Direct Monetisation of Deficit

Context:

The COVID-19 spread has meant that the Indian economy, which was already slowing down over the past couple of years, has completely stalled. Most estimates suggest that India’s GDP (gross domestic product) will barely grow in the current financial year — that is, if it does not contract as is likely to be the case in most major economies of the world.

What is the reason for this fall?

  • With a nationwide lockdown, incomes have fallen and so have consumption levels. In other words, the demand for goods (say a pizza or a car) and services (say a haircut or a holiday) in the economy has gone down.
  • The economic impact of Covd19 has been devastating with widespread income destruction – from middle-class employees of Small and Medium Enterprises (SME) that cannot pay salaries as business has disappeared to millions of daily-wage workers who have lost wages as construction sites and factories have been shut.

Globally, governments have rolled out massive fiscal (and monetary) support programmes in order to partially mitigate the impact. The extent of fiscal intervention is varying – but mostly in double-digit percentages (of GDP). Closer home, Malaysia’s fiscal package adds up to a whopping 20% of GDP. US, Japan and Germany have also announced packages in the 10-15% (of GDP) range.

Fiscal Deficit:

  • Fiscal deficit is the total amount of borrowings required to bridge the gap between governments’s spending and revenues.
  • The borrowings can be from the internal sources (public, commercial banks, central bank etc.) or the external sources (foreign governments, international organisations etc.).

Fear of Fiscal Deficit Ballooning

  • The government’s finances were already overextended going into this crisis, with its fiscal deficit way over the permissible limit.
  • As things stand because the economy has stalled and the government will not be getting its revenues, the “general” government (that is, Centre plus states) fiscal deficit is expected to shoot up to around 15% of GDP when the permissible limit is only 6%.
  • On top of that, if the government was to provide some kind of a bailout or relief package, it would have to borrow a huge amount. The fiscal deficit will go through the roof.
  • Moreover, for the government to borrow the money, the market should have it as savings. Data show that savings of domestic households have been faltering and are barely enough to fund the government’s existing borrowing needs.
  • Foreign investors, too, have been pulling out and rushing to “safer” economies like the US, and are unwilling to lend in times of such uncertainty.
  • So there isn’t enough money in the market for the government to borrow. Moreover, as the government borrows more from the market, it pushes up the interest rate.

Ideal government debt level

  • While no ideal level of debt is set in stone, most economists believe developing economies like India should not have debt higher than 80%-90% of the GDP. At present, it is around 70% of GDP in India.
  • It should commit to a pre-determined amount of additional borrowing and to reversing the action once the crisis is over. Only such explicitly affirmed fiscal restraint can retain market confidence in an emerging economy.

What can be done?

  • People need to have money so that they can boost consumption and in turn push the demand and supply chains.
  • For its part, the Reserve Bank of India (RBI) has been trying to boost the liquidity in the financial system. It has bought government bonds from the financial system and left it with money. Most banks, however, are unwilling to extend new loans as they are risk-averse. Moreover, this process could take time.
  • Globally, the strategy adopted by many governments is a coordinated fiscal-monetary strategy – government issues more bonds to finance a larger fiscal programme, while the Central Bank (CB) purchases these bonds on its own balance-sheet in the process.
  • There are various interesting terms to describe the phenomenon – Helicopter money (made famous by Ben Bernanke, ex-Chairman of the US Federal Reserve), MMT (or Modern Monetary Theory about government having the ability to print as many notes as it takes to remove unemployment) or indeed Deficit Monetisation (the oldest definition of the exercise).

“Direct” monetisation of deficit

Monetised deficit is the monetary support the Reserve Bank of India (RBI) extends to the Centre as part of the government’s borrowing programme. In other words, the term refers to the purchase of government bonds by the central bank to finance the spending needs of the government.

Also known as debt monetisation, the exercise leads to an increase in total money supply in the system, and hence inflation, as RBI creates fresh money to purchase the bonds. The same bonds are later used to bring down inflation as they are sold in the open market. This helps RBI suck excess money out of the market and rein in rising prices.

  • Imagine a scenario where the government deals with the RBI directly — bypassing the financial system — and asks it to print new currency in return for new bonds that the government gives to the RBI.
  • Now, the government would have the cash to spend and alleviate the stress in the economy — via direct benefit transfers to the poor or starting construction of a hospital or providing wage subsidy to workers of small and medium enterprises etc.
  • In lieu of printing this cash, which is a liability for the RBI (recall that every currency note has the RBI Governor promising to pay the bearer the designated sum of rupees), it gets government bonds, which are an asset for the RBI since such bonds carry the government’s promise to pay back the designated sum at a specified date.
  • And since the government is not expected to default, the RBI is sorted on its balance sheet even as the government can carry on rebooting the economy.
  • This is different from the “indirect” monetising that RBI does when it conducts regular Open Market Operations (OMOs) – which essentially involve buying and selling of Government Securities (G-Secs) – to obtain its monetary policy objectives around interest rates, yield curve and liquidity. RBI also operates a Repo/Reverse-Repo window – via which it lends (and accepts) short-term (and recently, even medium-term) money to banks against the latters’ holdings in G-Secs – again to modulate monetary policy outcomes. In effect, large RBI intervention in the G-Sec market is part of monetary policy operations, somewhat independent of the fiscal strategy of the government.

 

Examples

  • In the UK on April 9, the Bank of England extended direct monetisation facility to the UK government
  • Until 1997, the RBI “automatically” monetised the government’s deficit. However, direct monetisation of government deficit has its downsides. In 1994, Manmohan Singh (former RBI Governor and then Finance Minister) and C Rangarajan, then RBI Governor, decided to end this facility by 1997.

 

 

Issues with Direct monetisation

Direct monetisation of deficit is a highly contested issue. The balance of payments crisis in 1991, and a near-crisis in 2013, were, at heart, a result of extended fiscal profligacy.”

Inflation

  • With RBI printing a lot of money to buy G-Secs, money supply will shoot up and engender an inflationary spiral
  • Ideally, this tool provides an opportunity for the government to boost overall demand at the time when private demand has fallen — like it has today. But if governments do not exit soon enough, this tool also sows the seeds for another crisis.
  • Government expenditure using this new money boosts incomes and raises private demand in the economy. Thus, it fuels inflation. A little increase in inflation is healthy as it encourages business activity.
  • But if the government doesn’t stop in time, more and more money floods the market and creates high inflation.
  • Since inflation is revealed with a lag, it is often too late before governments realise they have over-borrowed. Higher inflation and higher government debt provide grounds for macroeconomic Inflation.

This has several mitigating factors in Indian case scenario.

  • One, the transmission of RBI “printing money”, ie, creating Base Money (M0) to broad money (M3) – via the money multiplier – is going to be slow.
  • As it is, because of slower credit growth, the multiplier in India has been trending down for several years now. With the lockdown, the moratorium (on several loans allowed by RBI) and invariable slow recovery, credit growth is unlikely to be high
  • The multiplier is likely to stay low – thereby ensuring that the growth of M3 is far more modest than the growth in M0.
  • Further, growth in M3, assuming constant productivity, translates into higher inflation via Velocity of Mooney (V) – or the number of times money is rotated within the economic system.
  • With economic activity currently nearly shut down and expected to recover only gradually, V is expected to remain at very modest level. Put both together – low Multiplier and low V – and the risk of higher inflation with RBI “printing money” goes away substantially.

External vulnerability:

  • The rationale is that aggressive DM could devalue the currency, causing foreign investors to lose confidence and pull out money, putting the existing fiscal financing plan at risk.
  • Now this is structurally not an issue for India. Government of India does not fund itself via direct external borrowings.
  • India allows a very limited access to G-Secs to foreign investors – as a result total foreign holdings of domestic G-Secs is barely ~5%.
  • That number is far higher for most developing countries – creating an external financing cap (and dependence) on fiscal expansion.
  • India’s external account, thanks to record low oil prices, is in good shape (current account deficit should remain well within the 2% comfort zone for the year).
  • With a monetisation funded nearly 100% via local savings, there is very little foreign capital vulnerability – much easier to embark on an aggressive DM to prime up the economy. Such an exercise would likely take the economy faster towards recovery – leading to better corporate performance – which in turn would cheer foreign investors in equity (who are far bigger and more relevant for equity investment into India than debt).

Inefficiency and corruption:

The other argument against direct monetising is that governments are considered inefficient and corrupt in their spending choices — for example, whom to bail out and to what extent. This may push corruption and lead to a further deepening of Crony capitalism.

Way Forward

With a lockdown, the most immediate issue that policymakers have to contend with would be a dramatic fall in inflation. That has deleterious impact on taxes, wages and ability of the government to take on more debt. The risk of very low inflation (no-one is still talking about deflation in India yet) is as real as the one of high inflation. “Printing money” ensures a backstop to ensure a certain amount of inflation in the economy – enabling the government to inflate away at least part of the new debt it is taking on to provide a safety net for the economy. Though this must be done prudently so as to avoid India falling into an inflation spiral.

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