What is deficit monetization?

In stressed times like the current ones posed by Covid-19, the banks cannot cater to the additional funding requirements of the government. Due to this, the government issues bonds directly to the Central Bank, in our case the RBI.

This week, our PM Narendra Modi has announced a mega plan to battle the economic impact of economic lockdowns due to COVID-19 with a fiscal stimulus amounting to INR 20 Tn. This translates to roughly 10% of our GDP. One question that comes in all our minds is how the government would fund this massive fiscal stimulus considering the decline in its current annual earnings which stand at 22 Tn.

Some economists have pointed out that deficit monetization is the only way out to rev-up the economic engines, while others say that it would result in runaway inflation and subsequently in our sovereign rating downgrade by rating agencies. Recently, our former RBI governor – Dr. Raghuram Rajan published a note as to how this – deficit monetization – would pan out for the nation at large and why it should be used appropriately. In this article let us understand Dr.Rajan’s point of view about this concept of Deficit Monetization and why it is neither a game changer nor a catastrophe as per him.

Firstly, let us understand how governments raise money in normal scenarios:

In normal times, the funds are raised by the government by issuing the bonds directly to the banks/Financial Institutions (FIs). Banks purchase these bonds by transferring the reserves they have in RBI to a government account. Also, these bonds are liquid enough and can be sold in open Market operations to other FIs. The holder of these bonds is entitled to coupon payments at regular intervals of time.

What happens in Deficit Monetization?

In stressed times like the current ones posed by Covid-19, the banks cannot cater to the additional funding requirements of the government. Due to this, the government issues bonds directly to the Central Bank, in our case the RBI.

Why are some economists wary about deficit Monetization and can it become catastrophic?

Many economists of the likes of Andrew Bailey, the governor of the Bank of England, Duvvuri Subbarao, former governor of RBI have vehemently opposed the move due to the inflationary tendencies of this type of financing. But a question arises as to how RBI purchasing the Bonds in place of commercial banks, spur inflation.

This is how Dr.Rajan explains it with an example –

Let’s say government issues Bonds worth 1 Lakh Cr(1 LC) and Banks purchase these bonds from their reserves. Now the banks have 1 LC less in their accounts and have 1LC worth govt bonds. When the government spends the 1LC it raised from the banks, all this amount eventually ends up with stakeholders like merchants or business houses who in turn keep the amount in banks. So now the reserves that the banks have has increased by 1 LC (Sometimes a multiplier of it) compensating for the amount they spent in purchasing the government bonds

Now let us say RBI purchases these bonds worth 1LC directly from the government through its reserves, now the amount invariably ends up with the banks as said in the above scenario. But now the banks have an additional 1LC with them in their reserves. This prompts the banks to issue more loans pumping additional liquidity which increases the money supply in the economy resulting in inflation which can be risky for the economy. However, this is built on the premise that banks issue loans from the excess reserves they have generated.

Dr.Rajan states that - due to abnormal situations, banks prefer not to lend to businesses and rather search for safer destinations like other banks or RBI through Reverse Repo operations.

So, inflation would not be a significant offshoot of deficit monetization during abnormal times like Covid-19, provided central bank intervenes once the normalcy returns with a suitable rate hike to control the flow of credit into the economy thereby controlling inflation. This is slightly tricky as inflation is measured with a time lag and a timely intervention without much delay is critical to curbing any possible runaway inflation.

If this can stir up the economy without causing inflation, why is this not a game-changer?

Deficit financing brings with it a plethora of associated costs. The dividends that RBI pays to the governments will come down as the central bank has to pay to the banks for financing this through reverse repo operations. Also, since most of the reserves of the banks are deployed in reverse repo window, the Net Interest Margin takes a hit, thereby impacting the profits of the banks. This will result in a commensurate decline in the dividend yield from the banks to the government.

Also, the adage – “Anything in excess becomes poison” fits deficit monetization too. If the government debt goes beyond a point (85-90% of GDP) or the fiscal deficit crosses a threshold (15%), there are good chances that it would result in investor fright followed by a sovereign rating downgrade to “Junk” from “Stable” by the rating agencies which puts the economy in a downward spiral.

As mentioned earlier if the inflation goes unchecked, higher debt coupled with higher inflation provides a perfect ground for macroeconomic instability. While deficit monetization can be an effective tool to spur economic growth and should be used judiciously by the governments world over as prescribed by Dr.Rajan

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The post is written by our EZPP partner Vamsi Gorthi with relevant edits and changes by our editorial team. Vamsi is a JBIMS graduate currently working with Ernst & Young.