Hi,👋
New topic for today is Monetization of the
Government’s Fiscal Deficit. 💡I first came across this topic after I read an interview by Dr.
C Rangarajan🕵️♂️ where he mentioned that monetization of Government deficit may
be inevitable amid the coronavirus disruption. So this led to a number of
questions revolving around this topic like how does this system exactly work
and how is this method different from others🤷♂️. So let’s dig
into this little bit and get some clarity on this aspect in Post #3 of the Quarantine
series.🧐🤔
Q1. What exactly is government deficit and how
does the government source its deficit?💰💵💶
A1. The difference between the total receipts
(without borrowings) of the government and the total expenditure is called as
the ‘fiscal deficit’💡 of the government which simply means how much the government
has to borrow or arrange for funds from different sources. There are a number
of ways in which the government funds this deficit but in recent years their
main source is borrowings from market participants (banks, MFs, insurance
companies, primary dealers) and borrowing money from the National Small Savings
Fund (NSSF). Apart from that they either use a tool called as the Ways and
Means Advances (WMA), which in simple terms means short term advances from the
RBI to meet the temporary mismatch in the receipts and payments of the
government or draw down money from their cash balances.
Q2. Then what about this new method of
Monetisation of Deficit?😎
A2. The term monetization of deficit means
that the RBI (central bank) will directly buy bonds from the government.💼 This is
different from the market borrowings (understood above) because in case of
monetization of the deficit, it is only the central bank which gets involved.
It is important to understand how this affects the balance sheet of the RBI.
When the RBI purchases the government bonds, it will be treated as an asset in
their books (under Investments). As in accounts, there is a double entry
system, the increase in assets should in turn lead to a decrease in other
assets or increase in liabilities. In the case of the RBI, the liabilities of
the RBI increase because the RBI prints new currency💵💵 (liability for
the RBI) and hands it over to the government. This is unlike other financial
institutions (like banks) purchasing government securities as in that case the
banks purchase the government securities and makes payment from their bank
account (thus no new currency is printed).
Q3. Is this allowed as per the regulations?
A3. The FRBM Act, 2003 clearly states that the
Central Government shall not borrow 🚫❌from the RBI except by way of advances to meet temporary cash
mismatches. However, it adds that the Central government shall borrow from the
RBI only under the following conditions:
- Grounds of national security🕵️♂️
- War/ Calamity🌊🌊🌫️💦☔
- Collapse of agriculture which
severely affects farm output 🚫🍊🍋🍒
- Decline in real output growth of a
quarter by atleast 3% below average of last one year 3️⃣⬇️
So, this is basically the “escape clause”
which the Government can use to borrow from the RBI. Just to remind you, this
is also the same escape clause of the FRBM Act which allows the Government to
deviate from the fiscal deficit target.
Q4. Isn’t Open market operations undertaken by
the RBI similar to monetization of deficit?
A4. Not really but indirectly yes. In open
market “purchase” operations, what the RBI does is it purchases government
securities from the market participants (banks, MFs, other financial
institutions) and infuses permanent liquidity (money) into the banking system
i.e it provides money to the banks. The objective here is that the banks would
devolve money into the credit channels and support growth in the economy. But
with the challenging financial conditions for the banks in the Indian economy
at present, the safer option which they resort to is either to hand out the
money back to RBI (via something called as reverse repo operations) or invest
the money in Government securities (as explained above as Government market
borrowings). Thus, there has been a semi-circle ↪️↩️created here as
the money moves from the RBI to the banks and then in turn the banks invests
the money into the government (via market borrowings). So, we can say there is
indirect monetization of deficit.
Q5. How will money flow after the monetization
of deficit and the problem called inflation?
A5. The new currency which is printed by the
RBI will be handed over to the Government for undertaking additional spending
amidst the unprecedented COVID-19 outbreak. The new money gets added to the
“reserve money” which in simple terms means currency in circulation with the
people. So the likely question which props up is that with higher currency in
circulation, wont it lead to excess aggregate demand and in turn lead to
inflationary concerns📈?
This is exactly the reason why since 1997,
there has been a complete phase out of monetization of fiscal deficit between
these two entities. The practice of automatic monetization was seen as one that
encouraged government profligacy and led to inflation in the economy. Prior to
1997, the RBI would replenish/refill the shortfall in Government’s cash balance
by issuing something called as “adhoc Treasury Bills”. Though these adhoc
treasury bills had a temporary nature, it became a popular source of financing
because the borrowing took place at a fixed interest rate pegged at in 1974.
Q6. Is the idea of monetization of deficit the
same as deficit financing?
A6.. The idea is not the same but it is
related. Deficit financing is when the government is spending more money than
it is receiving as revenue for which they have to meet the additional spending
via raising funds. One of the ways of raising this additional funds is by
printing money which is called as monetization of deficit.
There have been a number of different fiscal
and monetary coordination activities seen in the recent few weeks to dissuade
the impact of the pandemic. This has been in the form of:
- RBI allowing the government to raise
62% of its market borrowings in the first half of FY21
- Increasing the limits of ways and
means advances for both the Centre and State
- Allowing 50% of net borrowing limit
of the state governments in FY21 to be raised in April itself
What will be interesting to see is whether the
monetization of deficit takes place as it would be something novel to study the
after effects of this decision over and above the novel COVID challenge
(especially for all the young economists!!)🕺💃
Regards,
Sushant
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