Why RBI shouldn't finance govt borrowings

The government announcement to borrow 54 per cent more than planned increases the Centre’s fiscal deficit up from the budgeted 3.5 per cent of gross domestic product (GDP) to 5.5 per cent. State governments will be encouraged by this to come out and borrow more, taking the combined fiscal deficit of the Centre and the states to well above 10 per cent of GDP. That could well be an underestimate by as much as 5 per cent of GDP as the budgeted growth of nominal GDP of 10 per cent is widely forecast to be 5 to 6 per cent. The final deficit could be even larger as the disinvestment target from Air India and Bharat Petroleum Corporation Limited is unlikely to materialise. 

In a crisis, it is imperative that a country borrows and spends more. What is sorely missing and what markets require in order to price that additional debt is a plan as to how the action is going to be reversed once the crisis is over. That was not forthcoming and one should have seen additional borrowing being accompanied by a rise in yields. Last month, for instance, when 19 state governments lined up to borrow, a part of it was not subscribed, and the yields requested by the markets were higher despite rate cuts and injection of adequate system-level liquidity by the Reserve Bank of India (RBI). In sharp contrast, the hike in borrowing by the Centre was announced on the same day as a new 10-year bond was introduced and it was trading at a historic 11-year low. That could only imply an expectation in the market that eventually the Centre will place a part of the borrowing programme directly with the RBI.

As direct purchases of government securities by the RBI or printing money to finance government expenditures do not have a legal mandate, suggestions are being made that as a one-off the RBI and the government should commit to this being a unique arrangement in these extraordinary times that will not be indulged in again. We know the difficulties of parties keeping to their promises — witness the slippages from the Fiscal Responsibility and Budget Management Act — but that is a minor concern with this suggestion.

The more important issue is that such policy recommendations blur the line of distinction between fiscal and monetary policies. If the RBI lends via open market operations, it provides liquidity via a monetary measure. But when it purchases securities outright from the government, it is a fiscal act. The RBI operates open market operations (OMOs) by issuing or redeeming currency, which is a liability and government debt is in such an instance considered to be redeemed by tax revenue. When money is issued as part of revenue for financing government expenditure, it is a fiscal act that suggests the government debt will be redeemed by tax revenue as well as an inflation tax.

Moreover, the central bank receives interest on its holding of government securities. And it is mandated by law to pay all its operating surpluses to the government. The government thereby saves on interest payments on the debt and the debt is also owed to itself. It seems like the government has found a way to have a free lunch. But the laws of economics do not allow for freebies. A central bank printing money to buy government bonds generates expectations of inflation as well as inflation down the line. Markets considering money issued by the RBI as revenue for the government would be encouraged to demand handouts, such as tax cuts or moratoriums on loans taken or relaxation of prices charged by public utilities, and can lead us down the path to fiscal plus monetary irresponsibility. 

In the current scenario, with the new rules for moratorium on bank loans, commercial banks will be attentive to their liquidity positions, which will put upward pressure on interest rates they would bid for government securities. The interest rate must be allowed to adjust in response to market forces because it improves the ability of the monetary authority to control inflation and steer the growth of the economy. If fiscal authorities are expanding the stock of government bonds at a faster pace than the central bank is adding government bonds to its portfolio, then the supply of bonds to the commercial banks and the private sector is expanding more rapidly than currency issued by the RBI. This portfolio shift cannot continue to endure. Either the demand for government bonds will cease or the interest rate will become excessively high. This instability will be checked in two ways: A government confronted with these costs to its expenditures will not overexploit this source of funding, and an independent monetary authority will not accommodate the expansionary fiscal policy. Direct financing of fiscal policy cannot ensure this desirable long run consequence for the economy. 

Apart from price stability and economic growth, another objective of policy is external balance. Financing a deficit directly from the central bank raises expected inflation even though actual inflation may be currently low and can impact credit ratings apart from hurting the credibility of the central bank. The corresponding real appreciation of the currency increases current account deficits and in turn causes exchange rate depreciation at a time when foreign investors have been exiting the country. To maintain external balance, the RBI has to either lose foreign exchange reserves or raise interest rates, which is a conflict with the requirement for internal balance. For many years prior to reforms, we had monetary policy subservient to fiscal policy and it resulted in endemic high inflation and even a currency crisis. These are hard times but we should not lose sight of the long-term benefits of keeping the central bank safe from direct financing of the fisc.

D’Souza is a professor of economics and director at the Indian Institute of Management Ahmedabad; Agarwalla is associate professor at Adani Institute of Infrastructure Management