Generally, monetisation of debt means the central bank printing currency for the government to take care of any emergency spending and to bridge its fiscal deficit.
“There just aren’t enough savings in the economy to finance borrowing of such a large size. Bond yields would spike so high that financial stability will be threatened. The RBI must therefore step in and finance the government directly to prevent this from happening,” he said.
Referring to the idea of debt monetisation, Subbarao said, “there is no reason to believe that we are anywhere close to that situation”.
“Through its Open Market Operations (OMOs), the RBI has injected such an extraordinary amount of systemic liquidity that bond yields are not only soft but are continuing to soften further,” he said.
“… right now, the government is able to borrow at a real rate of zero per cent. How do you justify direct monetisation in such a scenario?,” he wondered.
Subbarao was speaking at a virtual event to release a book titled ‘Quest for Restoring Financial Stability in India’ by former RBI Deputy Governor Viral V Acharya.
Earlier this month, Economic Affairs Secretary Tarun Bajaj said that monetisation of debt is not on the government”s agenda at the moment as there are some positive signs on the revenue collection front.
According to Subbarao, both monetisation and OMOs involve expansion of money supply which can potentially stoke inflation.
“But the inflation risk they carry is different. OMOs are a monetary policy tool with the RBI in the driver’s seat, deciding on how much liquidity to inject and when.
“In contrast, monetisation is and is seen, as 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,” he said.
In spite of all this, he said that if the government decides to cross the rubicon, the markets will fear that the government is abandoning all constraints on fiscal policy and is planning to solve its fiscal problems by inflating its debt.
If that happens, yields on government bonds will shoot up, the opposite of what is sought to be achieved, he noted.
“For sure, monetisation, despite its costs, might become inevitable at some point in the future. If the government cannot finance its deficit at reasonable rates and bond yields spike so high as to threaten financial instability, there may be no alternative to direct monetisation. We are not there yet,” he said.
In the wake of the COVID-19 crisis, revenue collections have taken a hit and the government spending is also on the rise.
On the inflation target framework for fixing benchmark interest rate by the Monetary Policy Committee (MPC), Subbaro said it has not been fully tested.
RBI has initiated a review of the retail inflation targeting framework behind monetary policy decisions as well as its effectiveness.
In a bid to keep inflation under a specified level, the government, in 2016, had decided to set up the MPC headed by RBI Governor to decide the benchmark policy rate.
The six-member panel, which had its first meeting in October 2016, was given the mandate to maintain annual inflation at 4 per cent until March 31, 2021 with an upper tolerance of 6 per cent and a lower tolerance of 2 per cent.
Subbaro said the four-year period since 2016 when RBI embarked on the inflation targeting framework has been unusually benign from an inflation perspective.
“Private demand for credit has been low because of, among other things, the NPA problem; so, not much demand push inflation. Globally there have been no hiccups on the financial stability front up until the corona crisis hit us six months ago. Yes, the corona crisis has turned our world upside down and caused a host of problems but not much on the inflation front,” he said.
In short, Subbarao said there has been no extraordinary circumstance to challenge the efficacy of the inflation targeting framework.
About the book and its author, Subbarao said the conviction and concern with which Acharya narrates the frontline battles of a policymaker to influence economic policy debates is the reason for recommending the book.
“Acharya served the RBI and the nation with dignity and distinction. He will certainly go down in the history of the RBI as one of its most influential deputy governors,” he added.
Acharya, who reportedly had differences with the government and made a fervent pitch for autonomy for the regulator, quit RBI in July 2019, six months ahead of his three-year term.
At the event, former RBI Governor Y V Reddy said issues relating to financial stability in India have become more complex and more challenging.
“In addition, the spread of virus has imparted more complications and greater urgency to address the problem of financial stability in the face of unprecedented fiscal challenges. In this background, the book is of special and urgent contemporary interest,” Reddy said.