FY19 was quite unique in so far as it witnessed the highest level of open market operations (OMOs) in India’s monetary history. At Rs 2.99 lakh crore of purchase of securities, it exceeded the previous high of Rs 1.54 lakh crore in FY13. OMOs are a tool of monetary policy whereby the RBI provides durable liquidity to the banking system by buying government securities held by banks or absorbs liquidity by selling such papers.
Can this be interpreted as a case of monetisation of deficit? In FY19, incremental deposits were Rs 10.5 lakh crore while incremental credit was Rs 11.4 lakh crore. Incremental investments were Rs 0.62 lakh crore. Considering that banks hold on to around 50 per cent of total G-Secs with issuances of Rs 5.71 lakh crore, the incremental investments should have been much higher even after adjusting for repayments. The answer is that the RBI had bought back Rs 2.99 lakh crore of G-Secs, thus providing liquidity to the system. Is this the right thing?
Two issues come up here. First is that we may be moving back to the system of monetisation of fiscal deficit. When the FRBM was introduced in 2003, it was decided that automatic monetisation of deficit by the RBI (through 4.6 per cent adhoc T-bills) would be done away with from April 2006. But, it was silent on RBI buying securities in the secondary market as part of monetary policy which implied monetisation through the backdoor.
The table gives the OMOs conducted in the last 8 years, gross borrowings of the central government and ratio of OMO/borrowings. In 6 of the 8 years, the RBI was buying G-Secs from banks and hence plugging the liquidity gap.
In FY19, a little over half of the gross borrowings has in effect been financed by the RBI through OMOs. This has also led to an increase in reserve money of Rs 3.67 lakh crore while the rise in net RBI credit to the government was Rs 3.70 lakh crore. Government lending was the main driver of money supply this year. The RBI support has been around 10-50 per cent of total borrowings.
There is a direct linkage between deficits and monetisation. While primary issuances are being subscribed, the RBI does step in to provide funding to banks by buying back other G-Secs under OMO.
The second issue relevant from the point of view of the market is that the RBI has actually helped to keep bond yields artificially down. Counterintuitively if liquidity was not supplied through OMOs, G-Sec yields would have increased sharply. On a point to point basis, G-Sec yields were almost unchanged – 7.42 per cent end-March 2018 and 7.34 per cent end-March 2019. By continuously intervening through OMOs, the RBI facilitates government borrowing at a lower cost. As a corollary, higher borrowing does not quite lead to private sector getting squeezed or crowded with automatic RBI support coming in as there is an implicit view that yields should not move up sharply.
Ideologically, OMOs should be used for supplying durable liquidity when the system has deep shortfalls. The 2018-19 ‘episode’ appeared to be one where the system could not generate funds because bank deposits did not grow as financial savings were down. As demand for credit picked up, the private sector had to compete with the government’s borrowing programme and the market equilibrium would have justified a higher rate of interest if not for RBI OMOs.
In this context, can we really say that there has to be some limit on the OMOs by the RBI so the true G-Sec yields are determined in the market? High government borrowing should lead to prices moving down and interest rates going up. However, with assured support from the RBI, the interest rate structure has been retained at a lower level. Whether this is right or wrong is hard to say, but for sure the case made out of high government borrowing crowding out the private sector can be contested.