The media is rife with discussions on whether and how the RBI should monetise the government’s deficits. India is no stranger to deficit financing as its 5-year Plans were based on it, which in turn created several problems for the Indian economy. We explore this long history and also try and answer the questions of today at the end.
India’s Plans and Deficit Financing
Right at the beginning, deficit financing from the RBI was seen as a way to fund the plan. The Reserve Bank agreed to the process because those were the early years of development and inflation was not high. Finance Minister CD Deshmukh in his Budget Speech (1952-53) remarked that inflation was not a worry for the first time in four years and with so much development at stake, “there is no clear indication of impunity for deficit financing”. In subsequent Budget speeches, Deshmukh said there are no undue risks of deficit financing due to low inflation. The central bank also believed that inflation in India was due to lack of supply which could be addressed by planned development.
The first Five-Year Plan resources were at Rs 1,960 crore of which Rs 333 crore (17 percent) was RBI’s contribution. In the second Plan, RBI’s contribution became even larger at 20.4 percent of the total Plan resources of Rs 4,672 crore. The share of deficit financing declined from the third Five-Year Plan onwards only to rise again in the sixth and seventh Plans. The high deficit financing coupled with high budget deficits led to the 1991 crisis. In March 1997, the RBI and the government signed an agreement to stop this deficit financing and as a result, finally from the 9th Plan onwards, we saw the share of deficit financing decline to zero.
Advent of ad hoc T-Bills
Section 17 (5) of RBI Act (1934) mandates the Bank to extend advances to the central (and state) government “repayable in each case not later than three months from the date of the making of the advance”. These are also called Ways and Means Advances (WMA). The RBI gives WMA against government securities. Typically, the government gives long tenure securities as collateral, but sometimes shorter tenure securities called Treasury Bills (T-bills) are also given. And when T-bills become of ad hoc nature (random), we have not just deficit financing but an automatic deficit financing.
RBI History (1951-67) has these important words on deficit financing: “The Reserve Bank of India Act merely enabled the Bank to make short-term advances to the central government. It did not require the Bank to make such advances.” What we learn from the above is that not just the government, but even the RBI thought that it should make such advances in the early days of deficit financing.
The first case of the government getting finances based on ad hoc T-bills was in 1920 when the funds were raised from the Currency Department (precursor to RBI). Later, ad hoc T-bills were used to replace sterling securities which were transferred to the British government in 1948-49.
In 1955, the government and the RBI once again used ad hoc T-bills albeit for a different purpose. As a banker to the government, the government is supposed to maintain minimum cash balance with the RBI which was Rs 50 crore in 1950s. Under this 1955 agreement, in case the cash balances fell below Rs 50 crore, the government will issue ad hoc T-bills and use the proceeds to fill the minimum balances.
RBI History Volume II (1951-67) narrates that the suggestion to fund the minimum balances came from a conversation between HS Negi, a Deputy Secretary at the Finance Ministry and G Balasubramanian, Secretary at RBI, on 8 January 1955. Negi said the balances had fallen to Rs 40 cr and given the WMA forecast, “it was necessary to create 'new special ad hocs' of about Rs 30 crore in January 1955 and Rs 20 crore in February 1955”.
RBI Governor B Rama Rau and Deputy Governor Ram Nath agreed and surprisingly delegated the decision to create ad hoc Treasury bills to Reserve Bank's Manager in Calcutta and its Secretary in Bombay. They could choose the amount before closing the books on Fridays. A decision which became a perennial thorn in Indian economy history was taken in such a casual manner!
The decision to engage in deficit financing and issue ad hoc T-Bills led to changes in other clauses of the RBI Act which prevented the expansion of RBI’s balance sheet. These changes led to several discussions and criticism in Parliament, but ultimately the government decision saw the light of day.
The T-bills were issued on tap at a pre-determined interest rate and were fixed at 4.8 percent since 1974. With inflation rising, it amounted to negative real rates. Thus, ad hoc T-bills turned into very attractive sources of financing and became a permanent source.
In 1957, RBI’s research department opposed the issuance of ad hoc T-bills. RBI Governor HVR Iyengar drew the attention of Finance Minister TT Krishnamachari to the fact that the process of creation of ad hoc T-bills each week had become a 'mechanical process' with no limits on the government. The automatic expansion of currency was making it difficult for the RBI to follow its objective of monetary stability. He also warned that “this was a recipe for disaster should a 'weak or careless Finance Minister' take office in Delhi”!
The FM allayed these fears saying ad hoc T-bills were limited by deficit financing which was in turn limited by financing of the Plan. The ad hoc T-bill issuance was worth Rs 250 crore in the First Five-Year Plan and rose to Rs 945 crore during the second Plan. Though it dropped to Rs 800 crore (or an average of Rs 160 crore per year) during the third Plan, it rose once more to Rs 260 crore in 1966-67.
Apart from RBI’s economists, BR Shenoy had famously criticised deficit financing. In his dissent note on the Second Plan, he wrote that deficit financing can help full utilisation of scarce real resources but not create real resources. Deficit financing should stop when inflation begins to rise.
Chakrabarty Report Warning
Deficit financing did not have as much adverse effect on inflation till the 1960s. However, from 1970 onwards, money supply and inflation began to rise. Inflation did not rise because of a rise in RBI credit to the government but on account of a rise in general credit on account of bank nationalisation and other government programmes to push lending.
In 1985, the RBI Committee to study Monetary System (Chair: S Chakrabarty) advocated monetary targets to limit inflation. The Committee noted that “increased recourse to deficit financing is a disconcerting development and it is necessary to ensure that deficit financing, measured in terms of recourse to credit from the Reserve Bank, does not exceed safe limits”.
The RBI was also being called to subscribe to the new government debt and its share in new debt issues was a shocking 64 percent in 1981-82. The share of RBI in overall public debt increased from 20 percent in 1978 to 28 percent in 1983. Within public debt, the share of RBI in outstanding T-bills was 90 percent. In terms of reserve money or base money created by the central bank, net RBI credit to government rose from 83 percent of reserve money to 92 percent in 1984.
Reviewing these trends, the committee noted that “the objective of growth with social justice can be achieved in the context of reasonable price stability only when the compulsions of demand management are adequately reflected in the level of the government's fiscal deficit financed by the RBI”.
1991 reforms and End of Deficit Financing
On the eve of reforms, the share of RBI in public debt had risen to touch 52 percent. The fiscal deficit was in the range of 8-9 percent for much of 1980s. In December 1989, Governor RN Malhotra in a letter to the government said, “This epitomises the impact of the automatic monetisation of the central government budget deficit.” The RBI had managed to dampen the impact on inflation by raising the Cash Reserve Ratio, but that was not possible anymore as it had touched a ceiling of 15 percent.
The years of excesses paved the way for the 1991 reforms. In his 1991-92 Budget speech, FM Manmohan Singh highlighted the need to lower the fiscal deficit as one of the first steps towards economic reform. The initial attempts were to lower the fiscal deficit by controlling expenditure and increasing sources of revenue. In the 1994-95 Budget speech, Singh finally spoke on abolishing the practice of deficit financing. He said, “I have long felt that the government should not be able to finance its deficits by creating money, through unlimited recourse to the Reserve Bank, by issue of ad hoc Treasury bills.”
He also announced a phased reduction of government reliance on ad hoc T-bills and “by 1997-98, the government will cease to have direct recourse to the Reserve Bank for financing its deficit and will have to meet its entire requirements through borrowing from the market”. This was followed by an agreement by the RBI and the government where ad hoc T-bills should not exceed Rs 9,000 crore for more than 10 continuous working days at any time during the year.
In his 1996-97 Budget speech, Finance Minister Chidambaram announced that ad hoc T-bills would be discontinued from April 1, 1997. This was replaced by WMA which would be available to accommodate temporary mismatches in the government’s receipts and payments. However, based on weekly RBI data, the WMAs have become a permanent source of government finance in recent years.
Accordingly, on 26 March 1997, a historic agreement was signed by the RBI and the government prohibiting the usage of ad hoc T-bills. Till 1997, the metric of deficit was the budget deficit which measured financing by T-bills. With this new agreement, the fiscal deficit became the main metric which indicated overall borrowing.
The RBI, however, was expected to continue to finance the deficit through participation in bond auctions. The RBI participation was shown specifically as ‘Monetised Fiscal Deficit’ in Budget documents. This was because the government securities market was still developing. By 2005, the RBI also stopped participating in primary auctions of government bonds, stopping 55 years of the practice of deficit financing in India!
Deficit Financing Today?
We are always tempted to draw lessons from history, but we should be careful. In the earlier era, the economists had warned against deficit financing, but governments went ahead with the policy. In today’s times, surprisingly quite a few economists are proposing deficit financing, but governments have been reluctant! Economists have welcomed deficit financing as interest rates have been low and one can use this opportunity to create real resources.
One is also seeing the rise in popularity of Modern Monetary Theory (MMT) which argues that countries which have their own sovereign currency should not worry about deficits, as long as those deficits go towards creation of real resources (read my pieces on MMT: one, two, three).
Followers of Shenoy are always going to point out that India’s case shows MMT does not work. Followers of MMT will counter saying India’s plans could not create the real resources which shows it was more of a governance problem than a deficit problem.
There is little doubt that COVID-19 has created gaping holes in government finances and it is difficult for governments to avoid deficit financing. The question is should they worry about the lessons of history or look to create new hopes and future. The choices once again take one back to the similar questions which India’s policymakers asked during the start of the planning process. It was not easy to answer the question back then and not surprisingly, it is not easy to answer the question even today. Amol Agrawal is faculty at Ahmedabad University. Views are personal.