New Delhi: If there is one issue to which finance minister Pranab Mukherjee takes strong exception, it is to the charge that the Congress-led United Progressive Alliance (UPA) has effectively revived the once common practice of financing its borrowings by printing currency notes—the so-called monetization of government debt.
Mukherjee’s concern stems from the fact that monetization of the government’s debt, projected at a record Rs4.51 trillion for the current fiscal, creates a liquidity surge in the economy which, if unchecked, creates ideal conditions for setting off an inflationary spiral through the simple phenomenon of too much money chasing too few goods, besides distorting interest rates.
Inflation worries? Finance minister Pranab Mukherjee. Indranil Bhoumik / Mint
More importantly, the finance minister is keen to ensure that the distance he and his predecessors have covered in the last two decades in sensitizing the country to avoid fiscal profligacy is not reversed in circumstances where the government has to ramp up spending without a commensurate increase in its revenue receipts.
Opinion among economic analysts, too, is split, with the only point of consensus being that if indeed monetization is taking place, it differs substantially from what prevailed prior to 1997, when the practice of automatic monetization of government debt was scrapped. Consequently, the macroeconomic effects of monetization, though still potentially harmful, would be relatively muted.
Following the Budget announcement that the fiscal deficit, or gross borrowings by the Union government, as a percentage of gross domestic product (GDP) is estimated to be 6.8% in the current fiscal year, finance secretary Ashok Chawla said the government’s borrowing programme would have to be supported by the Reserve Bank of India (RBI) through open market operations (OMOs), “maybe to the extent of 50% (of the borrowing programme)”.
OMOs are a monetary policy tool used by the central bank to calibrate liquidity in the market by buying or selling government securities in the market. When it sells gilts, it drains liquidity, and infuses liquidity when it buys them.
RBI’s OMOs to support government borrowing, which had commenced even before the presentation of the Budget, triggered the charge that the Union government is monetizing its fiscal deficit. Not only did Chawla and Mukherjee strongly refute these claims, they also put out a press release on 8 July arguing that OMOs were not tantamount to monetization.
Technically, the finance ministry may not be correct. According to the ministry’s old discussion papers, monetized deficit is that part of fiscal deficit which leads to increased money supply. In the strict sense, the finance ministry’s definition would mean RBI’s OMOs this year are bound to partially monetize the deficit.
That OMOs lead to an increase in money supply is a truism no one disputes.
The finance ministry’s argument is that labelling the outcome of OMOs as monetization overlooks the substantial progress achieved in the last decade in the processes of financing the fiscal deficit and exaggerates the macroeconomic fallout.
All-round effort: Finance secretary Ashok Chawla had said the government’s borrowing programme would have to be supported by RBI. Ramesh Pathania / Mint
The finance ministry’s claim for a more nuanced view on the subject has some support outside.
“It is not correct to equate the current situation with ad hoc treasury bills. There is a penalty of paying (by government) market interest rates,” Shubhada Rao, chief economist at Yes Bank Ltd, said.
Ad hoc treasury bills refer to short-term government debt first used in the 1950s to help bridge temporary cash problems. However, they soon became a way for finance ministers to automatically monetize deficits. The ad hoc bills were dumped with RBI through private placement at an interest rate fixed by the government.
However, a snap poll of 11 analysts by a Mumbai-based think tank, viewed by Mint, shows that nine of them believed that purchase of government paper through OMOs by RBI was indeed monetization.
According to a finance ministry official, who did not want to be named because he is not authorized to speak to the media on the subject, there are three key reasons why an OMO to support the government’s borrowing programme should not be equated with the past practice of monetizing deficits.
Today, central bank support to the government borrowing programme is done without issue of ad hoc treasury bills, without bending an administered interest rate regime in the government’s favour and also without the government directly dumping its securities with RBI (also called private placement), the official said.
Prior to 1997, the Centre could freely use these measures to monetize the deficit, and by clubbing present-day OMOs along with them introduces a negative implication to current market operations, the official explained.
The Union government can today automatically monetize its fiscal deficit through a private placement only on grounds of national security or national calamity, according to the Fiscal Responsibility and Budget Management Act. Moreover, the reason to invoke them has to be explained to Parliament.
“It is a significant change in process. Automatic monetization was allowed by law, there is nothing automatic about OMO,” Rao said. “Now, control is in RBI’s hands. It (OMO) is not an unbridled issue like private placements.”
The government’s view in the debate has support abroad. On Friday, James McCormack, head of Asia-Pacific sovereign ratings for credit rating agency Fitch, said: “We don’t expect debt monetization. Although we see debt issuance going up, we don’t think the debt level has gone so far that the central bank is the only entity that can provide funding.”
In 2008, Fitch was the first of the overseas rating agencies to mark down the outlook on India’s local currency rating to negative from stable. Standard and Poor’s followed suit in 2009 for the outlook on both foreign currency and local currency ratings.
A changed mindset
The three recent finance ministers in Congress-led governments—Manmohan Singh, P. Chidambaram and Mukherjee—have all been wary of ballooning deficits and had to work hard to effect a change in the mindset of both politicians and policy planners in government.
In 1994, Singh, in his budget speech, first announced the government’s resolve to phase out ad hoc treasury bills over a three-year timeline. Singh then pointed out that he had earlier been governor of RBI and was aware automatic monetization of deficits undermined the central bank’s monetary policy.
Fifteen years later, the clamour for monetizing deficits has not yet subsided completely. Even as the government cranks up its publicity machinery to refute comments suggesting it is monetizing deficits, a section of the industry is demanding it as a part of the stimulus package to combat the economic slowdown.
However, like Mukherjee, RBI too is against the practice.
In April, RBI governor D. Subbarao, during an interaction with a section of industry in Mumbai, said: “There is no free lunch. I can print a lot of money. I can put up another printing press, lease another printing press and print money... They are not benign solutions. So when people say monetize the deficit, these things are not about the next three months, but the next three years.”
Kathleen Brooks contributed to this story.