With the economy stalled, there isn’t enough money in the market for the government to borrow. Can it ask the RBI to print more money? How does this process work, and what are the arguments against it? Let us see:

Discuss the scope and feasiblity of “Direct” Monetization by the government for Deficit Financing as an option of the last resort.

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What is “direct” monetisation of the deficit?

• 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 DBT to the poor or starting social and capital expenditure 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.
• Such bonds 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.

What triggers a demand for direct monetization?

1) Decline of Demand

• With a nationwide lockdown, incomes have fallen and so have consumption levels.
• In other words, the demand for consumer goods and services (say a haircut) in the economy has gone down.
• What can be done to boost demand? People need to have money. But, of course, who will give them money.
• From the highest-ranking CEOs to stranded workers, incomes have taken a huge hit, if not completely dried up.

2) Moving ahead for a fiscal deficit

• For its part, the 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.
• The government’s finances were already overextended going into this crisis, with its fiscal deficit way over the permissible limit.
• 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.

3) No money in the market

• 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.
• Hence, the govt. is left with the only solution — the “direct” monetisation of government deficit.

How is DM different form OMOs?

• Direct monetization is different from the “indirect” monetizing that RBI does when it conducts the so-called Open Market Operations (OMOs) and/ or purchases bonds in the secondary market.

Global examples

• Other countries are doing it to counter the economic crisis related to COVID-19.
• In the UK on April 9, the Bank of England extended direct monetisation facility to the UK government even though the Governor of the Bank opposed the move till the last moment.

Has India ever done this in the past?

• Yes, until 1997, the RBI “automatically” monetized the government’s deficit.
• In 1994, Manmohan Singh (former RBI Governor and then Finance Minister) and C Rangarajan, then RBI Governor, decided to end this facility by 1997.
• Now, though, even Rangarajan believes that India would have to resort to monetising the deficit.

Issues with Direct monetisation

• Direct monetisation of the deficit is a highly contested issue.
• Another former RBI Governor D Subbarao has said that there is no question that India must borrow and spend more in this crisis.
• He regarded this as a moral and a political imperative.

Issues: Inflationary practice

• 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. Here’s how:
• 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.

To what level should government debt be ideally limited?

• 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.
• The other argument against direct monetizing is that governments are considered inefficient and corrupt in their spending choices — for example, whom to bail out and to what extent.

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India’s bond market suffers from several issues. This article discusses such issues, and also highlights the recent positive trends seen in the debt market owing to several steps taken by the government.

The Indian debt market, primarily of the fixed-income variety, can be broadly classified into:

• 1. Money Market
• Where the borrowing is for a tenor of less than a year.
• Different types of money market instruments: Inter-Bank Term Money, repo transactions, Certificate of Deposits, Commercial Papers, T-Bills, etc. are some of the money market instruments.
• Through these instruments, short term requirement of funds is met by banks, institutions and the state and central governments.
• 2. Bank and Corporate Deposits
• Bank fixed deposits (FDs) have been popular and widely subscribed to, as the feeling of no-default-risk.
• Corporate deposits are FDs issued by a company (non-bank).
• 3. Government Securities
• G-Secs are sovereign-rated debt papers, issued by the government with a face value of a fixed denomination.
• 4. Corporate & PSU Bond Market
• Corporate bonds are issued by public sector undertakings (PSUs) and private firms.
• These bonds are issued for a wide tenor between 1 year – 15 years.
• These bonds carry a different risk profile and hence will have associated rating.

Debt market plays a significant role in the economy of a country. But India’s debt market suffers from shallowness. Some of the steps taken by the government to improve the situation have been showing positive trends. In the light of this development, the UPSC can frame a direct question, for ex. “What are the factors responsible for the shallowness of the debt market in India? Suggest ways to increase the depth of the debt market in India.”

What are the problems of India’s debt market?

• Wholesale market: The Indian debt market is largely a wholesale market.
• It is a wholesale market in a sense that a majority of institutional investors comprises of mainly banks, financial institutions, mutual funds, EPFO, insurance companies and corporates.
• The concentration of these large players has resulted in the debt markets being fairly skewed, evolving into a wholesale & bilaterally-priced trades.
• Lack of retail sell and transparency: It also lacks the retailness and the contractual transparency that the Indian capital markets have been able to build in the past 2 decades.
• Skewed towards G-secs: Structurally, the debt market remains firmly skewed towards government securities (G-secs).
• Also, the largest investor group in the G-secs market are the banks, due to their regulatory requirement to invest in SLR.
• Low and unstable trading in the corporate bond market: The Indian corporate bond market has low & unstable trading volumes.
• Sadly, the corporate bond market remains largely about top-rated financial and public sector issuances.
• The domestic debt managers have forgotten that the logic of the business of finance is “to price the risk”.

Regulation and comparison with other countries

• RBI regulates money markets & G-secs.
• SEBI regulates the Corporate debt market & bond markets.
• The domestic debt market in India amounts to about 67% of GDP.
• The size of India’s corporate bond market is a mere 16% of GDP — compared with 46% in Malaysia, and 73% in South Korea.

The recent positive trend in the debt market

• In the past few years, the domestic corporate bond market had seen increasing volumes, largely due to financial investments going into it, including retail participation.
• Also, the banks had ceded space to NBFCs over past many years.
• This is because banks found it easier to buy securitisation pools to achieve their PSL targets rather than develop competencies that NBFCs had built-in serving affinity groups, in smaller cities & towns.
• And post the ILFS crisis, the markets have started shunning non-banks again.
• Policy initiative by the government: The various policy initiatives undertaken in the last few years would take time to fructify and to stabilise.
• These include the IBC, SEBI’s bond market policies, RBI’s large borrower framework for enhancing credit supply.
• Some of these have already seen changes/addendums to the original draft, with the intent being to course-correct, for the stability of the markets.

Roll over of debt papers in India

• We have seen liquidity problems in our markets every few years.
• The concept of “roll-over” of debt paper was usual as our markets did not build long term papers.
• With the ILFS slowdown, it was easy for name-calling on “ALM mismatch” concept.
• Not much had been anyways done before and later to address the availability of debt to reduce the Asset-to-Liability mismatches.
• Also, we have played it safe so far by even lending for large infra projects with shorter paper and hoped to roll it over at the end of the debt term.

Conclusion

This is the time that our regulators need to work along with the various governments, especially the states, for smoother ironing of fiscal hiccups and use this to redress any structural glitches. It’s time that there is actual intent to deepen the domestic debt market and to listen to the industry about their requirements.

Back2Basics: What is ASM?

• Banks’ primary source of funds is deposits, which typically have short- to medium-term maturities.
• They need to be paid back to the investor in 3-5 years.
• In contrast, banks usually provide loans for a longer period to borrowers.
• Home loans, for instance, can have a tenure of up to 20 years.
• Providing such loans from much shorter maturity funds is called an asset-liability mismatch.
• It creates risks for banks that need to be managed.
• The most serious consequences of asset-liability mismatch are interest rate risk and liquidity risk.
• Because deposits are of shorter maturity they are repriced faster than loans.
• Every time a deposit matures and is rebooked if the interest rates have moved up the bank will have to pay a higher rate on them.
• But the loans cannot be repriced that easily. Because of this faster adjusting of deposits to interest rates asset-liability mismatch affects net interest margin or the spread banks earn.

Priority Sector Lending (PSL)

• Priority Sector Lending is an important role given by the (RBI) to the banks for providing a specified portion of the bank lending to few specific sectors like agriculture and allied activities, micro and small enterprises, poor people for housing, students for education and other low-income groups and weaker sections etc.

Roll over of debt

• When debt becomes due there is a need to either repay the principal or alternatively, to enter into a new agreement.
• Structurally, funds from the second debt are used to repay the first debt.
• Then you repay the second debt as required. Quite often these new terms will be agreed with the initial lender.
• In essence, you’re ‘rolling’ the repayment obligation from one period into the next.
• This all leads to rollover risk, which is the risk you that you won’t be able to find anyone willing to lend the value of the outstanding debt and/or offer a comparable rate as the first principle repayment obligation approaches.
• This may be due to either movement in the borrowers perceived credit status and/or changes to the broader credit environment.
• This was a key theme during the financial crisis of 2007 – 2008.
• The reasons for refinancing may include the above, but also other themes such as debt consolidation (which doesn’t directly imply a change to the debt term).

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