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| A Seshan: Monetisation of the fiscal deficit | |
| A Seshan / New Delhi March 23, 2009, 0:00 IST | |
Why not amend the FRBM Act to discard the fig leaf provided to prevent monetising the deficit, asks A Seshan.
One of the major features of the Fiscal Responsibility and Budget Management Act (FRMBA), 2003, is the prohibition of the RBI from buying government securities in the primary market, effective April 1, 2006. It is also against direct borrowing by the Centre from the RBI, except for meeting temporary cash needs through Ways and Means Advances (WMA). It can, however, deal in government paper in the secondary market in consonance with its monetary policy. The constraint on the RBI on lending to the government was decided after years of discussion of the harm done to the economy by the central bank monetising government debt which, in a way, resulted in a laxity in fiscal discipline as the authorities were aware that they could open the monetary tap at will. For more than two years, despite rising expenditures, this discipline worked without any problem for the government. Tax buoyancy and improvement in state finances helped in the matter. In the past, the Centre often had to borrow to help the states in distress as the RBI spigot was closed to them except for limited WMA, which had to be revised upwards from time to time.
The massive inflow of foreign capital resulted at one point of time in the RBI being close to running out of securities in its portfolio as they were exhausted in the course of its sterilisation operations. The Market Stabilisation Scheme (MSS) was devised to get over the problem. MSS bonds were issued by the RBI to mop up excess liquidity in the system. In order to ensure control over money supply, the principal was sequestered in a separate account of the Centre so that it had no access to the funds and the spirit of the FRBMA was preserved. However, the government agreed to meet the interest cost. Strictly speaking, it should have been borne by the RBI as the MSS bonds were created for monetary and not fiscal purposes. This writer recalls a similar instance during the Gulf crisis of the early 1990s when the country got financial assistance from the International Monetary Fund (IMF). The amount, borrowed by the Centre, was credited to the country’s forex reserves with the RBI and not to the Consolidated Fund of India. However, interest charges were paid by the government to the IMF for some time. Then some smart alec in North Block woke up to the anomaly of government paying interest on money that it did not have access to. The RBI agreed to reimburse the government for the interest payments. But it needs to be pointed out that in the consolidated balance sheet of the government and the central bank it does not matter which one pays the interest.
Of late, strains have developed in the working of the FRBMA because of the various financial stimulus packages announced by the government to deal with the current economic crisis. There have been suggestions to scrap the prohibitory provision referred to earlier to facilitate the government’s unlimited access to RBI credit, as in the past. There is already an enabling clause in the Act to escape the rigours of the discipline on grounds of national calamity, security or other exceptional circumstances. In fact, the Act was not observed whenever the RBI purchased government oil bonds from petroleum marketing companies who needed to trade in these bonds for foreign exchange. It was a primary market transaction in spirit despite legal quibbling to the contrary. How can there be a secondary market when there was no primary market unless one resorts to a specious argument?
More recently, the RBI agreed to transfer a portion of the sequestered MSS funds to government’s regular cash account to facilitate its use for defraying the expenses of the latter. It is also not a secondary market transaction. In a typical secondary market transaction, only the ownership of securities changes; no money accrues to government. It gets the amount when the securities are first issued. If the RBI buys or sells the securities in the secondary market, government’s finances are not affected. But, in the case of the MSS, the RBI is making available high-powered money to the government, enabling the monetisation of deficit. An anti-climax of the legislation is the clause, made by way of abundant caution, that no civil court will have jurisdiction to question the legality of any action or decision taken by the government under the Act. Thus the Act is like the Directive Principles of State Policy in the Constitution, which are not justiciable.
Since fiscal deficits are going to be with us in the foreseeable future, especially in the context of the rising interest burden on a growing public debt, it would be more transparent or revealing if the government, after the general elections, amends the Act to discard the fig leaf provided to prevent the monetisation of the deficit. Instead, it could concentrate on the achievement of the targets of fiscal and revenue deficits, prescribed under the rules, as early as possible. It would minimise the damage due to the monetisation of the deficit. In the meantime, the total amount in the sequestered account of the RBI, not just Rs 45,000 crore as envisaged now, may be transferred to government’s regular account. It would help in meeting the deficit of the next year.
Since the private sector cannot be crowded out of the market in the current circumstances, the suggestion will help it to a large extent in getting credit at rates of interest that would otherwise be under pressure when the government enters periodically in a massive way.
There is an advantage in the future placement of securities privately with the RBI in the first instance. The central bank can unload them on the market later, at an appropriate time, and absorb liquidity without disturbing the market working as would happen if such massive amounts are borrowed directly. Such private placements have worked well in the past. The arrangement would also serve to coordinate monetary policy with debt management. Then the proposed National Treasury Management Agency to centralise all operations of debt management will become redundant.
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