The Monetisation Trap

The global pandemic has exacerbated the fiscal health of every economy. Similarly, the Indian fiscal health is worsening, with the growth of debt rising to 4.59% of the gross domestic product. Due to the growing size of government debt, monetary policy has to accommodate and adjust itself to correct the deficiencies and ignore other economic targets. This phenomenon is known as fiscal dominance and helps the government from going bankrupt. This article explores debt management through monetisation of debts, theoretical causation of inflationary pressures as a consequence of growing fiscal deficits and how fiscal deficit affects the interaction of fiscal-monetary policies?

The Reserve Bank of India through a series of fiscal and monetary responses has regulated fiscal dominance in India. Some reforms significantly impacted the treatment of prevalent debt. These reforms included auction of government debt, contracting the automatic monetization of fiscal deficits and enactment of the Fiscal Responsibility and Budget Management (FRBM) Act, 2003. Notably, the Fiscal Responsibility and Budget Management (FRBM) Act, 2003 curbed the monetisation of debt by preventing the RBI from subscribing to primary issuances of government securities.

According to the Ricardian equivalence principles, debt financing of expenditure is financed by future taxes and non-tax revenues  to repay obligation on the government. If the future revenue is not enough to meet the funding requirement of past debts, the government employs an alternative financing route popularly known as Ponzi financing. Under Ponzi financing, the government uses fresh borrowings to pay off its old debt.

In order to finance the deficit, the government can either issue debt or print money. Printing money directly affects the monetary control, which is governed by the central bank of the country, therefore the government finances its deficit through the issuance of government bonds. These bonds can be purchased by the central bank or the public. If purchased by the central bank, it increases the monetary base and thereby the money supply. The existing supply of money does not change, when purchased by the public. Does any purchase by the central bank, monetise the debt? The Reserve Bank can no longer subscribe to the primary issuances in government auctions, so has the monetisation process been completely phased out in Indian? While de-facto monetisation has been considerably phased out, there is no complete restriction. As long as fiscal deficits remain large, the size of market borrowings will be bound to remain large and change the conduct of monetary policy, no matter how the debt management is conducted.

Structural reforms by Government of India have changed the debt financing landscape in India. Historically, for a long-time government debt was automatically monetized through the issuance of ad-hoc treasury bills with 91-day maturity. Since these bills were non marketable, the burden was automatically issued to the Reserve Bank to furnish the central government’s cash balances with it to meet the government deficit. This problem of automatic monetisation was in addition to the financial repression caused by issuances of 91-day treasury bills “on tap” (at a fixed discount of 4.6 per cent per annum), which were taken up mainly by banks for short-term investment or to comply with the requirements of maintaining the Statutory Liquidity Ratio (SLR). This SLR requirement forces banks to hold government securities. Financing government expenditure by issuing ad hoc treasury bills to the Reserve Bank leads to an increase in the reserve money. Thus in a high inflation period caused by monetization, financial repression results in a negative real interest rate. In addition, the Reserve Bank also rediscounted the tap treasury bills subscribed to by the banks, thus adding to the monetisation. Hence, financial repression is a tool that helps the government to finance its fiscal deficit at lower costs while the banks become the captive investors.

The introduction of Fiscal Responsibility and Budget Management (FRBM) Act-2003, changed the treatment of  fiscal deficit and debt in India’s economy by introducing fiscal discipline and supplanting monetary independence. Although debt is a resultant of fiscal policy, its structure and composition are determined by the debt management policy. When dealing with large fiscal deficits, the central bank has to carefully align fiscal and monetary policy to achieve a better control on both monetary and debt management. To achieve this coordination, Institutional arrangements are made to allow the central bank to conduct debt management on behalf of the government. If a specialised agency  is allowed to manage debt, it would require a coordination mechanism which will not be feasible for large government market borrowings. It lacks control over interest rates, liquidity management and credit flows which makes the management of large fiscal deficit cumbersome. According to Sections 20 and 21 of the Reserve Bank of India (RBI) Act, 1934, management of the public debt of the Government of India and the issuance of new loans is vested with the Reserve Bank of India. Further, under Section 21A of the RBI Act, the Reserve Bank may undertake the debt management of states, by agreements with the state governments. Thus, in India both the debt management policy and monetary policy are vested with the same institution. The amount of deficit is exogenously given for financing to the central banks. The interaction of debt management policy and monetary policy is a major determinant of how the fiscal and monetary are aligned.  

Standard theoretical arguments concerning fiscal-monetary interface are dependent on the interactions between debt management policy and monetary policy. Therefore, the source of funding the deficit/debt is equally important as the size of the deficit/debt. If we assume that the deficit/debt can be financed easily when its size is small, it would imply that fiscal discipline with commitment to bring down deficit/ debt will improve the manoeuvrability available to central banks while conducting monetary policy.

Despite the restrictions on participation of RBI in the issuance of government securities as presented in the FRBM Act, 2003 large fiscal deficits might lead to some form of monetization of debt. Large borrowing crowd-out private credit due to which monetary authorities are compelled to conduct open market purchases of government bonds and thereby  inject greater liquidity in the economy. This underscores the effect of monetary policy. According to debt management rules more than 90 percent of government debt in India has to be financed through internal sources. Holding public debt domestically minimises the risk of public debt to be perceived with low risk from the point of view of external sustainability. If a domestically-held deficit grows too large, it creates refinancing risks, monetary turbulences, and crowding out problems. A higher share of total loanable funds in the economy, interest rates rise for the private sector. The high interest rates may reduce private sector investment and finally result in a lower aggregate supply. Theoretically, allocations of a higher share of total loanable funds towards deficit financing, raises the overall interest rates for the private sector. The high interest rates may reduce private sector investment and finally result in a lower aggregate supply. Crowding out due to fiscal deficit, can potentially reduce the overall output and increase the price level in the economy. This impact can be offset by increasing the overall money supply and this corrects the deficiencies caused by crowding out. However, the level of employment can adversely affect the increase in money supply and give rise to inflationary pressure. 

The creation of large fiscal deficits has inflationary consequences. As explained under Fiscal Theory of Price Level, fiscal dominance can occur in a weak or a strong form. Inflationary pressure rises under weak form when growth of money supply rises to match and curb the fiscal deficit. Even if the money supply is not sensitive and responsive to the rising deficits, fiscal gap impacts the aggregate demand and thereby raises the level of inflation. The latter phenomenon is observed under the strong form of fiscal dominance. The strong form signals that inflation is not only caused by the monetary changes but is also implication of the fiscal policy, while the weak form suggests that fiscal dominance attenuates the control of money supply and therefore affects the ability of the central bank to curb inflation.  

Divyansh Singh Parihar is a third-year student of O.P Jindal Global University pursuing his major in Economics.

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