The types of eco stimulus & Rupee

Stimulus in an economy can be of three types:

 1)      Monetary- expands RBI's balance sheet

 2)      Fiscal- Expands the fiscal deficit. State + center

 3)      Financial: Does not expand fiscal deficit but can increase contingent liability of Government

 MONETARY POLICY:

• RBI expands its balance sheet by buying foreign currency, gold, domestic bonds. When anything of these purchases occur, the ASSET BALANCE of RBI increase by those instruments & LIABILITY BALANCE increases by BANK RESERVES.
• Bank reserves are money issued by RBI and is asset of the banking system. Banks use these reserves to pay RBI for the maintenance of CRR or it can use them to clear in the inter-bank market. Example: When you transfer 1 lakh from you Kotak bank to HDFC bank account. Kotak bank transfers 1 lac of reserves to HDFC. The actual amount is decided after netting off all transactions.
•   Banks also use the reserves to deposit with RBI under LAF or lend in the interbank market.
•  Bank also use these reserves to buy financial assets like BONDS & CREDIT INSTRUMENTS.
•   It also uses reserves to pay government any dues. It is to be noted. Government's bank is RBI. So all the deposits of Government do not show up in the books of Banks but in the book of RBI, as a liability.
•  Banks do not lend reserves. Therefore, there is no question of RBI’s money printing becoming loans in the economy. Therefore, there is no direct linkage between RBI’s bond purchase and increase in loan growth in the economy. The linkage is indirect by way of ease in financial conditions and lower cost of capital.
•  Therefore monetary stimulus acts to increase the RESERVES at a low cost. Central banks hope that excess reserves will be utilised by banks to buy financial assets. As banks buy more Govt bonds, yields can come down. If banks buy more corporate bonds and bonds of shadow banks, the credit spreads will also fall. Therefore, via reserves, RBI hopes to manage the yield curve as well as the credit spreads.
•  But when there is deep strain in the economy and lenders fear loss of capital, then Bankers do not utlise the reserves from RBI to buy credit risky instruments. If there is fear of spike in yields of Govt bonds, then bankers can even shy away from buy long term Govt bonds. Now RBI cannot influence the yield curve and the credit spreads. This was the situation in March 2020. During such times, banks are happy using the reserves to buy short dated Govt bonds, short dated instruments of high quality banks and also invest at reverse repo.
•   RBI tried to take one more step in the wild. It made its lending to banks against collateral conditional or TLTROs (Targeted Long term Repo Operations). Banks taking the funding from RBI by pledging their holdings of government securities had to utilise those funds to buy bonds issues by NBFCs and MSMEs. But it was not effective. Banks had the wriggle room. It was optional to get the funding. Banks had to warehouse the credit risk and duration risk and hence they shied away from. Credit risk denotes risk of default and duration risk refers to fall in price of long term bonds if yields rise.
•  RBI now can take another step: It can allow banks to refinance their holdings of corporate bonds and shadow bank bonds with RBI at repo rate and a certain mark-up. This means, default risk will be on the books of RBI. If such a scheme is announced, I expect banks to fall over each other to participate. Banks will buy the papers in the secondary market at a discount and offer to RBI and pocket the difference.

 FISCAL STIMULUS:

•  Economic activity is sum total of spending or income or good/services produced in the economy over a defined period of time. Goods and services produced generates income. Income leads to spending. Spending converts goods and services into Income. One feeds the other.
•  Money plays a very important role here as a medium of exchange. 100 rupees of my income when it moves from my pocket to your pocket and from there to your neighbour’s pocket by way of expenditure, it ends up generating 300 rupees of economic activity or GDP. That is known as velocity of money. The faster the money moves, bigger the economic activity. 
• As economic activity expands, people and firms borrow money from their expected future income. Banks expands money supply by creating it from thin air, via credit creation. With a stroke of pen they create deposit and loans on their balance sheet. Credit fuels more spending and that in turn converts more goods and services into income.
•  Government, like households and firms is an important player in the economy. When government spends more than what it earns via taxes, it expands the overall pie of economic activity, as this excess spending is funded by credit. Therefore, a credit funded spending from government increases the velocity of money in the economy.
•  The mismatch between spending and revenue is known as fiscal deficit. Fiscal deficit leads to borrowing. Borrowing increases debt. However, debt is not same as debt servicing capacity. Former is the accumulated borrowing but latter is ability to repay. When debt is used productively, it increases debt servicing capacity even though debt increases. But if same debt is used unproductively, then it will lower debt servicing capacity. Former is like creating JP Associate and latter is like Reliance Industries.
•  During COVID crises, In India, with private sector, households and firms, out of action, the velocity of money has collapsed. Money is not able to move as rapidly as it was moving 6 months back and therefore economic activity has collapsed. Government being a player who can stimulate the velocity enters the arena with higher borrowing funded spending.
•  Fiscal stimulus can be by way of higher expenditure or by forgoing tax revenue. Intuitively, former increases velocity of money more than latter. Hence, in a condition we are in, higher expenditure should be given priority over tax relief. Tax relief can be provided to producers to improve supply of goods and services, which generates employment. However, tax relief to individuals will either be irrelevant to someone who lost his job or be saved by others who have jobs. It would not be spend forward. Government expenditure stimulating when the income generated from it is spend forward by private sector, instead of being saved.

 FINANCIAL STIMULUS:

• These different forms of credit enhancements or credit guarantees extended by the Government. These guarantees create contingent liability and do not increase the fiscal deficit immediately. The adverse impact on fiscal deficit depends on how much of the guaranteed loans become bad debts which cannot be recovered.
•  Financial stimulus is a way to improve cash flows of the targeted audience. To help firms and individuals tide over short term cash flow mismatches via bridge financing and also allow them to rollover their existing debt.

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1)      Therefore, mixing all three monetary, fiscal and financial what do we get?

Ans: Monetary stimulus eases the access to credit and lowers than cost of borrowing. Financial stimulus address liquidity needs and restores base demand and also lowers the risk of liquidity crunch morphing into solvency problem. Fiscal stimulus looks to boost demand, via expenditure and tax relief. Fiscal can augment supply as well via tweaks in tax policy, like incentives for certain investments and economic activities.

 2)      How will government finance the expanded fiscal expenditure and weak revenues?

 Ans: Apart from market borrowing and small savings funds, GoI can access NRIs, overseas bonds and even RBI financing. I think, RBI can be the card which they can use, via OMOs.

 3)      Will RBI’s buying of bonds lead to inflation?

Ans:   RBI’s asset purchase and inflation are like a couple getting married and they having a child. Marriage is not an automatic visa towards parenthood. Conditions need to be there to happen. RBI has been expanding its balance sheet since ages. Over the past 5 years, RBI has engaged in OMOs and unsterilized US Dollar buying of lakhs of crores but inflation is still under check. Inflation is the effect we measure via prices of factors of production and goods and services. The linkage between central bank balance sheet and that is pretty weak. Lot of things has to happen for that.

Currently with private sector out of the game of demand creation and credit creation, money supply growth has stalled. Here RBI stepping in with reserve money and converting that into purchasing power for the government is an act of the filling the gap left by private sector. They cannot fill it completely and hence, the risk of it generating inflation is very low. We have to see, when economy gets into full throttle. But that may be long time away.

 4)      How will RBI's debt monetisation impact Rupee?

Ans:  Rupee’s movement is function of demand and supply.

•  Foreign capital flows
• Speculative flows (offshore + onshore)
• RBI intervention

are what determines the trend Rupee takes. Therefore, the question remains, what will be the impact of RBI’s bond buying on capital flows.

Foreign Capital Flows = 

FPI Flows Into Equity + FPI Flows into Debt + FDI + Foreign Currency Debt Borrowed By Indian Corporates+ NRI Deposits

Speculators, like you and me and large institutional players like corporate treasuries and Hedge funds want to follow direction of capital flows. They look to pre-empt the flows and then take bets accordingly. Hence, they amplify the impact of capital flows on Rupee.

 RBI will be reactive, depending on the trend of the Rupee. They look to act as a shock absorber. They buy Dollars when there is persistently large capital inflow and speculative buying in Rupee. They sell Dollars , when opposite happens.