In a battlefield, the infantry is the first line of defence. The foot soldiers. But it is the artillery that provides the cover that the foot soldiers need to keep the borders secure.
The spread of Covid-19 and its economic consequences have been described as a war. And in this war, if governments—state and central—are the foot soldiers, then central banks have the artillery that can provide the cover.
That artillery is the ability to ensure that state and central governments get all the support they need, including in the form of urgently needed funds to fight the spreading pandemic. This support may be needed by states, who are facing large expenses even as revenues have stalled, and also the centre.
The Many Roles Of A Central Bank
In times of peace, or in normal economic circumstances, a central bank is often called upon to restrain the government in its spending and stamp out profligacy for fear that it will create inflation. In war times, veteran central bankers believe that the central bank’s role is the reverse.
A Bank of International Settlements working paper, authored by CAE Goodhart in 2010, is often cited. It details the various phases the global central banking has been through and describes it roles.
Central banks have generally had three main objectives or functional roles, Goodhart writes.
- To maintain price stability, subject to the monetary regime in current operation, for example the gold standard, a pegged exchange rate or an inflation target.
- To maintain financial stability, and to foster financial development more broadly.
- To support the state’s financing needs at times of crisis, but in normal times to constrain misuse of the state’s financial powers. In the past this meant preventing debasement and misuse of the inflation tax. Prospectively it may in future also involve preventing misuse of the bank tax.
In fact, RBI Governor Shaktikanta Das referred to this role in a speech in July 2019.
“Some of the oldest central banks were set up with the primary objective of providing war time finance to governments and managing their debts. Since then, their role has evolved over time in line with the changes in economic systems,” he said.
Das may now need to go back and review that war time role of central banks to see whether the RBI needs to dust-off some of those strategies.
Are The Tools Available?
The tools, should the RBI decide to use them, are available.
The first of them, which it has already put into play, is the use of ‘Ways And Means Advances.’
The facility was introduced in April 1, 1997, when the system of ad hoc bills used for automatic financing of the deficit were phased out. The very purpose of WMA, as defined back then, was “to accommodate temporary mismatches in government receipts and payments.”
The RBI has a fair amount of discretion in how to use this facility. “The limit and the rate of interest on WMA and the rate of interest on overdraft will be mutually agreed between RBI and Government from time to time,” said the 1997 release announcing the new facility.
So far the RBI has raised the WMA limit for the government to Rs 1.2 lakh crore from Rs 75,000 crore last year. For states, the limit has been raised by 30 percent to Rs 42,000 crore.
More may need to be done.
Rathin Roy, director of NIPFP, has advocated the use of WMA for the centre and states. For states, he suggests that Rs 1 lakh crore in WMA be offered at zero percent interest for 11-months. This could prove to be crucial support for states who are seeing large cash flow mismatches as revenues fall and expenditure rises.
But the problem may not end there.
Apart from temporary cash mismatches, longer term borrowing needs will rise too. After all, the revenues of states and the centre will fall sharply due to the slowdown in growth and expenses will remain high.
The RBI has tried to enable a supporting environment by infusing large amounts of liquidity and restarting purchases of central government bonds in the secondary market. It may need to take a leaf out the U.S. Federal Reserve playbook and expand its purchases to state government bonds.
Should it go a step further and consider buying government bonds directly?
Central banking veterans believe the decision will depend on the state of the markets. If the markets are broken, forcing governments to face the vagaries of the market at a time like this is not ideal.
Take, for instance, what happened in the debt markets this week. The central government borrowed 10-year funds at 210 basis points over the central bank’s overnight rate. The state governments had to pay an even stepper cost. They paid close to 8 percent to raise ten-year funds. That’s 360 basis points above the benchmark policy rate and a 150 basis points about the sovereign yield. Kerala paid a hefty 9 percent to raise 15-year bonds.
If the market dynamics do not improve, the central bank may have to at least consider direct purchases.
The Fiscal Responsibility and Budget Management Act does not permit this so legislative changes will be needed. In the case of central government bonds, the government has already invoked the fiscal ‘escape clause’ for FY20 and FY21. This clause opens the window for direct purchase of government bonds by the central bank.
Divided Views
This is not to say that the decision is an easy one and views are divided.
Two former finance minister’s have called for partial monetisation of the deficit.
P Chidambaram, on his twitter account, said that resources needed in the Covid-19 fight can be found by: 1) re-allocating budget resources; 2) cutting all wasteful expenditure; 3) higher borrowing; d) monetising part of the deficit.
“If government runs huge deficit to tackle crisis and asks RBI to monetise part of it, so be it,” wrote Yashwant Sinha, in an article in the Indian Express.
Among former central bankers, C Rangarajan, in a conversation with BloombergQuint, said that deficit monetisation may be inevitable either through secondary or primary markets. He argued that primary role of the central bank in a time like this is to support the government’s programmes. He, however, said the RBI must take into account long term inflationary risks of any large deficit monetisation.
Raghuram Rajan, writing in a blog, said that unlike the US, whose currency is the global reserve currency, countries like India need to be more cautious. A sharp expansion in the fiscal deficit could lead to a sovereign rating downgrade, a run on the currency and higher long term rates, Rajan cautioned.
Urjit Patel, in an article in the Indian Express, cautioned against “non-trivial consequences for macroeconomic stability” if the fiscal and monetary responses are overdone. “It is a fine line between aggressively proactive and being perceived as reckless,” he wrote.
The final judgement call will rest with the current top brass at the central bank. But they may need to stay prepared to put their heavy artillery to use in helping fight one of the most unprecedented health, social and economic challenges faced by the world and India in recent history.
Ira Dugal is Editor - Banking, Finance & Economy at BloombergQuint.
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