This piece is in response to the continued debate in India (in particular the paper Taming Food Inflation in India Ashok Gulati and referred to in FE) regarding the fiscal-monetary policy inter-linkage. The bottom line of the aforesaid paper is that ballooning fiscal deficit since 2008 has been the primary cause of food inflation (in turn, establishing a strong causation between fiscal deficit and monetary expansion). In fact, the assertion of fiscal monetary policy inter-linkage has been re-emphasised repeatedly in recent times. While there indeed was a significant slippage in fiscal consolidation, the subsequent linkage between fiscal dominance of monetary policy may be exaggerated, particularly in the last couple of years, when RBI has been following a contractionary monetary policy.
First, let us get our facts straight. As per IMF estimates, the discretionary fiscal stimulus India resorted to was the lowest among major countries during the post-crisis period. The size of the stimulus estimated at 0.5% of GDP in year 2009 was significantly lower than BRICS group of countries or other emerging and developed countries. Despite this, the stimulus reinvigorated the quarterly growth rate of the Indian economy from a low of 3.5% in March 2009 to 11.2% in March 2010 (exposition 2), before it started tapering off (apart from a spike in December 2010). While the growth could not be sustained in the later period, clearly the quick recovery was significantly aided by the stimulus. Critics, however, hold that since the discretionary stimulus was consumption-led, it led to an unsustainable growth path. However, even if we assume that prognosis, it is difficult to comprehend how could such a stimulus, the lowest across the G20 countries, resulted in structural bottlenecks thereafter!
In India, the inter-linkage between fiscal and monetary policy is well-documented. In the initial years, RBI used to subscribe to the government deficits through issuance of ad hoc treasury bills that led to automatic monetisation of government debt through increase in reserve money, Later on rapid strides were made to reduce the fiscal dominance of monetary policy by introducing a system of ways and means advances and later on prohibiting RBI from subscribing to primary issuances of government securities.
However, even after all this, there is a widely-held viewpoint that the large size of the government borrowings may still influence conduct of monetary policy, no matter how the debt management is conducted (RBI, March 2013 in Report on Currency and Finance). The large size of the government borrowing could be a potential trigger for RBI to conduct open market operations (OMOs), the size of which has increased since FY2009. However, we believe that in a situation of monetary tightening and with RBI resorting to frequent interventions in the foreign exchange market in FY2012-13, it would be incorrect to conclude that OMOs led to the requisite degree of reserve money expansion.
Consider, for example, exposition 1. The reserve money (RM) component could primarily be thought of as the sum of net domestic assets (NDA) and net foreign exchange assets (NFA). While the OMOs directly impact the creation of NDA (we have taken net OMO as the proxy), RBI intervention in the foreign exchange assets (taken as a proxy for NFA creation) would have the opposite effect when intervention is used to support the rupee. Please note that we have not used the NDA and NFA components from RM, as such numbers include valuation impacts (for example, even though foreign exchange reserves in dollar terms have declined in current fiscal, in rupee terms it shows an increase, reflecting currency depreciation) that are separately captured in net non-monetary liabilities (NNML) as a residual item. Alternatively, a larger negative entry of NNML in RM would imply a lower RM expansion, as was evident in FY2012-13 (NNML expanded by 64% in FY12 and in FY13 has grown by 16%).
Now coming back to our argument of OMO purchases and its net impact on RM expansion, particularly in FY2012-13, a concomitant decline in NFA through RBI forex selling while mitigating the impact of a rapidly depreciating rupee also contained the RM expanded through OMOs. This fact has also been acknowledged by RBI recently in the Report on Currency and Finance. Interestingly, in FY13, RBI also sold dollars in the forward market, ultimately which has to recouped by the central bank at a later date. On the whole, the expansion of reserve money was inadequate to meet the indicative growth of money supply envisaged by RBI; in an earlier column Dont blame MSP alone (http://goo.gl/z0gxj, FE, April 2, 2013) we pointed out this fact. Thus, higher fiscal deficit or borrowing didnt result in RBIs monetary targets off gear at least in the most recent period.
In India, there has been a considerable debate regarding the fiscal-monetary policy inter-linkage in the last couple of years. RBI has been entrusted with perhaps the most difficult task of controlling inflation in a situation where multiplicity of objectives continues to dominate the conduct of monetary policy while many exogenous factors result in higher inflation. While increase in food prices and supply-side factors are the usual suspects in fuelling inflation, the role of fiscal policy in expanded money supply and hence inflation may just be a little exaggerated.
The author is senior fellow, Icrier. Views are personal