Monetisation Neither A Game Changer Nor A Catastrophe, Says Raghuram Rajan
Former Reserve Bank of India Governor Raghuram Rajan has weighed in on the debate over whether the Indian central bank should monetise the government’s additional financing requirements amid the Covid-19 crisis.
Monetisation will neither be a game changer nor a catastrophe, Rajan wrote in a note posted on his LinkedIn account. At a time like this, the government should be concerned about protecting the health of the economy and should spend what’s needed, Rajan said.
“Obviously it should 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 it will be. However, its inability to finance itself or fears of monetisation should not be a constraint,” Rajan, who currently teaches at Chicago Booth School of Business, wrote.
Explaining How Monetisation Works
Rajan went on to explain how direct monetisation of government debt compares to the usual practice of the government selling bonds in the open market.
He took the hypothetical example of the government wanting to raise Rs 1 lakh crore.
- In normal times, the government would issue bonds in the market. Banks would spend Rs 1 lakh crore from their RBI deposits in buying government bonds. If the earlier level of reserves was what banks were happy holding, they are happy once again when that Rs 1 lakh crore comes back to their deposit accounts when the government spends the money it has raised.
- In abnormal times, if the RBI directly buys the government bonds, banks will eventually have excess reserves of Rs 1 lakh crore when the government spends the money it has raised.
- If times were normal, bankss would “use up” those reserves by lending more and thus creating more deposits as well. Since banks have to hold more reserves against deposits created, this would ensure that bank reserves with the RBI are no longer in excess.
- However, all this lending, in normal times, would be expansionary and fuel inflation. This is why the RBI is reluctant to accommodate the government in normal times.
“However, in abnormal times banks are reluctant to lend to business,” Rajan explained. “So they try and lend their excess reserves sitting in their RBI deposit accounts to other banks. No other bank wants it so eventually these excess reserves are redeposited at an RBI special window called the Reverse Repo window at a very low rate (currently at 3.75%). Effectively the RBI borrows from the banks through this window. On net, the RBI holds the government bonds, and the commercial banks finance it at the reverse repo rate.”
The former central banker explained that there are implications of direct financing and it isn’t “free” as often believed. Rajan said:
- Direct RBI financing is sometimes loosely termed as money printing and thought to be free. This is misleading. As we have seen, the RBI finances itself from the banks at the reverse repo rate of 3.75 percent.
- Instead of the banks holding government bonds paying 6 percent or so, they hold claims against the RBI paying 3.75 percent. Of course, the claim they hold is shorter term and probably more liquid. Most important, it’s not subject to interest rate risk.
- In abnormal times, the government gains by placing the paper quickly with the RBI, and the banks have no choice but to hold 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, given 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.
Such direct financing is not inflationary so long as banks are reluctant to lend further to businesses or consumers, Rajan said. “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.”
Rajan said at a time when demand is depressed and the environment is disinflationary, inflation should not be a “central worry”. He said that the process is not “free” for the government either.
“Not only is the RBI paying 3.75 percent for the money it onlends to the government (which will reduce the annual dividend it pays the government commensurately), the banks get 3.75 percent instead of the 6 percent they would get by buying government bonds directly. Since the government owns 70 percent of the banking sector, its dividends from public sector banks also fall commensurately,” Rajan wrote.
The fact that the RBI absorbs the government’s financing seamlessly also does not change the fiscal math. “If the fiscal deficit and growth in government debt is deemed unsustainable, investors and rating agencies will take fright.” To avoid this, Rajan suggests that the government adopt medium term debt targets suggested by the NK Singh committee and set up an independent fiscal council.
“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,” the former RBI governor cautioned.