Monday, April 15, 2013

Monetisation of Fiscal Deficit !

Someone on Orkut asked me about Monetisation of Fiscal Deficit !! My two cents !! 

1. Monetary and fiscal policies in any country are two macroeconomic stabilisation tools. 

2. These two policies can be used in different directions as is the case in India. So while monetary policy is often pursued to achieve the objective of low inflation and thereby stabilise the economy from output and price shocks, fiscal policy is often biased towards high growth and employment even at the cost of higher inflation, as these are in the hands of govt. and they want to win elections. 

3. For achieving an optimal mix of macroeconomic objectives of growth and price stability, it is necessary that the two policies complement each other. Sovereign debt crisis in Europe has emphasised the need for monetary and fiscal policies coordination. 

4. How much can these two policies complement each other will vary according to the stage of development of the country’s financial markets and institutions.

5. However in the context of developing economies, it is often seen that the fiscal policy dominates the monetary policy and the central bank is subordinate to the fiscal authority i.e. the govt. Hence the question of co-ordination may not arise since the two institutions are NOT independent. 

6. Background:

6.1. The Reserve Bank of India was placed on the statute book in 1934 through the RBI Act, 1934. 

6.2. The RBI Act provides for RBI to manage the public debt of the Central and the State Govt. and also acts as a banker to them. This developed the much needed interface b/w the monetary and fiscal policy. 

6.3. In the pre-independent days the British govt. adopted a stance of fiscal neutrality (i.e. net of tax and govt. spending which led to no growth in aggregate demand). 

6.4. The fiscal-monetary interaction evolved post 1947. The low level of savings of citizens and poor investment climate, gave fiscal policy an upper hand in the development process under the 5YPs beginning 1950s.  Fiscal policy was increasingly used to gain adequate command over the resources of the economy, which the monetary policy provide. 

6.5. Very soon the govt. began resorting to deficit financing to bridge the resource gap (Revenue - expenses). Thus the functioning of monetary policy came to be influenced by the size and mode of financing the fiscal deficit !! Thus resorting to cash mgmt provisions(mentioned as one of the function of RBI in the  in the RBI Act 1934), govt. misused RBI's role. Budget deficit financing became a permanent feature. So, now whenever government’s balances with the RBI fell below the minimum stipulation, it was replenished through automatic creation of ad hoc T-Bills. Though these were temporary, but repayment of 1 led to creation of 2 and to refund it 3 was created. So a cycle had been established and monetisation of deficit of the Government became a permanent feature, leading to loss of control over base money creation by the RBI !! Things didn't stop here. RBI also subscribed to govt. securities !! Why? Large govt. borrowings to finance plans (5YPs) and markets alone could not finance it. 

6.6. All these however, constrained the operation of monetary policy as it led to creation of primary liquidity in the system and involved postponing any increase in bank rates by RBI to control govt. borrowings. The RBI Act was amended to empower RBI to vary CRR to enable control of credit boom in the private sector emanating from reserve money creation through deficit financing. Likewise SLR, which essentialy is a prudential norm to ensure banks have a certain % of liquid fund w.r.t liabilities, was used essentially to secure an increasing captive investor base for govt. securities, which will ultimately finance the increasing fiscal deficit of gov.t especially after the nationalisation of banks in 1969.

6.7. So you see how monetary policy is working essentially to approve the fiscal policy. Those days(pre-1991) fiscal policy laid greater emphasis on social justice and poverty alleviation (DPSP ne govt. ki le li), the monetary policy and thereby RBI's focus shifted from playing with the interest rates to essentialy debt mgmt for the govt. This changed the relationship b/w RBI and govt. and RBI played a limited role in the structure of the financial system and use of the interest rate as a monetary policy instrument. Reserve money created through monetisation was riding high and it was the single most imp factor influencing monetary policy in 1970s and 80s. With little room for manipulation, RBI was left with no choice but to have high CRR and SLR to curtail liquidity.

6.8. Single most constructive work done in supporting monetary policy in pre-1991 time was the movement to establishing a market based public-debt market. So, t-bills were now auctioned enabling a better control of reserve money by the Reserve Bank.

6.9. 1991 - CRISIS !! You know what happened ... don't you ?? We airlifted gold to pledge with IMF in return for SDRs(Special Drawing Rights) to buy us imports !! 

The elephant(read Indian govt.) finally woke up .. and came to terms with fiscal prudence !! 

6.10. Phasing out of the automatic monetisation of fiscal deficits through the significant agreements between the govt. and RBI. One such agreement was that issuance of ad-hoc t-bills which enabled automatic monetisation of govt. deficit, which I talked about above, was reduced to minimum and was to be ultimately phased out. This enabled the Reserve Bank to bring down the CRR and the SLR, thereby freeing resources of the banking system for the commercial sector. Remember, it was at this time that Mr. MMS and NSR promised to IMF that they would open up their sector to private and foreign players.

6.11. Then came the major step towards phasing out the monetisation of debt, through the FRBM Act, 2003 that barred the RBI from subscribing to the primary issuances of the  government from April 1, 2006. (Remember earlier the RBI used to subscribe for govt. securities to finance govt. deficits).

7. So, has the monetisation been completely phased out in India now that the RBI no longer subscribes to the primary issuances in government auctions?

Prima facie, monetisation of fiscal deficit has been considerably phased out, but not completely !! Why? 

As long as fiscal deficits remain large, the size of market borrowings would also remain large and influence the conduct of monetary policy, no matter how the debt management is conducted. How? Through its impact on aggregate demand and inflation. 

So nowadays RBI uses something called Open Market Operations(OMO), in which it sells/purchases govt. securities to/ from the market, as a monetary/liquidity adjustment tool. Also, a new innovative technique called Special Market Operations (SMOs) are conducted by the RBI. The 

SMOs enabled PSU oil companies to sell oil bonds to the RBI to raise foreign exchange. These SMOs essentially weakened the FRBM Act as it indirectly monetised government deficits. How? 

- The govt. by issuing oil bonds understated the true fiscal deficit. 

- If the govt. had to fund it through its own securities, the RBI could not have subscribed to it as it would have been against the FRBM act. 

However since the oil bonds lacked liquidity, RBI stepped in to provide the same while resolving the $$ funding requirement of the oil companies. This creative instrument helped minimise the pressure on interest rates as well as exchange rates. 

So, we see that monetisation of fiscal deficit has not been completely done away with !!

1 comment:

  1. So new money is still being created!


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