The Central fiscal deficit is budgeted at a staggering sum of Rs 4 lakh crore. This is roughly 40% of the expenditure of government. It is hard to even comprehend such big numbers; perhaps it is easier to visualise it as requiring borrowing of Rs 76 lakh per hour. A large fiscal deficit in a business cycle downturn is not that hard to finance, because the financial sector is not that keen to give loans to the private sector. There is a ?flight to quality?; households and financial firms are over-keen to hold safe assets. The demand for government bonds is innately greater. Indeed, in this situation it is odd that the 700 basis point drop in inflation has not yielded a commensurate drop in the cost of borrowing for the government. There is talk that some of the deficit will be monetised. On one hand, it is true that most central banks hold some government bonds on their balance sheet. But monetisation of deficits is a dangerous course, one that can lead to explosive inflation, as was understood in India in the period after 1984.
The right way to think about this is to see that the job of the central bank is to do monetary policy, i.e. to set the short-term interest rate. How does a central bank do monetary policy? There has to be a clear strategy for monetary policy. The state of the art involves ?inflation targeting?: the central bank is given independence for the narrow function of setting interest rates, but is held accountable to deliver on an inflation target in the medium term. Once such a strategy is in place (and protected by independence) the central bank can do monetary policy based on a clearly articulated monetary policy strategy. Monetary policy strategy (of any kind) can get derailed through extraneous pressures. In India, where RBI is also the investment banker to the government, RBI has an incentive to distort monetary policy in order to help the government to borrow. In other words, the magnitude of government bonds held on RBI?s balance sheet?which should solely be driven by monetary policy strategy ? gets distorted owing to the needs of debt management. The solution for this problem lies in setting up an independent Debt Management Office, so that RBI is not burdened by this conflict of interest when making decisions on monetary policy. In summary, government bonds will always be on RBI?s balance sheet, but RBI?s thinking on what should be done should never be contaminated by the need of MoF to borrow. MoF should do its own borrowing through a separate DMO. So, Mr Finance Minister, where is the DMO if you are planning to monetise part of the deficit?
