The Indian economic policy debate is at a dangerous crossroads.
Fiscal caution has already been thrown to the winds—and there is now a growing clamour for equally irresponsible monetary policy.
The total government deficit is now close to the levels that pushed us into a full-blown macroeconomic crisis in 1991. The government now puts forward the disingenuous argument that it let the fiscal deficit rise because it had anticipated the economic slowdown in early 2008 itself, though this claim does not quite fit with the various official growth forecasts and ministerial statements put out through the year.
The big question now is how is this huge deficit to be financed by the Reserve Bank of India (RBI)—by selling bonds in the market or by printing money?
Bond sales have already spooked the market and kept interest rates at relatively high levels. The other option is to print money.
There are now growing demands for greater monetization of the deficit. There is nothing wrong in occasional monetization. Most central banks do it selectively. RBI has already monetized the deficit by buying oil bonds, through open market operations and by sequestering the funds in the market stabilization scheme. The total monetization could be around $32 billion, not exactly a small sum. This is all part of what is now fashionably known as quantitative easing, or the creation of new money by the central bank out of thin air.
What matters is how this is done and to what extent. In a recent note, Goldman Sachs economist Tushar Poddar quite rightly says that large-scale quantitative easing could severely compromise macro health. “We do not think RBI can indefinitely fund a structurally higher fiscal deficit by printing money, as it would lead to a large monetary overhang, which could stoke inflation and weaken the currency as demand returns.”
The problem is not selective monetization but an extreme version, when the government forces RBI to operate the printing press at full speed to cover its burgeoning and high-risk deficit.
This was indeed common practice in India before the reforms of the 1990s. Two important events helped cut the umbilical cord between fiscal and monetary policy, to ensure that government profligacy does not spark off high inflation and financial instability. The central bank got some welcome room to manoeuvre.
First, there was the 1997 deal between the finance ministry and RBI to do away with the so-called ad hoc treasury bills. These instruments of short-term government debt were initially introduced in the 1950s to help the government tide over temporary cash problems, but they eventually became a permanent feature of the Indian economy that allowed the finance ministry to almost automatically monetize the deficit. They were eased out in 1997 and replaced by ways and means advances.
Second, the Fiscal Responsibility and Budget Management (FRBM) Act of 2003 ensured that the government’s access to the printing press is even more restricted. The FRBM Act prevented the government from borrowing directly from RBI after 1 April 2006. The central bank can now only buy government debt from the secondary market through its open market operations, rather than directly subscribing to such debt in the primary market. Some analysts now believe that this provision should be done away with to allow for greater monetization of the fiscal deficit.
Are the fears overblown? Why shouldn’t the Indian central bank be allowed—or asked—to do what its peers in the US and the UK are already busy doing? The US Federal Reserve said this month that it would directly buy nearly a trillion dollars of US government and private sector mortgage debt. Why can’t India do the same?
That’s because the situation in the US is quite different. The credit markets there are dysfunctional. The base money created by the Federal Reserve through its balance sheet is growing faster than broad money, which means that the money multiplier is less than one. This is almost a unique problem—and Ben Bernanke believes that more direct funding of the government and private sector in the US will ease the situation, even though the dollar has been hammered in the foreign exchange markets because of the fear that such high monetization will harm the US economy in the long run.
India has its own problems of monetary transmission, but it is nothing like what the US is struggling with right now. The problem here is that an unacceptably large fiscal deficit has spooked the bond markets and will most likely crowd out private sector borrowing when the economy recovers.
RBI would do well to stand up against the pressures that will inevitably build up in the months ahead and expand its balance sheet only at the pace it is comfortable with.
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