The RBI could finance the government debt by buying bonds from the secondary market. Or it could directly finance the debt. And both could stoke inflation. But, do they carry the same inflation risk. The answer is an unambiguous ‘No’. So, how monetisation of debt is different from Open Market Operation by the RBI? Read the article to know…

What is Monetised deficit?

• The Monetised Deficit is the extent to which the RBI helps the central government in its borrowing programme.
• In other words, monetised deficit means the increase in the net RBI credit to the central government, such that the monetary needs of the government could be met easily.

What monetisation of deficit mean (and doesn’t mean)

• Monetisation of the deficit does not mean the government is getting free money from the RBI.
• If one works through the combined balance sheet of the government and the RBI, it will turn out that the government does not get a free lunch.
• But it does get a heavily subsidised lunch.
• That subsidy is forced out of the banks.
• And, as in the case of all invisible subsidies, they don’t even know.

So, is the RBI monetising the debt?

• It is not as if the RBI is not monetising the deficit now; it is doing so.
• It is doing so indirectly by buying government bonds in the secondary market through what are called open market operations (OMOs).
• Note that both monetisation and OMOs involve printing of money by the RBI.
• But there are important differences between the two options that make shifting over to monetisation a non-trivial decision.

Historical context of the monetisation of debt: An agreement

• In the pre-reform era, the RBI used to directly monetise the government’s deficit almost automatically.
• That practice ended in 1997 with a landmark agreement between the government and the RBI.
• It was agreed that henceforth, the RBI would operate only in the secondary market through the OMO route.
• The implied understanding also was that the RBI would use the OMO route not so much to support government borrowing.
• So, the RBI uses OMO as liquidity instrument to manage the balance between the policy objectives of supporting growth, checking inflation and preserving financial stability.

So, what were the outcomes of the agreement?

• The outcomes of that agreement were historic.
• Since the government started borrowing in the open market, interest rates went up.
• HIgh interest rates incentivised saving and thereby spurred investment and growth.
• Also, the interest rate that the government commanded in the open market acted as a critical market signal of fiscal sustainability.
• Importantly, the agreement shifted control over money supply, and hence over inflation, from the government’s fiscal policy to the RBI’s monetary policy.
• The India growth story that unfolded in the years before the global financial crisis in 2008 when the economy clocked growth rates in the range of 9 per cent was at least in part a consequence of the high savings rate and low inflation which in turn were a consequence of this agreement.

What is the reasoning for jeopardising the hard-won gains of agreement?

• The Fiscal Responsibility and Budget Management Act as amended in 2017 contains an escape clause.
• Escape clause permits monetisation of the deficit under special circumstances.
• What is the case for invoking this escape clause?
• The case is made on the grounds that there just aren’t enough savings in the economy to finance government borrowing of such a large size.
• Bond yields would spike so high that financial stability will be threatened.
• The RBI must therefore step in and finance the government directly to prevent this from happening.

No, the situation is not so grim-Look at the bond yields

• There is no reason to believe that we are anywhere close to the above-mentioned situation.
• Through its OMOs, the RBI has injected such an extraordinary amount of systemic liquidity that bond yields are still relatively soft.
• In fact the yield on the benchmark 10 year bond which was ruling at 8 per cent in September last year has since dropped to just around 6 per cent.
• Even on the day the government announced its additional borrowing to the extent of 2.1 per cent of GDP, the yield settled at 6.17 per cent.
• That should, if anything, be evidence that the market feels quite comfortable about financing the enhanced government borrowing.

Why worry about monetisation if OMO also leads to inflation?

The following four issues make clear the difference in OMO and monetisation

1. Issue of RBI’s control over monetary policy

• Both monetisation and OMOs involve expansion of money supply which can potentially stoke inflation.
• If so, why should we be so wary of monetisation?
• Because although they are both potentially inflationary, the inflation risk they carry is different.
• OMOs are a monetary policy tool with the RBI in the driver’s seat, deciding on how much liquidity to inject and when.
• In contrast, monetisation is, and is seen, as a way of financing the fiscal deficit with the quantum and timing of money supply determined by the government’s borrowing rather than the RBI’s monetary policy.
• If RBI is seen as losing control over monetary policy, it will raise concerns about inflation.
• That can be a more serious problem than it seems.

2. Credibility of RBI on curbing inflation

• India is inflation prone.
• Note that after the global financial crisis when inflation “died” everywhere, we were hit with a high and stubborn bout of inflation.
• In hindsight, it is clear that the RBI failed to tighten policy in good time.
• Since then we have embraced a monetary policy framework and the RBI has earned credibility for delivering on inflation within the target.
• Forsaking that credibility can be costly.

3. Yield on bond could shoot up anyway

• If, in spite of above problems, the government decides to cross the line, markets will fear that the constraints on fiscal policy are being abandoned.
• Perception in the market will be that the government is planning to solve its fiscal problems by inflating away its debt.
• If that occurs, yields on government bonds will shoot up, the opposite of what is sought to be achieved.

4. Monetisation is not inevitable yet

• What is the problem that monetisation is trying to solve?
• There are cases when monetisation — despite its costs — is inevitable.
• If the government cannot finance its deficit at reasonable rates, then it really doesn’t have much choice.
• But right now, it is able to 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.
• We are not there yet.

Consider the question asked in 2019, “Do you agree with the view that steady GDP growth and low inflation have left the Indian economy in good shape? Give reasons in support of your argument.”

Conclusion

Though OMO and monetisation both leads to inflation, the issues with monetisation have far-reaching consequences. Also, the situation we are in doesn’t yet warrant monetisation which should be seen as a last resort.

Back2Basics:  Open Market operation

• OMOs are conducted by the RBI by way of sale and purchase of G-Secs to and from the market with an objective to adjust the rupee liquidity conditions in the market on a durable basis.
• When the RBI feels that there is excess liquidity in the market, it resorts to sale of securities thereby sucking out the rupee liquidity.
• Similarly, when the liquidity conditions are tight, RBI may buy securities from the market, thereby releasing liquidity into the market.

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