Why RBI shouldn't finance govt borrowings

Context: In the current scenario where borrowing by the govt. is imperative, distinction between fiscal and monetary policy should be maintained.

Implications of recently announced Borrowings

• 54% more than planned borrowings: increases the Centre’s fiscal deficit up from the budgeted 3.5% of GDP to 5.5%.
• Encourage states to borrow more: combined fiscal deficit to go above 10% of GDP.

Downsides to borrowing from RBI

• Increased bond yield: Recently when state government lined up to borrow, the yields were higher despite rate cuts and liquidity injection.

• Blurred distinction between fiscal and monetary policy: When govt. borrows through Open Market Operations, debt is redeemed by tax revenue only but when bank’s revenue is for financing govt. expenditure, the debt is redeemed by tax revenue and inflation tax.

• No interest to RBI: Govt. saves on interest payments and the debt is also owed to itself. This showcases loophole for the govt. to have free lunch. But the laws of economics doesn’t allow freebies.

• Fiscal plus monetary irresponsibility: It will encourage demand handouts such as tax cuts or moratoriums in the market.

• Hurting the credibility of the central bank: Financing a deficit directly from the central bank raises expected inflation and can impact credit ratings.

• Exchange rate depreciation: Corresponding real appreciation of the currency increases current account deficits and in turn causes exchange rate depreciation.

• Creating imbalance: To maintain external balance, the RBI has to either lose foreign exchange reserves or raise interest rates.

Way forward

• Interest rates must be allowed to adjust in response to market forces. Maintaining a balance between expanding the stock go govt. bonds and issuing of currency .
• Government should avoid exploiting this source of funding and independent monetary authority should not accommodate expansionary fiscal policy.