By Yanis Iqbal
On May 5, 2021, Reserve Bank of India (RBI) Governor Shaktikanta Das unveiled liquidity support measures for the Indian economy. Prominent among these measures was the announcement that the second purchase of government securities (G-SECS) for Rs 35,000 crore – against Rs 25,000 crore purchased at the first auction – under Government Securities Acquisition Program (G-SAP) will be conducted on May 20, 2021. This had an immediate impact on the bond market: sovereign bonds gained, with yield on the benchmark 10-year bonds falling two basis points to 6% and its price moving up about 15 paise to Rs 98.96.
Under G-SAP, the RBI prints money and buys government securities to reduce volatility in the bond market. For the first quarter of 2021-22 (April to June), the RBI has committed to buying government securities worth Rs 1 lakh crore. Why is this being done? Among other things, the RBI is also the debt manager for the central government. It manages government’s borrowing programme. After borrowing Rs 12.8 lakh crore in 2020-21, the government is expected to borrow another Rs 12.05 lakh crore in 2021-22.
Due to the COVID-pandemic and a slowdown in tax revenues over the years, the government has had to borrow more in order to finance its expenditure and the fiscal deficit. The problem with this hefty borrowing is that the financial system can lend money up to a certain limit. When the demand for money in the market goes up, it is quite natural that the investors in the bond market start demanding a higher rate of return (popularly known as yield-to-maturity; YTM) on their lending. When the returns on existing government securities go up, the RBI has to offer higher rates of interest on the fresh financial securities that it plans to issue on behalf of the government to fund the fiscal deficit.
This pushes up the interest bill of the government, which the government is trying to minimise because debt servicing eventually eats up a large part of public spending. Hence, through G-SAP, RBI will print money and buy government bonds, so as to pump more money into the financial system and in the process ensure that yields on government securities go down.
While RBI’s announcement to buy government bonds has brought down yields, this impact is likely to be fleeting. Corporate bond yields reflect the interest rate outlook and the underlying risk of the issuer. This yield curve may swing upwards, thanks to two other curves – the Coronavirus infection curve and the inflation curve. First, resurgence of the pandemic has led to a spate of lockdowns, which will impact businesses. Second, inflationary pressures have increased, which means that the odds of bond yields easing again are low.
Considering the present-day economic situation in India, it is absolutely imperative that the government eliminate all obstacles in the way of an expansionary fiscal policy. Therefore, it needs to find alternative avenues to bond-financed deficit spending. One of them is monetary financing. It involves the creation of central bank money on a regular basis to either finance government deficits or to provide an injection of funding to citizens. Sometimes, it can also involve requiring private banks to buy and hold government debt or lend directly to governments.
John Maynard Keynes – keen for Depression-era governments to boost demand through direct money creation (“loan-expenditure”) – rued that “hitherto war has been the only object of government loan-expenditure on a large scale which governments have considered respectable.” Even amongst pro-free market economists, it was widely accepted that monetary authorities had two valid options when it came to funding fiscal deficits: bond financing or money financing via central bank or private bank purchase of government debt (monetization).
A number of early Chicago School economists including Irving Fisher, a young Milton Friedman, and Henry Simons argued that monetary financing of government deficits would create greater stability than bond financing. The “Chicago Plan”, written after the Great Depression by Fisher and a number of other Chicago School economists, argued that private bank credit creation via fractional reserves was inherently unstable, and should be outlawed via the imposition of a 100% reserve ratio i.e. a return to a public monopoly on money creation.
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Nowadays, conventional wisdom holds that central bank financing of government deficit would increase the monetary base, consequently money supply and could prove inflationary and undermine the independent status as well credibility of the central bank, on which the effectiveness of monetary policy largely hinges. This is only true for an economy working at full capacity and full employment. In an economy characterized by idle resources, monetary financing will not lead to inflation. Rather, an expansion of the fiscal deficit – aided by central bank money – will help in generating additional demand which in turn will lead to the utilization of disposable productive capacity.
Today, the government needs to withdraw the Fiscal Responsibility and Budget Management Act (FRBMA) of 2003 which – in addition to promising the diminution of the country’s fiscal deficit to 3% or less of the GDP by 2008 – made it mandatory for the government to finance fiscal deficits, if any, by using public borrowings in the capital market rather than from the RBI, as the practice used to be earlier. A rapid pace of market borrowing contributed to a proportionate rise in interest liabilities – reflected in the reduced share of the primary deficit as compared to the fiscal deficit as ratios to GDP.
If FRMBA is scrapped, the difficulties of pandemic management experienced by different states will be greatly reduced as money is opened up for containment and relief. The interest rates on open market auction of state bonds have spiked in recent times, placing a huge burden on the already fiscally beleaguered states. Instead of relying on this route, state bonds must be bought by the RBI at the prevailing repo rate. This is being done in different ways by the US Federal Reserve, the European Central Bank and the Bank of England, as well as several central banks in developing countries. India must follow the same path.