Financing deficit | The Financial Express

Financing deficit

It has been 25 years since outright deficit financing through ad hoc T-Bills ended. The principle that fiscal and monetary policies should be conservative guided the 1997 agreement. But the 2008 crisis and the pandemic have tested these lessons.

Financing deficit
One of the major functions of RBI is to act as the banker to the government. (IE)

By Amol Agrawal

On March 26, 1997, the government of India and RBI signed an agreement that ended a ‘more than four-decade old’ system of deficit financing. Deficit financing means the government borrows directly from the central banks for meeting its deficits. The year 2022 marks the 25th anniversary of this landmark agreement. Before reflecting on the anniversary and its future, we need to understand the history.

One of the major functions of RBI is to act as the banker to the government. Post Independence, India lacked both high savings and financial markets. Hence, the government opted to use deficit financing as a source for financing the five-year plans. However, deficit financing was soon used to finance not just long term plans but also short-term cash mismatches.

In 1955, there was an agreement between the government and RBI. The agreement said that if the government cash balances fell below `50 crore, the government will issue ad hoc Treasury bills (T-bills) to the central bank and use the proceeds to fill the minimum balances. This agreement soon became permanent, and the government resorted to borrowing funds from RBI for both long-term plans and short-term cash balances. The ad hoc T-bills became attractive sources of financing as they were available on tap and at low fixed interest rates. Over 1952-1997, which comprised eight five-year plans, deficit financing contributed an average of 13.5% of the total government funds. Such a long period of deficit financing led to higher money supply and inflation. The monetary policy also remained subservient to fiscal policy.

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The 1991 balance of payments crisis was a fiscal crisis too. The fiscal deficit averaged of 6.6% in the 1980s, twice what was seen in the 1970s. The share of deficit financing had risen to 17% in the 7th plan (1985-90). The Centre knew that ending deficit financing was crucial, but given political economy considerations, decided to unwind it in a phased manner.

The reforms started in 1991, but then-finance minister Manmohan Singh first proposed phasing out deficit finance in the 1994-95 Budget speech. He said that the government should not finance its deficits “through unlimited recourse to the Reserve Bank, by issue of ad hoc Treasury Bills.” He announced that the government will phase out ad hoc T-bills over a period of three years, and the historic step will “give the Reserve Bank greater scope for effective monetary management.”

In his 1997-98 Budget speech, then-finance minister P Chidambaram announced that ad hocs will be phased as per schedule, from April 1997 onward. RBI would also introduce the Ways and Means Advances (WMA) scheme to accommodate temporary mismatches. The government and the central bank followed up on the finance minister’s announcement, and signed the agreement on March 26, 1997, putting an end to the four-decade old system of deficit financing.

How has India fared in the last 25 years since the landmark agreement? First, the government is no longer resorting to deficit financing, but has found new ways to fund the deficit, such as issuing off-balance-sheet bonds, demanding larger dividends from central bank/PSUs, spectrum auctions, disinvestments, etc. The WMA, which was supposed to be used temporarily, was used very actively for financing deficits in 2019-20. The government had also passed legislation to reduce fiscal and revenue deficits, but has not made much progress.

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Second, the autonomy and performance of RBI has improved compared to pre-1991 era. RBI may not be funding deficits, but is often pressurised to pay higher dividends, leading to friction between the government and the bank. The central bank is also criticised for indirectly supporting the government’s borrowing programme. The appointments at the central bank have also been wanting, as argued in my earlier article. RBI has adopted inflation targeting, making the monetary policy more rules-based.

Third, the biggest gain has been in terms of financial markets. Finance minister Singh, in his 1994 speech, had announced that the government “will have to meet its entire requirements through borrowing from the market.” In order to enable market borrowing, RBI took several measures. The measures ranged from developing institutions such as Primary Dealership, Clearing Corporation, etc, to developing markets such as yield curve, repo markets, etc.

What lessons can we draw from the 25th anniversary going forward? The 1997 agreement was based on global experiences, which suggested that fiscal and monetary policies should be conservative and have their own instruments. The 2008 crisis and the pandemic turned these lessons upside down as we saw both fiscal and monetary policy acting aggressively to boost growth and employment. The government deficit and debt levels rose significantly, but inflation was absent.

Post the Ukraine war, inflation has risen significantly, leading central banks to once again focus on inflation. The Indian economy’s indicators have deteriorated as well, but are much better compared to rest of the world.

Should India change its policy stance? Not really. Most policymakers do wish to take their economies and policies to the pre-crisis period. The principles of the1997 agreement of running policies conservatively have served us well and we need to keep working on them.

The writer is assistant professor, economics, Ahmedabad University.

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