Monetisation Neither A Game Changer Nor A Catastrophe, Says Raghuram Rajan

Implications

The former central banker explained that there are implications of direct financing and it isn’t “free” as often believed. Rajan said:

• Direct RBI financing is sometimes loosely termed as money printing and thought to be free. This is misleading. As we have seen, the RBI finances itself from the banks at the reverse repo rate of 3.75 percent.
• Instead of the banks holding government bonds paying 6 percent or so, they hold claims against the RBI paying 3.75 percent. Of course, the claim they hold is shorter term and probably more liquid. Most important, it’s not subject to interest rate risk.
• In abnormal times, the government gains by placing the paper quickly with the RBI, and the banks have no choice but to hold excess reserves at a below market rate. The only way out for an individual bank would be to make more loans or buy more government bonds. This it may be reluctant to do, given the additional risks involved.
• Collectively, however, banks have no choice but to accept the reserves the RBI creates. This is why the financing is forced.

Such direct financing is not inflationary so long as banks are reluctant to lend further to businesses or consumers, Rajan said. “However as normal times return, the central bank will have to pay a higher rate on excess reserves or sell its government bond holdings and extinguish excess reserves, else it will risk excessive credit expansion and inflation.”

Rajan said at a time when demand is depressed and the environment is disinflationary, inflation should not be a “central worry”. He said that the process is not “free” for the government either.

“Not only is the RBI paying 3.75 percent for the money it onlends to the government (which will reduce the annual dividend it pays the government commensurately), the banks get 3.75 percent instead of the 6 percent they would get by buying government bonds directly. Since the government owns 70 percent of the banking sector, its dividends from public sector banks also fall commensurately,” Rajan wrote.

The fact that the RBI absorbs the government’s financing seamlessly also does not change the fiscal math. “If the fiscal deficit and growth in government debt is deemed unsustainable, investors and rating agencies will take fright.” To avoid this, Rajan suggests that the government adopt medium term debt targets suggested by the NK Singh committee and set up an independent fiscal council.

“Modern Monetary Theorists are wrong to think that central bank financing of the government can be ignored. The consolidated liabilities of the government and the central bank have to be seen as sustainable, else confidence in both money and government debt will collapse,” the former RBI governor cautioned.