to contract, India is hoping to be one of the few countries that expand their overall GDP, regardless of how small that increase may be.

First off, two clarifications:

Monetisation of the deficit does not mean the government is getting free money from the RBI.

If one works through the combined balance sheet of the government and the RBI, it will turn out that the government does not get a free lunch, but it does get a heavily subsidised lunch.

That subsidy is forced out of the banks. And, as in the case of all invisible subsidies, they don’t even know.

Second, it is not as if the RBI is not monetising the deficit now; it is doing so, but indirectly by buying government bonds in the secondary market through what are called open market operations (OMOs).

Note that 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 non-trivial decision.

RBI operate through only OMO route: Liquidity Instrument:

To understand the issue, some historical context will help.

1. In the pre-reform era, the RBI used to directly monetise the government’s deficit almost automatically.
2. That practice ended in 1997 with a landmark agreement between the government and the RBI.
3. It was agreed that henceforth, the RBI would operate only in the secondary market through the OMO route.
4. The implied understanding also was that the RBI would use the OMO route not so much to support government borrowing but as a liquidity instrument to manage the balance between the policy objectives of supporting growth, checking inflation and preserving financial stability.

Landmark agreement between the government and the RBI:

In hindsight, the outcomes of that agreement were historic.

1. Since the government started borrowing in the open market, interest rates went up which incentivised saving and thereby spurred investment and growth.
2. Also, the interest rate that the government commanded in the open market acted as a critical market signal of fiscal sustainability.
3. Importantly, the agreement shifted control over money supply, and hence over inflation, from the government’s fiscal policy to the RBI’s monetary policy.
4. The India growth story that unfolded in the years before the global financial crisis in 2008 when the economy clocked growth rates in the range of 9 per cent was at least in part a consequence of the high savings rate and low inflation which in turn were a consequence of this agreement.
5. The Fiscal Responsibility and Budget Management Act as amended in 2017 contains an escape clause which permits monetisation of the deficit under special circumstances.
6. The case is made on the grounds that there just aren’t enough savings in the economy to finance government borrowing of such a large size. Bond yields would spike so high that financial stability will be threatened.
7. The RBI must therefore step in and finance the government directly to prevent this from happening.
8. Through its OMOs, the RBI has injected such an extraordinary amount of systemic liquidity that bond yields are still relatively soft.

Other side of Monetisation is, it will lead to Inflation:

Both monetisation and OMOs involve expansion of money supply which can potentially stoke inflation.

If so, why should we be so wary of monetisation?

Because although they are both potentially inflationary, the inflation risk they carry is different. OMOs are a monetary policy tool with the RBI in the driver’s seat, deciding on how much liquidity to inject and when.

In contrast, monetisation is, and is seen, as a way of financing the fiscal deficit with the quantum and timing of money supply determined by the government’s borrowing rather than the RBI’s monetary policy.

What is the problem that monetisation is trying to solve?

There are cases when monetisation despite its costs is inevitable.

If the government cannot finance its deficit at reasonable rates, then it really doesn’t have much choice.

But right now, it is able to borrow at around the same rate as inflation, implying a real rate (at current inflation) of 0 per cent.

Recently, RBI cuts Interest rates: Why the cut in rates?

The interest rates have been on a decline since the global growth rate projections have been brought down following the spread of coronavirus Pandemic.

The Reserve Bank of India first announced a 75 basis point cut in repo rate on March 27, 2020 to 4.4 per cent and then again announced a cut in repo rate by 40 basis points to 4 per cent on May 22.

A cut in repo rates not only reduces the rate at which commercial banks borrow from RBI but also leads to a cut in deposit and lending rates for banks.

The RBIs move to cut in repo rate has been to push credit growth and demand in the economy in a bid to augur growth in the economy.

Way Ahead:

The author is suggesting that government should not borrow directly from RBI.

The logic which is he giving is right now the banks are flush with liquidity (savings from the public and liquidity push by RBI) and the interest rate is less in the economy and yield is also less in the economy (remember yield is directly proportional to interest rate in economy).

Government can easily finance its deficit from the market. If the interest rate becomes so high that borrowing from the market becomes unsustainable and there is less savings in the banks then Government can think of borrowing from the RBI directly and that again should be one-time measure.

Conclusion:

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.

India is inflation prone. Note that after the global financial crisis when inflation “died” everywhere, we were hit with a high and stubborn bout of inflation.

In hindsight, it is clear that the RBI, failed to tighten policy in good time.

Since then we have embraced a monetary policy framework and the RBI has earned credibility for delivering on inflation within the target. Forsaking that credibility can be costly.