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“If not now, when?” asked Uday Kotak, the Managing Director and CEO of a bank that bears his name, at the end of May while demitting office as President of the Confederation of Indian Industry, a business lobby group. He was referring to the urgency of the government putting more money in the hands of people to the extent of about 0.5 percent to 1 percent of GDP. It is rare for bankers to support expansionary policies.

Kotak said the government should use this money to alleviate the distress of those people who are down and out due to the second wave of the novel coronavirus epidemic that has resulted in the economy being shuttered to various degrees across states. This could happen in the form of direct cash transfers, payment of wages through the rural manual work scheme called MNREGS, and in the form of rations of grains to those who are newly unable to buy food because of loss of livelihoods.

Government borrowings

In the budget for this year, the government had estimated it would need to borrow Rs 15 lakh cr or 6.8 percent of GDP. The assumption was that the economy would grow by 14.4 percent over the last year (in nominal terms, without discounting the inflation). The Reserve Bank has now revised the projected growth downwards by one percentage points. Experts like the former Reserve Bank Governor C Rangarajan expect GDP to grow at 13.4 percent. If the government acts as Kotak suggests, it will have to borrow Rs 17.46 lakh cr or 7.8 percent of GDP.

There is common agreement that the government should spend more to revive demand. The contentious issue is how this should be financed? Kotak says the Reserve Bank should “print money.” Kaushik Basu, who was Chief Economic Adviser in the Manmohan Singh government and also Chief Economist of the World Bank till 2016 has tweeted that Kotak’s are “excellent ideas.” But D. Subbarrao, who took over as RBI governor in 2008 just before Lehman Brothers collapsed (resulting in the global financial meltdown) has sounded caution. In an interview to news agency PTI, he said there are times when monetisation, despite its costs, becomes inevitable such as when the government cannot finance its deficit at reasonable rates. “We are nowhere near such a scenario.” Rangarajan has also been guarded. “Direct monetisation is best avoided,” he wrote in an article. He says the RBI should do more of what it is currently doing: make more bond issuances to support the government, should it choose to borrow more than budgeted for.

Market discipline

The Reserve Bank is the government’s debt manager. It can lend directly to the government or raise money by selling government bonds in the wholesale market. Money is created in both instances. But market discipline is brought to bear on the government when the RBI raises money through the market. This will be reflected in the price the buyers are willing to pay or the yields they seek. That, in turn, depends on their perception of where interest rates are headed, which is a function of economic growth, inflation expectations and so on. The government will be forced to husband its resources carefully, as a higher interest outgo will leave it with less money for other expenditures, including investment.

The government can also bypass the market and borrow directly from the Reserve Bank. This is what Kotak and Basu are suggesting. It will not crowd out private sector borrowings or raise general interest rates. (When the RBI sells bonds in the market it takes money out of the system, making less available for other players).

The government will still have to pay interest to the RBI. This is the RBI’s income. The government can claw it back in the form of dividend, which makes monetisation of the fiscal deficit a costless exercise. (The cost manifests as inflation). Deficit financing was the norm till 1994. That year a decision was taken to end the practice from 1997.

Liquidity

Those opposed to monetising the deficit say there is enough liquidity in the system. Banks are flush with funds but are not lending because they have become risk averse as they fear that loans will turn bad. They will readily subscribe to government bonds. Another fear is that monetising the deficit will erode the credibility of the Reserve Bank. Creditors might think that the RBI is not in control of money supply, and is obeying the dictates of the government.

That fear may not be unfounded. In October 2018, Viral Acharya, the deputy governor of the Reserve Bank had made a speech about why independent central banks are necessary for financial stability. That was in the context of the government pressing the Reserve Bank to declare a higher dividend. Acharya had pointed to the Argentine government’s decision of 2009, requiring its central bank to part with ‘excess reserves.’ When its central bank governor declined, he was sacked. Creditors took it badly. Argentine sovereign bond yields and the premium on insurance against the risk of the government defaulting on bond payments shot up.

“Greater supply of money can facilitate ease of financial transactions, including the financing of government deficits, but this can cause economy to over-heat in due course and trigger (hyper-) inflationary pressures or even a full-blown crisis that eventually require sharper monetary contractions,” Acharya noted. (Acharya’s speech did not agree with the government. He quit a few months later).

Pronab Sen, who was Chief Statistician of India from 2007 to 2010, says he is not opposed to deficit financing but wonders whether it is required now. The uncoordinated lockdowns which states have imposed during the second wave of the pandemic have made him wary. Monetisation will add to the money supply, which will stimulate demand, but the supply response will be constrained as factories are unable to operate. That could give a leg up to inflation.