The Reserve Bank of India (RBI) has once again expressed its anguish over the state of central finances in its latest monetary policy review. This is a repetition of the view in an earlier review that monetary policy cannot bear the burden of fiscal deficits. The proposed additional borrowing by the Centre of Rs 53,000 crore has already sent the securities market into jitters. RBI refers to the consequent crowding out of the private sector from the market. Yields on central bonds are rising. State governments are hit even worse than the Centre because, generally, their securities carry a few basis points more as yields than the central ones on the grounds that they are more risky than the latter. The truth is that the Centre has the backing of RBI to honour its financial obligations, which states do not have. This is one aspect of the absence of level playing in our federal polity that has escaped the attention of political scientists and fiscal experts.
For a long time, the Centre had unlimited access to the spigot of money creation by RBI. Its excess borrowings from the central bank were automatically transformed into treasury bills owned by the latter. This arrangement was supposed to be terminated after an agreement between RBI and the Centre under which the Ways and Means Advances System (WAMA) was devised with penalties and other provisions for overdrafts. It was only cosmetic since at the end of the year, the penalties were returned to the government by RBI as part of the transfer of the available surplus of income over expenditure. In the consolidated balance sheet of the government and the central bank interest payments and penalties are just transfers of entries with no material significance for the government, which is not affected adversely.
Then came the Fiscal Responsibility and Budget Management Act that was supposed to put an end to RBI buying securities in the primary market. Thus, the monetisation of public debt was sought to be eliminated, except for Open Market Operations (OMO) that had a monetary objective. But the financial wizards found a way out when they discovered that the central bank could buy back old securities in the secondary market, thus, releasing funds that would facilitate the purchase by banks of new securities in the primary market ensuring their success. Does this not, then, amount to RBI financing the government by the back door? I have called it Debt Management Operations (DMO), the objective of which is fiscal, while OMO has a monetary objective of tightening or loosening money supply. Of course, financial sophists would argue that DMO is also OMO because it relieves the market of the stringency of funds! The point is that RBI should stop the practice of DMO. If, as a result, yields and interest rates go up, then so be it. The blame will then be on the government, not on RBI. After all, the aim of a tightening regime is to raise the yields and rates.
Coming back to federal-state relations, state governments do not enjoy the Centre’s privileges, except for their own WAMA. Right from the beginning, RBI never bought any treasury bill or long-term security of states on grounds of controlling the money supply. The states do not have the advantage of RBI engaging in buybacks of their securities to help banks subscribe to new flotations. This asymmetrical position has resulted in yields of state loans going up substantially in the recent period. Although the Finance Commissions have done their bit to increase the transfer of resources from the Centre to states, some thought needs to be given to the asymmetry in the relationship between RBI and the Centre, on the one hand, and that between the former and states on the other. I am not saying states should have the same privileges in RBI as the Centre does. On the other hand, I would urge the central bank to consider placing its policy approach to debt transactions with the Centre on a par with those with the states. But then, this is more easily said than done, given RBI’s lack of autonomy. As Sir Ivor Jennings said in a memorable lecture at the University of Madras shortly after the inauguration of the Republic, the Indian Constitution is federal in structure but unitary in spirit.
One reason given for the proposed separation of public debt office from RBI is that there is a conflict of interest in the present arrangement under which RBI acts as an agent of the government and its duty is to ensure the best terms for its client in raising loans as against its responsibility to formulate its interest rate policy in accordance with its monetary objective. Now the question is: Will RBI stop its DMO once it is divested of its function to manage public debt?
The author is an economic consultant and was officer-in-charge in the department of economic analysis and policy at the Reserve Bank of India