A lot of experts have been asking the Reserve Bank of India to print notes and directly give them to the government to meet its fiscal deficit. They advise so because banks have been risk-averse to buying bonds since they fear the prices may fall and they will have to provide for mark-to-market risk. On the other hand, other experts worry that the RBI should never go back to the bad habit of the '80s and '90s when the central bank funded the government directly. They worry this will make for a spendthrift government, high inflation, possible rating downgrades, a flight of foreign investment, and a run on the rupee.
Raghuram Rajan, former RBI governor and now a professor of finance at Chicago Booth School, in a note on LinkedIn, lucidly explains what monetisation of deficit is all about. He concludes, "The so-called monetization is neither a game-changer in stressed times nor a catastrophe. It helps a little at the margin, but does not solve the government’s fiscal problems nor does it lead to runaway inflation. If used in the wrong way, it could, however, be problematic.”
But more useful than his verdict, is his explainer. He divides periods into normal and abnormal times. In normal times, say the government wants Rs 1 lakh crore. It would raise money by selling bonds to banks. It will then use the money to pay say salaries or government contractors. This money will once again come back to the banking system. So no mischief.
In abnormal times, because banks are risk-averse and demand high yields to buy government bonds, RBI buys say Rs 1 lakh crore of bonds directly from the govt. The money will be spent by the government as salaries or payments to companies. These come back as deposits to banks. But because banks are risk-averse, this money will remain as deposits, which the banks may lend to RBI at 3.75% in the reverse repo. Because RBI is paying 3.75% every day in reverse repo, its dividend to the government will fall. But the excess government expense won't necessarily be a catastrophe.
But if times were normal, this money put by the government in the salary accounts of employees or companies would be “used” up by banks to lending more and thus also expanding the deposits their customers hold with them. All this new lending would be expansionary and fuel inflation. This is why the RBI is reluctant to accommodate the government in normal times, explains Rajan.
So what are the implications of direct government financing of RBI? We reproduce in full Rajan’s points:
1) Direct RBI financing is sometimes loosely termed money printing and thought to be free. This is misleading. As we have seen, the government finances itself from the RBI, and the RBI finances itself from the banks at the reverse repo rate of 3.75%.
2) Instead of the banks holding government bonds paying 6% or so, they hold claims against the RBI paying 3.75%. Of course, the claim they hold is shorter term and possibly more liquid. Most important, it is not subject to interest rate risk.
3) In abnormal times, the government gains by placing the paper quickly with the RBI, and the banks have no choice but to hold the excess reserves at a below-market rate. The only way out for an individual bank would be to make more loans or buy more government bonds. This it may be reluctant to do because of the additional risks involved. Collectively, however, banks have no choice but to accept the reserves the RBI creates. This is why the financing is forced.
4) Such direct financing is not inflationary per se, so long as banks are reluctant to lend further to business or consumers. However, as normal times return, the central bank will have to pay a higher rate on excess reserves, or sell its government bond holdings and extinguish excess reserves, else it will risk excessive credit expansion and inflation. This process of extinguishing excess reserves is manageable (though see the caveat below).
5) The government does not get a free lunch. Not only is the RBI paying 3.75% for the money it on lends to the government (which will reduce the annual dividend the RBI pays the government commensurately), the banks get 3.75% instead of the 6% they could get by buying the government bonds directly. Since the government owns 70 percent of the banking sector, its dividends from public sector banks also fall commensurately. Essentially, the small amount of government saving in its financing comes from the costs borne by the private banks. Their lower profitability will affect their capital and their lending over time.
6) Even though the way government spending is financed (either directly by banks or directly by the RBI) should not alter its inflationary consequences, the larger government spending will directly ignite demand. In abnormal times when demand is depressed and the environment is disinflationary, this should not be a central worry.
7) Similarly, the fact that the RBI will absorb government bonds seamlessly does not alter the fiscal math. If the fiscal deficit and the growth in government debt is deemed unsustainable, investors and rating agencies will take fright. This is where we need to put in place measures that ensure we will go back to fiscal health over the medium term – such as the debt target and the fiscal council suggested by the NK Singh Committee. Modern Monetary Theorists are wrong to think that central bank financing of the government can be ignored. The consolidated liabilities of the government and the central bank have to be seen as sustainable, else confidence in both money and government debt will collapse.
8) Some observers will have an important question. If the main difference in outcomes between direct RBI financing of the government and private financing of the government is the presence of substantial excess reserves, are we not already there? Is the RBI not already absorbing lakhs of crores through reverse repos? The answer is yes, we are.
Finally Rajan answers what he calls some obvious questions, which we reproduce below:
Why is the central bank hesitant to finance the government directly? Why does it insist on the fig leaf of the bonds being issued to the market and then the central bank buying through Open Market Operations (as the RBI has been doing in the last few years)?
Direct central bank financing in normal times can be inflationary (as can be excess OMOs). Moreover, direct financing of the government obscures market signals for a while when the government spends beyond its means. It is important the government gets market feedback. The RBI/government accord allows the RBI to say no to the government, even if it rarely does so. It is best to retain the fig leaf.
Is there no limit to RBI financing?
Not so long as the banks are willing to passively reinvest excess reserves. However, the more the government issues to the RBI, the more debt the government will have to service, and the less creditworthy the debt. If the government’s debt falls in value, RBI’s balance sheet will get eroded. Once again, what is manageable in small quantities becomes problematic in excess.
Why can’t the RBI pay the government a large dividend instead?
If the RBI’s accountants agreed (they don’t), the RBI could increase the government’s deposit account at the RBI by 1 LC and say it was a dividend. While this would reduce the government’s notional fiscal deficit (it would now not issue bonds to the RBI) everything else would be the same. Ultimately, banks would have excess reserves, which would have to be taken in by the RBI at the reverse repo window.
Should “monetisation” be a constraint on government spending today?
No, the government should be concerned about protecting the health of the economy and should spend what is needed. Obviously, it should try and cut back unneeded spending, and prioritise. It should also worry about getting the fiscal deficit and its debt back in shape over the medium term, and the more it spends now, the harder that will be. However, its inability to finance itself or fears of monetization should not be a constraint. Monetization will neither be a game-changer nor a catastrophe, if done in a measured way. In fact, India is already doing it! However, the caveat – it should be measured -- is key.
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