Past Fiscal Profligacy Should Not Stop Deficit Monetisation Now
This crisis needs fiscal dominance to make a comeback and monetary policy to play a supportive role, writes Sabyasachi Kar.
There is a strong consensus among Indian policy experts that the government will have to come up with a significant stimulus to combat the Covid-19 epidemic. Most also argue that a sizeable part of this expenditure will have to be funded by Reserve Bank of India, i.e., the deficit will have to be monetised. This argument, however, has met with some opposition from other experts, and currently, the government and the RBI also seems reluctant to go down this path.
How The Deficit Gets Monetised
If any government runs up a deficit, i.e., an excess of expenditure over revenues collected, then this can be financed either by a debt instrument purchased by a private investor or be monetised by the central bank of the country. However, in practice, the distinction between these two options is not always very clear. The simplest and easily understandable form of deficit monetisation involves the central bank directly purchasing government bonds in the primary market providing the government with money, which will then fund the deficit. This can take the form of a temporary monetisation if the central bank later sells off the bonds in the secondary market, or a permanent monetisation if the central bank subsequently writes off this government debt.
A more complex form of deficit monetisation takes place when the central bank purchases government bonds from the secondary market to support the deficit. This enables private investors to use funds received from their transactions with the central bank to then purchase government bonds from the primary market, thus monetising the deficit indirectly.
However, it is more complicated than that. One must keep in mind that there is a second unconnected reason why central banks purchase and sell government bonds from the secondary market, namely, the enforcement of monetary policy objectives, particularly, liquidity management.
Not surprisingly then, it frequently becomes difficult to distinguish deficit monetisation from normal liquidity management activities of the central bank.
Broadly, this indirect deficit monetisation is identified as the central bank’s purchases in the secondary market which is inconsistent with its monetary policy objectives.
Finally, another mode of deficit monetisation that was widely debated recently in India involves the central bank transferring its excess reserves to the government budget. This is also deficit monetisation, in effect, since the money supplied to the government would have had to be borrowed otherwise from private investors.
Bruises From A Long Journey
The Indian government’s reluctance to monetise our deficit is, at least partly, due to our experience with this practice in the past, when it became closely related to fiscal profligacy.
The genesis of this phenomenon can be traced back to agreements between the government and the RBI in the years 1937 and 1955. Under these agreements, whenever the government’s cash reserves with the RBI fell below a certain threshold, it was to be automatically monetised by the creation of treasury bills, also known as ad-hoc T-bills. During the 1980s, the centre’s fiscal deficit started increasing rapidly with the decadal average going up to 6.7 percent of GDP, compared to 3.8 percent in the previous decade.
The automatic monetisation of these deficits and an administered interest rate mechanism during that period meant that monetary policy was completely ineffective and dominated by fiscal policy. This pre-reform period was also characterised by structural bottlenecks and acute supply constraints due to statist policymaking.
The supply bottlenecks and the profligate money creation together led to frequent inflationary surges during this period.
Steps to correct this situation began in the 1980s. In 1986, the RBI started to auction these T-bills in order to open up public debts to the market and relieve some of RBI’s own burden. In 1994, an agreement was signed between the government and RBI to impose some restrictions on the issuance of ad-hoc T-bills. Finally, an agreement was signed in 1997 which completely phased out these treasury bills.
With the automatic monetisation mechanism out of the way, focus returned to limiting the size of the fiscal deficit, as it would otherwise lead to indirect monetisation. Under the FRBM Act of 2003, the centre’s fiscal deficit was legally capped at 3 percent in order to achieve this.
The establishment of the inflation targeting framework in 2016 further consolidated this approach and monetary policy actions moved away from fiscal considerations. Thus, despite fiscal slippages in 2017-18, the Monetary Policy Committee continued with its neutral stance on the policy rate keeping inflation targeting as its prime objective. Clearly, the process of dismantling fiscal dominance has been a long journey in the Indian context, and this makes our policymakers and central banker reluctant to undo these reforms in our monetary policy framework.
Time To Act
The Covid-19 pandemic, however, is no regular phenomenon. Attacking both lives and livelihoods, it has the capability to set all progress back by decades, if not more.
In terms of macroeconomic policy stance, one major shift that is taking place is understanding that this crisis will need fiscal dominance to make a comeback and monetary policy will have to play a supportive role. Understanding this change, many countries have moved towards some form of deficit monetisation in these dire times.
India’s reluctance to go down this path is understandable, given our history with fiscal profligacy in the past. However, we should have more confidence in the resilience of the reforms in our monetary framework. These reforms will need to be relaxed temporarily for monetisation, as has been done in Indonesia. In a post-Covid-19 world, the discipline of the financial markets will surely ensure a quick return to a regime of fiscal discipline.
If India has to monetise at least a part of her deficit in order to fight the current crisis, what form should such a policy take? Should it be monetised only indirectly, so that we do not need to go against the FRBM Act? If not, then should the direct monetisation be temporary or should it be permanent in nature?
To answer these questions satisfactorily, it is important to understand the advantages and disadvantages of each of these in the current scenario.
The indirect monetisation of the deficit works well within the FRBM framework and may be the preferred option, provided the interest rates are not too high in the secondary markets.
However, if large funds become necessary, then interest rates could go up. In such a situation, direct monetisation is a preferred option as it is a private placement of the government securities with the central bank.
Experts, like former RBI governor C Rangarajan, have in fact suggested that the deficit monetisation should include purchases of central government securities, both in the primary and secondary markets.
Monetisation of deficits raise questions about the solvency of governments.
This is why, it will be prudent to treat most of the monetisation as temporary, with the RBI selling off the government securities when the crisis is over. Moreover, this might also be necessary keeping in mind the potential for inflationary impulses that the monetisation could give rise to later on.
Should we consider the strongest form of permanent monetisation—a write-off of the government’s debt by the central bank?
Despite the reputational costs associated with debt write-offs, they become necessary when regular developmental expenditures made by governments are completely crowded out by their interest burden. Whether some of the monetisation in India will become permanent due to debt write-offs by the RBI will depend on how much resilience the Indian economy shows after the crisis.
Given the current uncertainties, however, it is better to keep all our options open.
Sabyasachi Kar is Professor, and Siddharth Naidu is Consultant, at the Institute of Economic Growth, University of Delhi.
The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.