At a time when the economy continues to face a difficult challenge, the govt has opened a minimum of two avoidable political fronts which can disrupt a co-ordinated response on the economic front. The first is that the GST compensation cess payment controversy with the states. The second is that the political showdown on the three agriculture reform bills.
The first half the financial year 2020-21 ends today. The year started under a nationwide lockdown imposed on March 25. While most lockdown restrictions are withdrawn, especially within the second quarter, the economy is way from normal. Neither the govt , nor the Federal Reserve Bank of India (RBI) features a projection for this year’s GDP.
At such times when the world turned to economic experts, majority of them are suggesting an economic stimulus for recovery. Even in the stimulus they are very specific on one particular tool i.e. The Monetisation of Deficit. From former Finance ministers to the former Governor of RBI, this economic policy is everybody’s plan of action for economic recovery of India.
Now, everyone even the common man is talking about deficit monetization. There is a big debate on this word. Who better than a professor of Finance and a former practitioner of monetary policy the Raguram Rajan’s words to understand it. Now he says the public debate in India is centring around some people who want monetization.
What is Monetisation of Deficits?
It means RBI should directly print notes and give it to the government in exchange for buying bonds. They say that- growth is in danger and markets are risk-averse. Banks don’t want to buy bonds because after they buy the bond, prices may fall. They have to provide for mark-to-market loss. So bond yields are rising and therefore interest rates are not falling. Growth is not kicking up.
There is the other side of this debate which says that RBI should never print money directly. That would amount to a catastrophe. Why do they say that? I mean if you keep on printing notes there will be no poor country. Right?
Actually their point is- too much of money and not enough goods and services will lead to inflation and then as there is high inflation and the government is reckless in foreign investments. Investors will run away. There will be a run on the currency. They can be rating downgrades. Don’t go down that path of printing too much money directly and giving it to RBI now.
So which side of the debate is correct?
Rajan says that you can divide it into two categories. One normal times and one abnormal times. In normal times what happens- government when it wants to say pay salaries it sells bonds to the banks. The banks then give it money. What does the government do with the money- it pays salaries. It pays contractors whomever it buys goods and services.
What does it do it deposits in their account- so all that money comes back as deposits to the bank and banks make loans. An economic activity goes on.
What happens in abnormal times- banks are refusing to buy bonds because they are risk-averse and therefore you come to the other abnormal picture. The Reserve Bank steps in. Government sells the bonds directly to RBI and RBI buys the bonds. The currency that it creates it gives the government. Government spends that money on salaries and contracts, contractors and services.
Banks never gives cash deposits in their respective accounts. So it comes back to the banks. Now what are the banks do in a risk-averse environment, where they are not even buying government bonds?
Banks who use that money to buy, to make loans they give it to RBI. In what is called the reverse repo window. Today there if you give idle money to our RBI, you get 3.75 percent. So actually that excess money does not create any mischief. Also this is not free money is what Rajan is pointing out. Government will get less dividend from RBI. Why? Because RBI is paying every day 3.75 percent for all this idle money.
Government also gets less money from the bank’s. See if the banks had bought government bonds the yield on it is 6 percent to 7 percent. If they keep the money idle what are the earning? Their earning is 3.75 %. So government loses dividend from banks and dividend from RBI. So printing money by RBI is not really free money. That is the key takeaway.
On the positive side Rajan says that governments should not be afraid of financing themselves through monetization. Because growth is important. Don’t get bogged down that monetization is bad and we won’t do it. Government’s primary concern should be growth and they should be concerned about protecting the health of the economy also from a recession.
So some element of monetization is very good. If you want growth to come back in a depressed or a risk-averse scenario government should actually spend that money wisely. It should not over borrow from RBI. It should prioritize and if it spends wisely then this excess monetization is not bad and it’s not as if this will always create problems. There is no limit.
Are we again go on printing 10 times the notes?
If the banks are just going to keep that money with RBI again in the reverse repo window, no mischief is created. So don’t write off monetization as a catastrophe. But government should worry and these are the negatives. Government should worry that monetization is not used in the wrong way. Don’t use it if you know excessively, do not create economic growth. So that central bank financing in normal times can be bad because what will the banks do. They will not put a little money with RBI. They will make more loans and that can be inflationary.
See the problem with RBI directly buying from government is that you don’t get a market signal. It obscures the market signal because they can give the government any interest rate. Also when there’s so much money coming cheap to the banks they also don’t do due diligence. When they give loans they may end up giving it to the wrong borrowers. I mean if I’m getting money at 3.75% and 4% I would think a builder or a real estate company or an NBFC which has a return of 6% is good enough but that interest rate can rise and that business can become a bad loan.
So you will end up when market signals obscured. You will make the wrong kind of loans. Also more government issues directly to RBI the more debt you are creating in future generations. Imagine instead of 10 bonds future generations have to service hundreds. I mean you’re taking away money from future governments because they have to service. They have to pay interest on that bond. So they will have less money for development. That is the crux of what Rajan is trying to say.
The government issuing buying directly from RBI or rather taking money directly from RBI will only mean that future generations will have a problem. Doing a monetization is not a game changer. It doesn’t mean that there is going to be easy growth there will be problems. The government will get less dividend from RBI and banks on the other hand. It is not a catastrophe either provided you do it with it or do it within limits. On both sides you have to be moderate that’s the message from this former governor and professor of Finance.
Fiscal deficit being where it is, the hardships that the people are suffering due to the Corona pandemic and the poor tax collections as a direct fallout, they’re off. The government is thinking of monetizing the deficit not only that but the opposition parties were also giving out statements. From the erstwhile Finance Minister Mr P Chidambaram and a couple of other guys who seem to agree that monetizing the fiscal deficit to be the way to go forward.
Now what does this very complicated jargon – technically monetizing the fiscal deficit actually mean. Monetizing the deficit would mean one of the two things. Either you commissioned the printing presses to run over time and print currency notes and buy currency notes.
I am referring to unpacked currency notes. Unpacked currency notes is when the government does not have the requisite amount of gold but it goes ahead and creates currency. Any which way you are basically either printing unpacked currency notes and or which means in addition to printing currency notes you might just also simultaneously buy back bonds from the banks.
The RBI will buy back bonds from the banks and release money which is invested off the banks into these bonds. Now why do these banks buy RBI bonds? Because you know in India the banks are supposed to keep a certain amount of capital with the RBI as CRR (cash reserve ratio) and SLR (statutory liquidity ratio).
Now since the banks are to keep money with the RBI part of it as cash part of it as bonds and the more they have bonds lying with the RBI the less they can lend to the business houses. So the RBI in its endeavour to release money off, the banks is planning to print currency as well as buy bonds from the banks what will be the near term and medium and far term impact for you and me.
How does it impact you and me as common people?
in the absolute narrative, if bond buying is a part of the entire package and not just printing on back currency. If bond-buying is part of the package your bond prices will rise which means bond years might compress a little bit is the recent week’s ten-year benchmark bond yield the going below the 6% mark a sign of the RBA’s bond buying. Maybe I’m keeping my mind absolutely open. Maybe the RBI has already started mopping up bonds from the markets. But let’s keep an open mind out there.
So in the near term bond prices will rise use will fall. There will be volatility and when the RBI sees it buying bond prices might fall again which means they might just go up a little bit. Now if you’ve noticed what happened on 29th May 2020- Barney’s which had fallen below the 6% mark actually edged higher to 6.01 percent mark. That basically tells me that somebody who was buying bonds has now basically backed off a little.
The other thing and that will happen is that printing unpacked currency will trigger some amount of inflation that unfortunately is a given when you essentially have a demand and supply equation where supply of any commodity is now suddenly escalating. In this case currency notes as a commodity the supply is about to go up.
The value of that commodity tends to weaken which means the purchasing power of the rupee might just contract a little bit. Which means your fruits vegetables and other essentials unfortunately might just get a little more expensive.
Invariably when any kind of stimulus packages where monetization of the deficit is resorted to the national currency of that country tends to weaken a little bit. Which means the USD-INR might just go up a little. I’ve always expressed concerns that the USD rising would unfortunately mean that we will start to import inflation.
Anything and everything that we import will now become more expensive. So your cell phones, your electronic items, your flat-screen TVs, your cars, your sneakers, your imported clothes, etc. All might just wind up costing you a level more.
The biggest negative news of all- fossil fuels which is natural gas and crude oil which form two thirds of our entire import bill will now suddenly cost us a lot more if the currency was to fall a little bit. The USD-INR was to rise and the rupee was to fall against the dollar which means that there would again be a second round of inflation.
So I think you and I need to brace up. That our returns on fixed income instruments which means bonds, fixed deposits, mutual funds, debt funds, insurance policies, your returns are likely to fall and inflation on the other hand is likely to go up a tad bit. Not a happy situation.