Budget 2020: Invoking Fiscal ‘Escape Clause’ May Allow RBI To Buy Government Bonds Directly
The central government is widely expected to miss its 3.3 percent fiscal deficit target for 2019-20, with the breach likely to be announced in the upcoming budget presentation on Saturday.
Lower taxes amid weaker growth have meant that the government may invoke the ‘escape clause’ provided by the Fiscal Responsibility and Budget Management Review Committee.
The 'escape clause' allows the government to breach its fiscal deficit target by 0.5 percentage points at times of severe stress in the economy, including periods of structural change and those when growth falls sharply.
The breach in itself may not seem alarming in a year when growth has fallen to 5 percent from 8 percent in a six-quarter period, but the implications of invoking the ‘escape clause’ are serious and will take India back towards ‘automatic monetisation’ of fiscal deficits — a practice done away with when the Fiscal Responsibility and Budget Management Act, 2003 was passed.
The amendments made to the FRBM Act in 2018 allow the Reserve Bank of India to buy bonds as part of primary auctions in the event that the government invokes the ‘escape clause’, pointed out Ananth Narayan, senior India analyst at the Observatory Group in his pre-budget note.
Under FRBM, if the escape clause is triggered to allow for a breach of fiscal deficit target, the RBI is then allowed to participate directly in primary auction of government bonds. If this is activated, it would further formalise the implicit deficit financing that is in the past few quarters.Ananth Narayan, Senior India Analyst, Observatory Group
FRBM 2018 Amendments
The amendments made to the FRBM Act in 2018 emerge from the FRBM Review Committee, headed by NK Singh.
The review committee, in keeping with international experience, had proposed that an escape clause be designed with clear rules to avoid misuse. The committee had also recommended that the decision to invoke the escape clause should ideally be taken on the advice of an independent fiscal council, which is yet to be set up in India.
The review committee, however, did not recommend any provision for automatic monetisation, where the RBI would buy government bonds directly in the primary market. This provision was later introduced in the 2018 amendments made to the FRBM Act.
“....the Reserve Bank may subscribe to the primary issues of central government securities due to ground or grounds specified in the proviso to sub-section (2) of Section 4.”
The sub-section quoted above details the conditions under which the ‘escape clause’ can be invoked. The provision applicable in the current circumstances would be: Sharp decline in real output growth of at least 3 percentage points below the average for the previous four quarters.
Back Towards Automatic Monetisation?
Should the RBI go ahead and subscribe to primary issues of government bonds, the government may be able to avoid increased borrowing from the market even if it breaches the fiscal deficit target.
The planned borrowing is nearly complete and the market has been nervous about fresh issuance of government bonds. Direct purchases by the RBI, if it happens, will ease the pressure of incremental borrowing and keep long-term bond yields in check. The central bank has already taken the unusual step of trying to keep long term bond yields in check by buying long term bonds from the secondary markets under its ‘Operation Twist’ program.
It would, however, take the economy back to a practice that had been left behind to try and end the fiscal dominance of monetary policy.
We have long argued that between Rs 3.5 lakh crore of open market operation bond purchases by the RBI since July 2018, the surplus transfer of Rs 1.76 lakh crore from the RBI for FY20, and the conduct of Rs 40,000 crore “operation twist” at the time of banking liquidity surpluses, effective deficit financing has been underway for a while. This could be formalised if the FRBM escape clause is exercised.Ananth Narayan, Senior India Analyst, Observatory Group