India: Backdoor Monetization
Government market borrowings in 2011-12 have overshot projections; three auctions of sovereign paper have already devolved upon the central bank as the government’s borrowing began for the second half of the fiscal year this October; and long-term yields are poised to touch 9%. [Full piece here]
That set off a process of education for me with Ms. Kohli and with a Indian government civil servant on what devolving on RBI meant in practice. One understands this intuitively but I wanted to know if the bonds sit on the central bank’s balance-sheet in which case there is instant monetization. It is stealth quantitative easing. I wanted to check if it was indeed happening.
This is what I gathered from them and I am grateful to them for this education:
It devolves on Primary Dealers. So it sits on their books & they offload when opportune (they fully underwrite the issue for a very small commission). So technically, it’s off RBI’s balance-sheet; operationally, it’s a neat arrangement to avoid instant monetization. RBI sets the cutoff auction price, and so chooses the extent of devolution, thereby managing yields. Clearly, by choosing devolvment, they are lowering borrowing costs for the govt.
The key phrases are ‘avoiding instant monetization’. In other words, monetization becomes inevitable later unless the Indian Government risk is acceptable to the market at the yields at which the bonds are sold.
So, there is no instant risk of inflation arising out of monetization. But, let us be clear. To the extent that fiscal deficits are unproductive (in the case of India, they, largely are), they are inflationary. They expand money supply without creation of commensurate productive assets.
Two, there is no disputing the ‘crowding out’ effect here. To the extent that these bonds devolve on the Primary Dealers, their ability to intermediate credit is constrained. Indeed, they might even try to make up for the lost NIM (because the government paper yields too little in relation to the risk and the inflation rate) by overcharging for credit to the private sector. There is the possibility of both a quantity & price ‘crowding out’ effect.
How does ‘later monetization’ happen, as opposed to instant monetization? Here is another piece of education I received:
Monetization still happens because debt is already issued. If RBI is trying to keep yields low in primary auctions, what will it do about the secondary market where they are zooming to 9%? The divergence will not be sustainable, so they will have to conduct Open Market Operations (OMO)s there.
In other words, RBI has to buy these bonds to keep their prices from declining. That means putting money in circulation and that can also be called Price-Keeping Operation (PKO).
In the process of the email education that I received, I was pointed to two Op-eds. one written in 2004 by DR. T.V. Somanathan, IAS and currently with the World Bank on leave from the Government of India and the other in 2009 by Sumita Kale of Indicus. Both are worth a read. Historical perspectives always help us to anchor our present thoughts.