Context: With the announcement of the government keeping her options open on direct monetisation of the deficit by the RBI, its significant implications for India’s economic prospects in the short-term, and in the long-term need a fair assessment.
- Until 1997, the RBI automatically monetised the government’s deficit.
- In 1997, the government and the RBI agreed that henceforth, the RBI would operate only in the secondary market through the Open Market Operations (OMO) route.
- The implied understanding was that the OMO route by the RBI will be used as a liquidity instrument to manage the balance between the policy objectives of supporting growth, checking inflation and preserving financial stability.
- It was not so much to support government borrowing.
- The outcomes of the agreement were unprecedented.
- With the government started borrowing in the open market, interest rates went up which incentivised saving and in turn spurred investment and growth.
- Also, the interest rate that the government commanded in the open market acted as a critical market signal of fiscal sustainability.
- Further, the agreement shifted control over money supply and inflation, from the government’s fiscal policy to the RBI’s monetary policy.
- The Indian economy in the years before the global financial crisis when the growth rates were in the range of 9 per cent was a consequence of the high savings rate and low inflation which in turn were a consequence of this agreement.
Indirect Monetisation (OMO) and Direct Monetisation : A comparison
- First of all, contrary to the popular perception, monetisation of the deficit does not mean the government getting free money from the RBI, rather it is a highly subsidised lending.
- Further, the RBI is not monetizing the deficit directly, but indirectly by buying government bonds in the secondary market through open market operations (OMOs).
- Although both monetisation and OMOs involve printing of money by the RBI.
- But the prominent differences between the two options that emphasize upon the banality of shifting over to monetisation.
- Although they are both potentially inflationary, the inflation risk they carry is different.
- OMOs are a monetary policy tool with the RBI in the lead, deciding on how much liquidity to inject and when.
- In contrast, monetisation is 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.
- If RBI is seen as losing control over monetary policy, it will raise concerns about inflation.
Case for Direct monetisation of the deficit
- The FRBM Act amendment in 2017 contains an escape clause which allows monetisation of the deficit under special circumstances.
- Even though it means potentially jeopardising the hard won gains of the government-RBI agreement there is a case to it.
- There aren’t enough savings in the economy to finance government borrowing of such a large size.
- The spike in bond yields would be so high that financial stability will be threatened.
- So, the situation calls for the RBI to step in and finance the government directly.
Case against Direct monetisation of the deficit
- However, there is no reason to believe that we are anywhere close to that situation.
- There has been injection of such an extraordinary amount of systemic liquidity through the OMO operations that bond yields are still relatively soft.
- The yield on the benchmark 10 year bond which was ruling at 8 percent last year has since dropped to just around 6 per cent.
- That should be evidence that the market feels quite comfortable about financing the enhanced government borrowing.
- If at all, the government decides to continue with monetization, markets will be apprehensive that the constraints on fiscal policy are being abandoned.
- It will also signal that the government is planning to solve its fiscal problems by inflating away its debt.
- If that occurs, yields on government bonds will shoot up, the opposite of what is sought to be achieved.
- There cannot be a blanket ban on direct monetisation despite its costs.
- If the government is not able to finance its deficit at reasonable rates, then it really doesn’t have much choice.
- If bond yields shoot up in real terms, there might be a case for monetisation, strictly as a one-time measure.