The Monetization Accusation

By Suyash ChoudharyThe run up to the Union Budget has been understandably laden with a wide variety of analysis and speculation with respect to the likely path of the fiscal deficit. This has been an exceptionally challenging year for government finances where slippages from the stated fiscal targets (and subsequent glide path) are almost a given.A related point is about the invocation of the so-called ‘escape clause’ to the steady fiscal consolidation targets that the government has indicated under a loose adherence to the Fiscal Responsibility and Budget Management (FRBM) Act. The clause allows for a 0.5% deviation on targets provided certain underlying conditions are fulfilled. The most likely such condition that may be met in the current context is the one about “structural reforms in the economy with unanticipated fiscal implications”.A more interesting aspect of the escape clause that it may allow RBI to subscribe to the primary issuances of Central Government Securities, or in other words, directly monetize the central government’s deficit. This discussion has gained ground recently, including a view that RBI anyway has been doing indirect monetization of deficit via its open market operations (OMOs) for a while. Actually this observation dates back to much before the recent discussion on direct monetization of deficit started. The primary objective of this note is to put forward our view on the matter.OMOs Have Been Only a Liquidity Tool Thus FarOur clear position is that RBI hasn’t been using OMOs as a tool for implicit deficit financing. One can go all the back to the Subbarao regime to show this, but we are sticking here to relatively recent history. It may be recalled that Governor Rajan switched the RBI’s stance on liquidity targeting to neutral from deficit, in the early part of 2016. Leading up to this change, and then reinforcing the change through subsequent action, the RBI launched large scale OMO purchases. This continued till a little before demonetization, post which event system liquidity anyway spiked into heavy surplus. With some lag as it awaited stabilization in currency trends, the RBI started OMO bond sales to the market to absorb the liquidity surplus. Soon after, however, system liquidity started going to negative territory again and the RBI had to start OMO purchase operations from somewhere around mid-2018 which lasted for roughly a year. Through this period the system continued in an average deficit mode, rising into surplus mode only after mid – 2019. By then the purchase operations had stopped. However, probably given economic circumstances and the glaring need for transmission, the RBI kept this liquidity in the system, not resorting to OMO sale operations to absorb the excess from the system. These timelines are captured in the chart below.It is quite evident from the above that OMOs have been used only as a liquidity tool. Till very recently they have been used to implement the Rajan era modification of guidance to ensure neutral liquidity. The break if at all from this tradition has been recently (and rightly so in our strong opinion) when excess liquidity has been allowed to persist in the system. The tool has been used symmetrically, as evidenced by the substantial OMO sale operations that had been done to mop up post demonetization liquidity. It can be argued that the exercise has been subject to forecasting errors. But these have been symmetric as well. Thus for instance, the post demonetization mop up of liquidity turned out to be quite unnecessary, as the pace of rise in currency in circulation (CIC) remained relatively strong for a longer period and the country’s balance of payment (BoP) turned negative for 3 quarters after March 2018 (forex operations of RBI are linked to net dollar flows and impact rupee system liquidity). This is shown in the graph below.These dynamics forced the RBI to restart OMO by mid-2018 and the period over which these ran coincides with liquidity remaining in deficit mode. However, these seemed to have experienced some forecasting uncertainties as well since BoP turned heavily positive again while CIC increase slowed (chart below).Finally, the RBI ended up paying a larger than expected dividend and one time capital transfer to government of India in 2019, thereby further augmenting core system liquidity. While on the subject of this transfer, it is prudent to recall that this was done after due examination by a committee led by a former RBI Governor. The recommended transfers were rule based and far short of some of the speculated numbers that were floating in the context at that time.The one potential criticism of the OMO tool is that of unintended consequences; that while the objective may be core liquidity augmentation it ends up influencing bond yields, even at the mid-long end of the curve. However, this aspect is not new and successive central bank leadership (at least Subbarao onwards) have lived with this consequence. Indeed, we remember pointing to this consequence around the Rajan OMOs but were met with tepid response.The RBI Should Not Buy Primary Government DebtAs shown above, the RBI has successfully kept its operations so far in the domain of monetary policy. While the latest operation twist may be termed borderline insofar that the amount of purchase of longer term assets is often higher than the amount of sale of shorter end ones even as system liquidity is heavily surplus, this is still justifiable given the new policy objective of targeting term spreads. We have spoken about the necessity of doing so before, and will not delve into it here. The only point we will use for re-emphasis is that in our view this isn’t RBI incentivizing reckless fiscal behavior from the government. Borrowing a favorite term of a past RBI governor, consider the counter-factual: economic growth has slipped to its slowest (by some measures) since financial year 2008-9, while core inflation and current account deficit have collapsed despite the government running a bloated deficit. Thus it is not as if an unwanted fiscal impulse was pursued, even as one must acknowledge unwarranted leakages of revenue owing to plugging delays in new tax reforms.In our strong view, the RBI should persist in keeping monetary policy distinct and use tools like twist for so long as the macro logic remains for such operations, rather than start to monetize government debt. India needs a turn towards stability in its macro narrative and overlapping monetary policy with the fiscal would create avoidable delays and disruptions to the resumption of such a narrative.(Suyash Choudhary is Head of Fixed Income, IDFC AMC. The views expressed are personal.)–IANSchoudhary/in

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