The logic is as follows. The primary driver of interest rates in the Indian economy is the huge borrowing programme of the government. If the RBI monetises too little of the government's deficit, the government is forced to borrow more from the market. This drives up interest rates in the economy, and crowds out private borrowings. This also means that the government has to pay a higher interest on its debt.

Eventually, if the present trend is carried through into the future, the government may have to monetise more of the debt, or default. But by then, the debt stock would have been built up to an extent that the rate of money growth required to finance the deficit will be much higher than it is now. The debate so far has focused almost exclusively on the possibility of the government reducing its borrowings.

This is still the most sensible and efficient way of reducing interest rates. But after a decade of economic reforms, we are now in a situation where the combined fiscal deficit of the central and state governments is, at 11% of GDP, around the same as in 1991.

At the same time, the revenue deficit has increased from 3 per cent of GDP in 1990-91 to an estimated 4 per cent of GDP in 2000. Government spending now accounts for 33 per cent of our GDP, but capital spending has been reduced to a mere 3.3 per cent of GDP. This makes it politically difficult to reduce spending any further, because current expenditure tends to be captured by various interest groups. The main components of this spending are Interest payments, subsidies, and wages and defense expenditure. Interest payments will account for over 10,000 crore of the governments money this fiscal year.

It is improbable that interest payments can be reduced all of a sudden. Wages, at the state government level are likely to go up, as the recommendations of the Fifth pay Commission are also applied to state government employees. Subsidies are not likely to be touched any time in the near future, as long as rural India continues to exercise its grip on electoral politics. Because of the Kargil war, the defence budget was increased by 13,000 crore. The defence budget is not likely to be reduced any time in the future, short of peace with Pakistan!

Most of this deficit will be financed by borrowing from the market. On average, over the last decade, only about 10% of the Gross Fiscal Deficit was monetised. This is probably far too low a figure. The consequently high degree of market borrowings throws up a number of problems.

For one thing, this has led to a buildup of debt that is clearly unsustainable in the long run. The stock of internal debt now stands at 36 per cent of GDP, compared to 28 per cent in 1991.The cost of funds to the government is now higher than the return it gets on these funds. Unless the government starts running a primary surplus, and retires its debt, the government may find itself technically bankrupt, on present trends. But this also means that we can no longer afford to run a tight money, large fiscal deficit policy mix.

This is because our interest burden will then get to a point where only a substantial primary surplus will be able to prevent a ballooning of the debt income ratio. This is not feasible, unless the nature of politics in India changes dramatically. The only politically feasible alternative at that point would be a monetary accommodation of the deficit.

This is why it makes sense to monetise the deficit now. As pointed out earlier, a greater monetisation of the deficit now makes more sense than putting off the decision for later. By then, a monetary accommodation would have to account not just for the primary surplus, but also for the increase in debt servicing burden which comes from postponing this decision. But this means that the Reserve Bank will have to forget propping up the value of the rupee for now. A strong rupee and a monetised deficit do not go well together. Monetising the deficit implies we have to settle for higher inflation at present. This will lead to a slide in the value of the rupee.

On the other hand, a monetised deficit will also lead to less variable inflation rates. If monetisation of the deficit leads to smaller budget deficits in the future, it would remove the biggest destabilizing factor in the Indian macroeconomy, and create a sound environment for decision- making. A weak rupee is a small price to pay for that.