Fiscal Deficit and Its Indirect Monetisation by Reserve Bank of India
Open Market Operations (OMO) by RBI are supposed to be two ways. Committee after committee have spoken against outright monetisation of fiscal deficit via OMO purchases--eroding RBI's credibility in discretionary liquidity management.
Practically, Government of India's fiscal deficits are financed by RBI's one-sided OMO buying (see image) & support from commercial banks through mandatory SLR (statutory liquidity ratio). On top of that, banks hold excess SLR securities leading to market distortions.
With the introduction of FRBM (Fiscal Responsibility and Budget Management) Act in 2004, RBI cannot participate in the primary issuance of government bonds. But RBI is still resorting to government debt financing through outright OMO purchases in the secondary market.
No other major central bank uses OMO (one-sided) as blatantly as RBI in yield curve management, though OMOs are not to be used for that. Bond prices are the building blocks of asset pricing--with such distortions how can market players be sure of pricing of other assets?
RBI uses OMO to bring down long term yields by resorting to buying of government bonds, which is practically yield curve management, also known as yield curve control (YCC). Lower bond yields help governments in borrowing money from markets at cheaper rates.
With automatic monetisation via large OMO purchases, Reserve Bank of India has been printing money leading to debasement of money (lowering the purchasing power of currency).
In financial markets, government bond (called G-Secs in India for short) yields are the starting point for pricing of other assets. For example, corporate bonds are priced as a spread over G-Sec yields. G-Sec yields are also used for pricing equities and others.
With this indirect monetisation of fiscal deficits, RBI loses its credibility in conducting monetary policy objectively--reflecting poorly on central bank independence.
Side note: In financial market operations, open market operations are termed as open mouth operations.
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Please check my comments posted below >
Related articles:
Primer on Market Stabilisation Scheme and Liquidity Management 02Dec2016
References:
My tweet thread dated 08Feb2021 on the above topic can be accessed at: weblink
Yield curve control (YCC): St Louis Fed blog dated 11Aug2020
Jan2014 Urjit Patel Report on Monetary Policy Framework (MPF)
04Mar2013 Fiscal-Monetary Co-ordination in India : An Assessment
Disclosure: I've vested interest in Indian stocks. It's safe to assume I've interest in the stocks discussed, if any.
Disclaimer: The analysis and opinion provided here are only for information purposes and should not be construed as investment advice. Investors should consult their own financial advisers before making any investments. The author is a CFA Charterholder with a vested interest in financial markets. He blogs at:
https://ramakrishnavadlamudi.blogspot.com/
1) LAF (Liquidity Adjustment Facility) by RBI allows banks complete freedom to access RBI liquidity (at repo rate), up to their excess SLR (statutory liquidity ratio) holdings.
ReplyDelete2) But the cost of holding excess SLR gets reflected in pricing of other assets.
3) Outright pruchase of G-Secs (one-sided OMO buying) crowds out private sector, creating reserve money--leading to excessive monetary expansion from indirect monetisation of fiscal deficit through OMO purchases.
4) Operating target of US Fed's monetary policy is the federal funds rate; for Australia it's the Cash Rate. Short-term interest rate remains the main operating target for most of the central banks globally. But, Bank of Japan switched its operating target from the uncollateralised overnight call rate to the monetary base in April 2013. It conducts money market operations with the explicit objective of expanding the monetary base at the rate of 60-70 trillion yen annually.