The monetisation question (The two choices for the Indian government)

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 The monetisation question (The two choices for the Indian government)

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• FM keeps options open: The Finance Minister has not closed the option of deficit monetisation by the RBI. That is a big decision with long-term implications.
• Two aspects of this: Both deficit monetisation and OMOs involve printing of money by RBI. But they are basically different paths.

1. "Deficit monetisation" is not the same as govt. getting free money from the RBI. It only gets a heavily subsidised support, forced out of the banks actually. The banks don't even get to know.
2. Today also, the RBI monetises the deficit, but does so by buying govt. bonds in secondary markets through OMOs - "Open Market Operations".

• Pre-reform era: The RBI was in automatic deficit monetisation mode. That was ended in 1997 by an agreement, and it was decided that the RBI would henceforth only operate in the secondary market via the OMO route. That would be more like a liquidity instrument (less to support govt. borrowing). Why? To balance the three objectives – supporting growth, controlling inflation, and maintaining financial stability.
• What changed: Post 1997, the govt. went to the open markets to borrow, so interest rates rose. So savers were incentivised more (to save), which pushed investment hugely. That pushed growth.

1. The interest rate that the govt. got in the open market was a big market signal of fiscal sustainability.
2. Now, RBI's monetary policy began controlling money supply and inflation.
3. Recall the high GDP growth rates in 2000-2008 period - that was also due to the huge investments made possible due to high savings rate, and low inflation

• FRBM 2017 amendment: The 2017 amendment to the Fiscal Responsibility and Budget Management Act had an escape clause permitting deficit monetisation under special circumstances. Should it be invoked now, during 2020? Can it harm earlier gains?
• Why do it: Those who support it, claim there aren't enough savings in the economy to finance govt. borrowings of a huge quantum. If still attempted, then bond yields would rise sharply, and hurt everyone. Hence, RBI must help finance govt. directly.
• A wrong assumption: That logic is wrong, as the RBI has injected huge systemic liquidity already through its OMOs and bond yields are soft.

1. Yield on benchmark 10 year bond was at 8% in Sept 2019, and is at 6% now.
2. When the govt. recently announced an extra 2.1% GDP borrowing, the yield was 6.17% only.
3. Lesson - the market is okay with its ability to finance more govt. borrowings (so yields won't go through the roof, so direct financing is not needed)

• Inflation: Both OMOs and monetisation potentially build the risk for future inflation, but of different types.

1. OMOs are in RBI's direct control but monetisation is not, as it's the government that decides how much to borrow and when
2. RBI losing control over monetary policy will raise concerns over inflation

• Inflation problem: India remains inflation prone, as seen post 2007 global financial crisis. India faced high inflation, when rest of the world did not.

1. RBI should have tightened policy quickly, which it did not.
2. After that, the new policy is working well, and people trust RBI with inflation control.
3. So if we dump that now, markets will feel that govt. is solving its fiscal problems by "inflating away its debts". Yields will shoot up.

• Final summary: Today, the govt. is able to borrow directly from markets at the same rate as inflation, so real rate is near zero. It is only when real rate bond yields shoot up, that monetisation should be considered. For that, either inflation has to reduce a lot, or yields rise a lot.
• Summary : There is no need for deficit monetisation today, as direct market borrowings are good enough to meet the government's borrowing needs.

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