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Raghuram Rajan explains how best to stimulate the economy

(This story originally appeared in on May 09, 2020)

The coronavirus crisis has crippled the economy and there’s little choice for the government but to provide a bigger stimulus to revive demand. Many have argued that while India’s lockdown has been the harshest, its stimulus package is one of the smallest — so far. To fund a bigger public spending programme, the government can either ask the RBI to print more money (monetise the deficit) or it can issue new bonds to be subscribed by the banks (raise money through borrowing). In a LinkedIn post, former RBI governor Raghuram Rajan explained how the two paths work and why ‘monetisation’ is a good option in the short-term and withing reasonable limits

So, is this a free lunch for the govt?

“Direct RBI financing is sometimes loosely termed money printing and thought to be free”, but Rajan says this is 'misleading'. The reason is because the government finances itself from RBI while RBI finances itself from the banks at the reverse repo rate of 3.75%.

This represents a loss to the government in two ways: first, a reduction in the annual dividend RBI pays the government. Second, banks get 3.75% instead of the 6% they could get by buying government bonds directly. And since the government owns 70% of the banking sector, its dividends from public sector banks also fall commensurately.

Will it fuel inflation?

Such direct financing is “not inflationary per se” as long as banks are reluctant to lend further to business or consumers. However, Rajan points out that as normal times return, RBI will have to pay a higher rate on excess reserves, or sell its government bond holdings and extinguish excess reserves, else it will risk excessive credit expansion and inflation.

Rajan says that if the fiscal deficit and the growth in government debt is deemed unsustainable, “investors and rating agencies will take fright”. He thus calls for measures that ensure “we will go back to fiscal health over the medium term”.

May 09, 2020

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