Fate rarely calls upon a government to deliver a fiscal stimulus at a time of its choosing. And so, the Modi Government finds itself in a bit of a fix with the need to stave off mass bankruptcies and unemployment coinciding with a drastic fall in revenues due to the lockdown. But heightened deficit spending based on domestic market borrowing alone may not be possible, which is why actual stimulus spending is only a fraction of Modi’s Rs 20 lakh crore of $265 billion fiscal package. Thus, those in favour of a bigger stimulus are calling upon the Reserve Bank of India (RBI) to monetize any deficit spending that cannot be covered through market borrowings by invoking the escape clause in the FRBM Act. In particular, there are suggestions that India resort to ‘helicopter money’, typically understood to be a ‘permanent’ monetization of deficit spending achieved through the creation of non-interest bearing liabilities by the central bank. It is therefore time to examine whether helicopter money will indeed create the desired fiscal space.
In the present context, a so-called ‘helicopter drop’ could take the form of the RBI directly funding transfers by the government to MSMEs and the unemployed. Since, the RBI has to give a ‘permanent character’ to the monetization, it can do so by buying a zero-coupon perpetual bond from the government. The emphasis is on ‘permanent’ since the idea is to perpetually rid the government of any liabilities arising from its expenditure. Moreover, the permanent monetization is also meant to convey to the private sector that it need not fear future tax increments to offset the same for those worried about any Ricardian equivalence effects (although I don’t see how they can be given the depressed economic situation). The ‘inflation-tax’ on the private sector would also be limited, since in depressed conditions additional spending is likely be taken up more by output growth than price rise. But is helicopter money a ‘free lunch’ for India, given the circumstances? Not really.
Any helicopter drop will lead to a commensurate increase in commercial bank reserves and it is unlikely that banks will be willing to hold a sizeable increase without being paid interest on it. This increase in bank reserves would occur even if the helicopter drop was done in the form of cash payments because the populace as a whole already holds most of the currency it desires and anything more will end up being deposited in bank accounts.
Now, banks hold reserves to meet the RBI’s cash reserve requirement (CRR) as well as to insure against the uncertainty related to fund flows, and in ‘good times’ they economize on their reserve holdings. The RBI takes advantage of this behaviour by supplying banks with just enough reserves to meet their demand and channels a ‘corridor’ for the RBI’s ‘operating target’ (i.e. the weighted average call rate or WACR), which is the rate at which banks advance unsecured overnight loans to each other and is aimed at being as close to the policy rate (repo), as possible. The lower end of that corridor is the reverse repo rate. In depressed economic circumstances banks may hold excess reserves which they typically lend to the RBI at the reverse repo rate. If the system becomes sloshed with excess reserves, the RBI’s operating target rate starts closing in on the reverse repo rate, as happened post-demonetisation, something that will be greatly accentuated subsequent to a major helicopter drop. So, the only way in which a helicopter drop can lead to a permanent ‘cost-less’ monetization is if the RBI sets the reverse repo rate to zero and keeps it there indefinitely, which is akin to giving up on monetary policy altogether. Hence, the RBI will have to pay a positive interest rate for the reserves it has created via the helicopter drop, assuming it doesn’t want to give up on monetary policy.
With the system full of reserves, the RBI can even change the way it pursues the operating target, by setting it as equal to the reverse repo rate and simply supplying banks with as much reserves as it wants, since they would be indifferent between holding the same and lending it to other banks at the reverse repo rate. This is of course similar to how some Western central banks who offer interest on excess reserves now operate having stuffed their commercial banks with reserves due to quantitative easing. But again, the reverse repo rate will have to be set to zero permanently, if the helicopter drop has to be interest free in perpetuity.
With a positive reverse repo rate being paid on the created reserves, a helicopter drop would be little different from a purchase of marketable government securities (g-secs) by the RBI, as far as the impact on the consolidated balance sheet of the government and the RBI is concerned. Since, any government-issued liabilities held as assets by the RBI simply cancel out on the consolidated balance sheet. Of course, a helicopter drop would immediately reduce the market-value of the RBI’s realized equity, something g-sec purchases will not. Naturally, any interest paid on reserves will reduce the RBI’s future remittances to the government by an equivalent amount.
Now, the RBI can always force commercial banks to hold the increase in reserves as part of an extended interest-free CRR. But this would be akin to a tax on commercial banks, although India is no stranger to this kind of financial repression. Till 1997, the RBI used to automatically monetize the treasury’s deficits by purchasing 91-day ad-hoc bills from the latter and banks were forced to hold the resulting reserves through high CRRs. However, the phasing out of that practice alongside the adoption of fiscal rules, which also stopped the RBI from purchasing government debt directly, marked India’s move away from fiscal dominance and towards monetary dominance, culminating in the adoption of a flexible inflation targeting framework by the RBI in 2016.
A helicopter drop will constitute a complete reversal of this trend. Naturally, ratings agencies will not like it, and it may lead to a downgrade of India’s sovereign rating. In fact, even large-scale purchases of government debt by the RBI via the secondary market (which it is permitted to do) is attracting the attention of rating agencies. Those scared of a downgrade advocate that India turn to cheap foreign borrowings instead and abjure debt monetisation altogether. However, large foreign borrowings can end up constraining monetary policy even more than what monetization might do.
Having said that, if monetization is deemed inevitable, it is best done though large-scale purchases of marketable g-secs either via the secondary market or even through primary auctions as Bank Indonesia did in April 2020. The impermanence of such debt monetization (since the RBI could always reduce its holdings) would signal to investors that the move is borne out of necessity & not the beginning of a norm. Also, unlike a large helicopter drop, monetization through g-sec purchases will not send the RBI’s equity into negative territory which will necessitate recapitalization at some point, if inflation targeting is to be credibly resumed in the future.
Saurav Jha is the founder of Delhi Defence Review. Follow him on twitter @SJha1618
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