TOPIC : MONETISATION OF GOVERNMENT DEFICIT

THE CONTEXT: Given a very poor and pessimistic fiscal situation in the economy a discussion was doing the round as to the use of ‘monetisation of deficit’. Even the finance minister of India remarked that the government is keeping this option too in its mind.

Usually, market borrowing is resorted to by the government to tide over its fiscal deficit. We need to understand if we have reached the point where borrowings are no longer a viable and feasible option.

PRESENT DEFICIT SCENARIO

• Indian economy is passing through an unprecedented phase, and so is the fiscal health of the country.
• Apparently, the government will not be able to achieve its FY21 fiscal deficit target of 3.5% of GDP.
• The exchequer is facing a revenue crunch due to falling tax revenue post the lockdown.
• There is also difficulty in realising the disinvestment target in an uncertain market.
• Adding to it, the RBI has projected a negative GDP growth rate for the Indian economy in FY21.
• The Government has even raised its gross market borrowing for FY21 by 54% (Rs 7.8 – 12 lakh crore).
• Given these, the fiscal deficit as a percentage of GDP may even cross the double-digit mark.
• The government stimulus package of Rs 20 lakh crore also seems to be inadequate to revive the economy.
• As is seen, a large part of it accounts for liquidity-boosting measures by the RBI.
• Because, the weak fiscal position has forced the government to restrict the stimulus.
• It is in this scenario, that the need for monetisation of deficit has been widely felt.

WHAT IS MONETISATION OF DEFICIT?

• Monetising of deficit is also called deficit financing in India. It simply refers to printing of new currencies by the RBI equal to help the government meet its expenditure. In other words, this means printing more money by the central bank, in order to give them to the government for its expenditure.
• In other way, deficit monetisation happens when the RBI buys government securities directly from the primary market to fund government’s expenses.

HOW HAVE THE MODES EVOLVED?

• Monetisation of deficit was in practice in India since 1955.
• It remained in force till 1997.
• Monetisation of debt or deficit is also known as deficit financing in India.
• Back then, the central bank automatically monetised government deficit.
• It does it through the issuance of ad-hoc treasury bills.
• However, two agreements were signed between the government and RBI in 1994 and 1997.
• This was to completely phase-out funding through ad-hoc treasury bills.
• Later on, with the enactment of FRBM Act, 2003, RBI was completely barred from subscribing to the primary issuances of the government from April 1, 2006.
• It was agreed that henceforth, the RBI would operate only in the secondary market through the OMO (open market operations) route.
• [OMOs involve the sale and purchase of government securities to and from the market by the RBI to adjust the rupee liquidity conditions.]
• The implied understanding was that the RBI would use the OMO route not so much to support government borrowing.
• Instead, it would be used as a liquidity instrument.
• This was to manage the balance between the policy objectives of supporting growth, checking inflation and preserving financial stability.

HOW DOES IT WORK?

• Government issues ad-hoc T-Bills which are subscribed by the central bank in the primary market. The government gets money directly from the central bank against those bills.
• Direct monetisation (or simply ‘monetisation’) of the deficit does not mean the government is getting free money from the RBI. However, the interest rate could be much lower as compared to market rate of interest.

DOWNSIDE OF MONETIZATION OF DEFICIT

• Since monetisation of deficit increases money supply, the move is replete with the danger of causing inflation.
• The central bank looses its control over money supply and finds it difficult to ensure stability of price.
• Monetisation of deficit puts a downward pressure on domestic currency leading to its depreciation.
• The government has no incentives to check its unnecessary expenditure.
• If, despite these, the government decides to go ahead, markets will fear that the constraints on fiscal policy are being abandoned.
• They may see the government as planning to solve its fiscal problems by inflating away its debt.
• If that occurs, yields on government bonds will shoot up, which is the opposite of what is sought to be achieved.
• If in fact bond yields shoot up in real terms, there might be a case for monetisation, strictly as a one-time measure.

WHAT GOES IN FAVOUR OF MONETISATION OF DEFICIT?

• The strongest argument given against ‘monetisation of deficit’ is that it causes expansion in money supply which could be inflationary. As long as inflation is kept under control, it is hard to argue against monetisation of the deficit in a situation such as the one we are now confronted with. For this, the RBI can issue bonds in the market to absorb excess liquidity.
• Secondly, this objection has little substance in a situation where aggregate demand has fallen sharply and there is an increase in unemployment. In such a situation, monetisation of the deficit is more likely to raise actual output closer to potential output without any great increase in inflation.
• Debt to GDP ratio would remain unchanged as a result of monetisation. Rating agencies will not downgrade our rating if we are able to control inflation and engender growth.
• It is a cost-effective way of overcoming deficit.

CONCLUSION:

The idea of monetising government deficit by the central bank is not a new one. We were using this before 1997 when this was put to an end following an agreement between the government and the RBI. Later on, FRBM Act, 2003 took this power of the RBI to subscribe to the government bonds in primary market since 2006. The economy experienced an enormous benefits of doing away with direct monetisation of government deficit by the RBI.

Then what is the reasoning for jeopardising the hard-won gains of this move? Has India exhausted its entire option and left with only monetisation of deficit?

The Fiscal Responsibility and Budget Management Act as amended in 2017 contains an escape clause which permits monetisation of the deficit under special circumstances. The case for invoking this escape clause is that there just aren’t enough savings in the economy to finance government borrowing of such a large size.

The situation on the ground is not that grim. There is no reason to believe that we are anywhere close to the above-mentioned situation. At present, India is a saving surplus economy with no so strong demand for funds by the private sector. The government can borrow at around the same rate as inflation, implying a real rate (at current inflation) of 0 per cent.

If in fact bond yields shoot up in real terms, there might be a case for monetisation, strictly as a one-time measure for specific purpose.

With the economy now showing positive vibes, coming on track and realization of GST increasing, monetisation of deficit is looking like a distant probability.