case-of-direct-monetisation

Context: The COVID-19 spread has given a severe blow to already slowing down Indian Economy  with most estimates suggesting that India’s GDP will hardly grow in the current financial year.

Background

  • Until 1997, the RBI automatically monetised the government’s deficit. 
  • In 1994, Manmohan Singh and C Rangarajan, then RBI Governor, decided to end this facility by 1997.

More on the news

  • With a nationwide lockdown owing to COVID-19, incomes have fallen of people from each strata, and so have consumption levels of Goods and services.
  • The RBI has been trying to boost the liquidity by the means of purchase of government bonds in the financial system. 
    • Most banks, however, are unwilling to disburse new loans as they are risk-averse.
  • In the UK too, the Bank of England extended direct monetisation facility to the UK government even though the Governor of the Bank of England, opposed the move till the last moment.

Breaching Fiscal Consolidation

  • The government’s finances were already overextended going into this crisis, with its fiscal deficit way over the permissible limit.
    • In the given circumstances, the general government (Centre plus states) fiscal deficit is expected to shoot up to around 15% of GDP when the permissible limit is only 6% as per the FRBM Act.
    • In addition to that , if the government was to provide some kind of relief package, it would have to borrow a huge amount resulting in a massive fiscal deficit.
  • For the government to borrow the money, the market should have it as savings. 
    • Data show that savings of domestic households have been faltering and are barely enough to fund the government’s existing borrowing needs.
    • Foreign investors, too, have been pulling out and rushing to safer havens like the US, and are unwilling to lend in times of such uncertainty.
    • In turn, there  isn’t enough money in the market for the government to borrow, pushing up the interest rate.

Direct monetisation of government deficit - A solution ?

  • It is a situation in which the government deals with the RBI directly bypassing the financial system and asks it to print new currency in return for new bonds that the government gives to the RBI. 
    • The government would then have the cash to spend and alleviate the stress in the economy.
  • Now, in exchange of printing this cash, which is a liability for the RBI, it gets government bonds, which are an asset for the RBI since such bonds carry the government’s promise to pay back the designated sum at a specified date.
    •  And since the government is not expected to default, the RBI’s balance sheet at the same time the government can carry on rebooting the economy.
  • The other argument against direct monetising is that governments are considered inefficient and corrupt in their spending choices for example, populist bailouts that may suit political agenda.

How is it different from indirect monetising ?

  • RBI does perform the indirect monetisation when it conducts the so-called Open Market Operations (OMOs) and/or purchases bonds in the secondary market.

Impacts of Direct monetisation in India

  • Ideally, this tool of Direct monetisation provides an opportunity for the government to boost overall demand at the time when private demand has fallen.
    • But if governments do not exit soon enough, this tool can also be a reason for another crisis.
  • Government expenditure using this new money boosts incomes and raises private demand in the economy in turn, it fuels inflation
    • A little increase in inflation is healthy as it encourages business activity. 
    • But if the government doesn’t stop in time, a high inflation situation will be created. 
    • Higher inflation and higher government debt provide grounds for macroeconomic instability.

Road Ahead

  • While no ideal level of debt is set, most economists believe developing economies like India should not have debt higher than 80%-90% of the GDP
    • At present, it is around 70% of GDP in India.
  • Also, It should commit to a predetermined amount of additional borrowing and to reversing the action once the crisis is over. 
    • Only such explicitly affirmed fiscal restraint can retain market confidence in an emerging economy like India.

Fiscal deficit

It is the difference between Total Revenue and Total Expenditure of the government. 

 

Mathematically,

Total Expenditure  = Revenue Expenditure + Capital Expenditure

Total Revenue = Revenue Receipts + Capital Receipts + Recovery of Loans - Borrowings

 

Fiscal Deficit = Total Expenditure - Total Revenue

 

Note

Revenue Expenditure

The expenditure for paying salaries and other such expenses is termed as revenue expenditure. 

 

Capital Expenditure

The expenditure that is used for building infrastructure, that in turn increases the production capacity of the economy.

 

Implications:

  • The fiscal deficit is a key marker that indicates the excess of revenue expenditure. To bridge this difference, the government needs to borrow money from the market.
  • A study shows that Capital Expenditure has a Multiplier effect (evaluated in terms of a change in the nominal GDP or total incomes) of 2.5 while Revenue Expenditure has a Multiplier effect of less than 1


Source: https://indianexpress.com/article/explained/explained-rbi-print-rupee-india-economy-coronavirus-6377979/

Image Source: Indian Express