The Monetisation of Deficit

Context: Deficit monetisation by Reserve Bank of India could threaten Fiscal sustainability and stability of the economy.

Monetisation of the deficit by the Reserve Bank of India (RBI)

• Direct monetisation: Government gets money from RBI at a subsidised rate, forced out of the banks.

• Indirect monetisation: by Open Market Operations (OMOs) in the secondary market.

• Printing of Money: both direct and indirect involve printing of money by the RBI resulting in expansion of money supply, inflation and high yields on government bonds.

• Difference between Monetisation and OMO: 

• OMOs are a monetary policy tool with the RBI deciding on how much liquidity to inject and when.
• Monetisation is a way of financing the fiscal deficit with the quantum and timing of money supply determined by the government’s borrowing rather than the RBI’s monetary policy.

• The Fiscal Responsibility and Budget Management Act: permits monetisation of the deficit under special circumstances (in absence of savings in the economy) but results in increase in bond yields.

RBI and government Agreement over Deficit Monetisation

• RBI to use OMO route as a liquidity instrument of monetary policy and not so much to support government borrowing.
• As a result of the agreement, the government’s borrowing in the open market resulted into an increase in interest rates, savings, investment, and growth.

Need for Deficit Monetisation

• Government’s inability to finance its deficit at reasonable rates.
• As a onetime measure when bond yields shoot up in real terms.