William Pesek is an award-winning Tokyo-based journalist and author of "Japanization: What the World Can Learn from Japan's Lost Decades."
Economists searching the globe for policy exemplars rarely look to Mumbai. But the Reserve Bank of India may soon start a trend peers everywhere are almost sure to follow.
The novelty in question is a central bank directly financing a government's fiscal deficit: when a government sells bonds directly to its monetary authority without ever having to pay them back. Long taboo among the globe's most advanced economies, the practice has been banned in India since 1997. Hoarding public debt in this way can fuel runaway inflation, weaken a currency and enable reckless government borrowing.
As fallout from COVID-19 hits growth and tax revenues, however, Prime Minister Narendra Modi is widely expected to go hat-in-hand to the RBI. There is no other way, many investors say, that his government can borrow the record $104 billion it needs this fiscal year. RBI Governor Shaktikanta Das should brace for a call from Modi any moment now.
That is just fine by at least two of Das's predecessors. Chakravarthi Rangarajan, who was governor in 1997 when New Delhi clipped the RBI's wings, is on board with monetization. So is Rangarajan's successor, Bimal Jalan, who ran the central bank from late 1997 to 2003. As a former chief RBI statistician told reporters last month: "There is no other option."
The question is whether investors will agree. Will markets take kindly to the RBI bankrolling Modi's government? What about credit rating companies, which have threatened to downgrade India to junk since 2013?
How India proceeds matters because it is at the vanguard of an epochal shift playing out across Asia. From Indonesia to New Zealand, central bankers are tiptoeing toward a policy that capitalism's true believers view as anathema. Asia would be breaking ground after years of watching the U.S. and Europe take the lead in global rescues.
India is right to get radical as COVID-19 ravages the economy. The nation entered 2020 with growth at a roughly 5% pace. Now, management consultancy McKinsey & Co. reckons India could be on track for a contraction of 2%-3% in fiscal year 2021. If lockdown efforts fail and COVID-19 cases surge repeatedly, McKinsey said gross domestic product could shrink 8%-10%.
Conventional rate cuts may ease tensions in credit markets. The RBI still has 440 basis points of monetary ammunition left. But collapsing demand requires an extraordinarily aggressive response. Hence this pressure on the RBI to get drastic.
Modi's government would have to trigger an escape clause that lawmakers passed in 2018, which frees the RBI from the 1997 ban on buying debt at government auctions if fiscal deficits breach targets by 0.5 percentage points. The gap will be much worse in the period ending March 2021.
To make this work, the RBI must devise a three-point plan and implement it firmly.
First, it needs an exit strategy. As the world learned from Japan, when you hoard nearly half of outstanding government debt, you tend to get trapped. Efforts to withdraw confront strong resistance from politicians, banks and traders because they quickly factor ultracheap money into economic decisions. Going too far underwriting debt could encourage reckless borrowing, which boosts inflation and imperils India's sovereign rating. Lawmakers must understand that RBI largesse is of a limited and short-term nature.
Second, surveil markets obsessively. The more a central bank dominates markets, the more risk premiums get distorted. As New Delhi issues ever more debt and sells it unconditionally to a deep-pocketed buyer, yields will be held irrationally low. That could warp the pricing of corporate, asset-backed, mortgage-backed and municipal debt. Private funds, meantime, which need to hold government debt, could get crowded out. The RBI must monitor market strains and ease them decisively.
Third, demand an exchange from the government. In return for handing its wallet to Team Modi, the RBI should extract reform pledges. Since 2014, Modi has slow-walked plans to revamp laws on labor, land and taxation. He moved glacially to allow foreigners to take sizable stakes in key sectors. The RBI should ensure efforts to boost demand are augmented by supply-side steps to make India more competitive and egalitarian.
It is unclear when other Asia-Pacific powers will also embrace monetization. Bank Indonesia seems days away from bankrolling Jakarta's coronavirus rescue spending. Reserve Bank of New Zealand Governor Adrian Orr says he is "open minded." Given that Canberra may sell a record $164 billion of bonds over the next 15 months, can the Reserve Bank of Australia be far behind?
The same goes for the Federal Reserve, as growth plummets ahead of a November election U.S. President Donald Trump is desperate to win. The European Central Bank might follow if COVID-19 disruptions push banking sectors back to the brink.
India has much riding on how Das strikes a balance between backstopping the government while preserving a modicum of independence. But then so do peers everywhere facing similar difficult bargains.