What do the RBI and the Batman movie have in common?

Can you recognize this character from the second movie in the Batman trilogy, The Dark Knight?

Harvey Dent - Two face - Batman movie

It is Harvey Dent, the crime-fighter, who after a horrible accident turns into a villain called Two-Face. His famous quirk? He flips a coin before deciding whether he takes an important decision, usually when deciding about someone’s life or death in his hands.

Alright, Harvey Dent has a split mind. He prefers that fate should decide outcomes.

What does this cinematic character have in common with the Reserve Bank of India (RBI)?

Government of India

Lets keep the popcorn aside and come back to what the Indian economy is going through. In my last article I talked about the huge borrowing of the Indian Government and its dangers.  The article before that was on the Indian fiscal deficit.

If you have not read these articles going through them first will be quite helpful.

We already know that we have a spendthrift government that is increasing expenditure year on year with income that is hardly keeping pace.

Government of India borrowing over 2007-12 in Rs. croreSource: Planning Commission, Capital Orbit

Reserve Bank of India

The RBI is India’s central bank. They have the task of formulating and enforcing what is known as monetary policy. Broadly, the RBI keeps a watch on the money supply, exchange rates, inflation, and the banking system of the country. They are the bankers to the Government of India.

The RBI has the sole right to create money in India. Money is needed for transactions by individuals, companies, and the government. Money is the lubricant that drives the economic engine. Without money we would be back in the era of barter transactions.

If you and I print money its a crime. The RBI can do it legitimately.

As you see in the graph above the Government of India has large borrowing needs. As I explained in the earlier article the Government issues bills and bonds to fulfill its borrowing need during the year.

When there is pressure on the economy, there is not enough surplus money available with financial institutions at large. In better times, they would have easily bought the bills and bonds and thus lent money to the Government of India. But when liquidity is tight they stay away from lending money to the government or expect higher rates of interest on these securities.

The RBI steps in when liquidity is low by purchasing government bonds from the market. How does it pay for them? It creates money given that it has the sovereign right to do so.

Quantitative Easing in India by RBI

Quantitative Easing (QE) is a word that has become famous since the financial crisis of 2008. If you have read till this point you have already understood what QE is. One of the key ways to do QE is for a central bank to buy government debt.

Its as simple as that. Its what you also read as Open Market Operations (OMO) in the media.

The chart below shows the amount of borrowing by the Government of India that the RBI supported by buying government bonds over the last 6 years.

Open market operations by the Reserve Bank of india as a percentage of the annual government borrrowing of India over 2007-2012Source: Planning Commission, RBI, Capital Orbit

 

The RBI bails out the government with newly created money so that it completes its borrowing programme successfully. In 2012, 1/4th of the government borrowing was supported by RBI. This is not a small amount.

And it is not too different from giving money to an addict begging for the next dose of drugs.

Two-faced statements and actions by the RBI

Over the last year the RBI has increasingly spoken against the government’s excess expenditures and growing fiscal deficit.

Statements

On 21 August 2012, the RBI made a press release. One of the lines was,

 They felt that given the fiscal dominance, double-digit consumer price inflation and no realistic expectation of credible action from the Government, the Reserve Bank needs to focus on tempering inflation expectations.

Actions

The OMOs are supporting the government borrowing. Ideally, a government should be able to earn enough to cover its expenditure.

Why is the RBI supporting the government’s borrowing? If it does not, the government will automatically have to pay higher rates of interest on its borrowing given that there is low liquidity. Higher rates of interest means higher interest payments adding to already high expenditure. It is not an attractive option for the government. Automatically, the government will have no option but to reduce the fiscal deficit.

Summary

There is little hope that Manmohan Singh’s government will put the country’s finances in proper shape. They had ample opportunity but have not shown the inclination to rein in spending.

The only hope is that we have a RBI that behaves in an independent manner. But it seems that it has a split mind like Two-Face. It has contradictory views and actions respectively. Increasingly it looks like India’s economy has been left to fate by its custodians.

And it does not end here. The new money that the RBI creates has a direct negative impact on all of us. How? Read the next article to read about the insidious and silent tax that each of us pays without noticing.

Update

The next article in this series on government finances and how they affect our investments has been posted.

Click here to read it.

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Comments

  1. Sundeep says

    I think the answer to RBI’s behavior as seemingly an independent body, lies in exploring the chain of command, who does it answer to ? What are its political compulsions ?( it should not have any, but it does) and finally, what will be the impact of the Govt defaulting on the domestic debt?

    Afterall, India has run deficits in excess of 5% since the economic librelisation happened, largely because it runs a subsidy culture and that’s inherently linked to vote bank politics, so we might need to explore the political connection between RBI and the finance ministry.

      • says

        Sundeep – Yes, seemingly the RBI should be independent from the government. But there are contradictions like you rightly pointed out.

        The 1934 RBI Act gives the Central government powers over the RBI though practically the RBI has become assertive over the years.

        Your point about the fiscal deficit being persistent around these levels since the last many years is true.

        There can be higher expenditure as compared to income. If it is made towards productive assets in the economy which will give savings or generate income it should take care of itself in the future years. But a lot of our spending outlay is simply siphoned off in corruption or inefficiencies.

        With OMOs supporting bad expenditure the stage is set for inflationary tendencies in the economy. Something that we are all suffering from!

        http://www.livemint.com/2010/06/16110753/How-independent-is-RBI.html

        This is a good article that has a nice summary of the RBI – Government relationship.

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