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What is Direct Monetisation by RBI? How Does the Government Borrow Money in Times of Crises?

May 11, 2020 9:25 AM 7 min read

The Government has raised its gross market borrowing target for FY21 to ₹12Lcr ($160bn) from the previously budgeted ₹7.8Lcr ($104bn). 

This increase by over 50% is due to the economic downturn caused by the coronavirus pandemic and the resulting nationwide lockdown. More money will be needed to boost a stalling national economy and finance the stimulus packages that have been announced. More money will also be needed since tax collections are plummeting and there isn’t enough revenue to fund more spending.

The methodology - you can even call it “science” - behind what drives Government spending and borrowing is as interesting as it is relevant. Where does the Government make money from? Where does it spend it? Why does it need to borrow money? Who does it borrow from, and How?  


Fiscal Policy vs Monetary Policy

Let us begin by understanding that on a national level, the economic cycle can be influenced by two things: fiscal policy and monetary policy. 

The former is legislated by the Government, through taxation, borrowing and spending.

Monetary policy, on the other hand, is what the Central Bank does. This involves controlling the flow of money in the system through various tools like repo rate, reverse repo rate, open market operations (OMOs), reserve requirements, quantitative easing etc. 

(It’s okay if you aren’t clear on what these terms mean – you’ll understand the gist of what’s happening by the time you reach the end.)


How Does the Government Make Money?

Next up: where does the Government get its revenue from? (And we’re talking about the Central Government specifically; state government revenue sources are a different story for another day.)

The Centre makes its money primarily from taxes. According to data from the Ministry of Finance, as of 2019, corporation tax is India’s biggest revenue source.

Let’s simplify this. Say the Government’s annual revenue is boiled down to ₹100. Then it can be said that ₹21 comes from corporation taxes. GST and income taxes contribute ₹19 and ₹16 respectively. Borrowings and other liabilities account for ₹20 and non-tax revenue contributes ₹9. That leaves ₹15. This comes from excise duties (₹8), customs (₹4) and non-debt capital receipts (₹3).

So that’s India’s revenue. (Of course, ₹100 is representational. As of February 2020, the Government’s actual revenue was about ₹14Lcr ($187bn).)


How Does the Government Spend Money?

Just as the Government earns, it also spends – on infrastructure projects, the military, paying salaries and pensions, education, agriculture, health, energy and interest payments. Much of this is budgeted (usually announced in the Union Budget). But usually, and especially for a developing country like India, more is spent than what comes in as revenue.


What is Fiscal Deficit?

When spending is more than revenue collections, a fiscal deficit is created (unless you’re fiscally prudent like Germany). This deficit involves additional money that is used for the extra spending – and this is the money that the Government “borrows”.


How Does the Government Borrow Money?

Okay, now we know why Governments need to borrow money from time to time. But right now, we’re facing extraordinary times. So Governments need to borrow more money ASAP, but the usual modes of borrowing may no longer hold. Let’s break it down.

An obvious way the Government can raise more money is by raising taxes. But this is (1) politically unfeasible. And (2) at a time when everyone from rich businessmen to gig economy workers to contract labourers have taken a pandemic-sized financial hit, it’s a destructive move. 

Meanwhile, household savings have been faltering for some time now, foreign investors are fleeing for safer markets like the US, disinvestment targets (already stalled) seem likely to be missed, business appetite was already facing a prolonged slowdown pre-COVID, and commercial banks are reluctant to lend more lest they face more bad loans in the near future.

So, “conventional” ways of raising more money and ensuring more money in the system are off the table for the Government.


The RBI's Role in Battling the COVID-19 Crisis

The RBI is the primary regulator of money supply in the country and as such it has a major role to play to boost a sagging economy.

Since March, it has used various monetary policy instruments to combat the coronavirus crisis. These include a Rupee-Dollar swap and additional long-term repo operation (LTRO). It also purchased Government bonds under OMOs by buying them from the ‘open market’. Moreover, it cut both the repo rate (to 4.4%) and the reverse repo rate (to 3.75%).

That’s a lot of things to increase liquidity (i.e. Money supply) in the system. But these are “indirect” methods of monetisation by the RBI. “Direct” monetisation would involve printing money and lending directly to the Government in exchange for new bonds.

And this is something that more and more people are calling for of late.

(PS: Borrowing more to spend more at a time when revenue sources are drying up has a caveat. The fiscal deficit is expected to shoot up to c. 15% of GDP when the permissible limit is only 6%. This means more Government debt and more interest payments down the lane.


How Does Direct Monetisation Work?

Let’s say COVID-19 never struck India, our growth trajectory remained positive and increasing and we were en route to becoming a $5trn economy soon. Things are relatively normal. 

Now, if the Government wants to borrow money it will sell ₹X amount of Government bonds in the open market. Commercial banks would transfer ₹X of their RBI deposits to the Government and buy these bonds. The Government invests the money it gets through this transaction in public spending. People spend more and duly there’s more money deposited in people’s bank accounts guessed it: commercial banks. So, ceteris paribus, ₹X is deposited back into commercial banks and everyone is happy.


What is Direct Monetisation by RBI? How Does the Government Borrow Money in Times of Crises?
How direct monetisation would work in normal times.


Now let’s come back to the real world. COVID-19 has struck India and the economy is staring at a brutal downturn and a painful recovery. Things are as abnormal as they can get. 

Now, if the Government wants to borrow money, it would have sold ₹X amount of Government bonds. But the open market is reluctant to buy these bonds in these uncertain times.

This is when the Government turns to the RBI for direct monetisation. The Central Bank steps in and buys the bonds directly (such transactions are prohibited in normal times). New currency is sent to the Centre, which uses it to boost the economy.


Direct Monetisation - Pros and Cons

Direct monetisation is a contested tool amongst economists. Some, like former RBI Governor Raghuram Rajan (who recently posted about this on LinkedIn) argue that it should not be a constraint on Government spending. He added that monetisation would “neither be a game-changer nor a catastrophe, if done in a measured way”. 

(PS - As per Rajan’s note, direct monetisation in the long run would deplete the RBI’s coffers and hurt the dividends the Government gets from the Central Bank in the future. This is because this instrument is in effect the RBI borrowing from commercial banks at the reverse repo rate. Why? Because in uncertain times like today’s, even if the Government spends the money it gets via direct monetisation to boost the economy, money saved in banks would not be reinvested in the economy because of banks’ reluctance to lend. Therefore, this money (i.e. The erstwhile ₹X) would be parked by banks in the RBI’s reverse repo window at the present 3.75% rate. 

What is Direct Monetisation by RBI? How Does the Government Borrow Money in Times of Crises?
The mechanics of direct monetisation in abnormal times (like right now).


On the other hand, there are other schools of thought that consider direct monetisation a dangerous tool that can send inflation surging. The main problem with direct monetisation, its opponents say, is not its initiation but its end: if the Government uses this window for too long and times get back to normal, it could lead to runaway inflation and devastate the economy. 

Another former RBI Governor, Duvvuri Subbarao, recently cautioned against it in an article in Financial Times: “There is no question that India must borrow and spend more in [the COVID-19] crisis; that is a moral and a political imperative. But New Delhi should not forget that its bruising balance of payments crisis in 1991, and a near-crisis in 2013, were, at heart, a result of extended fiscal profligacy.”



There is no doubt that Government spending will increase in the near term as a means to propel economic growth. The question remains as to which route the Government will take.Will it rely on the methods already employed by the RBI? Or will it opt for direct monetisation to finance spending?


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