The Hindu Business Line : Fall in Govt’s RBI borrowing: An accounting illusion

In an incisive piece in the Business Line on May 12, the former RBI Governor, Mr S. Venkitaramanan, refers to ‘Macroeconomic and Monetary Developments in 2007-8’ (released ahead of the Annual Credit Policy), which shows that the RBI’s credit to Government shrank about Rs 110,000 crore in 2007-8. The allusion is possibly to the data in Table 25 (‘Monetary Indicators’), item vi(a) (i) of the document. (By mistake, an extra zero seems to have crept into the figure in the article). Rubbing salt into the wounds of monetarists, Mr Venkitaramanan asks how inflation could increase amidst such severe central bank tightening.

The data cited suggest monetary contraction on a gigantic scale. The normal result of such drastic action would be hyperdeflation, not inflation. Also, financial markets would have been squeezed of liquidity and money rates would have soared. But conditions were entirely the opposite. Easy liquidity conditions prevailed right through 2007-8, with interbank money rates at one point dropping to zero. In fact, the RBI was on a liquidity absorption offensive for most of the year, raising the CRR several times in a valiant effort to protect its benchmark rates from being undermined by the liquidity overhang.

What, then, is the explanation for the dramatic drop in Government’s borrowing from the RBI?

The answer must be sought in the recently (i.e., just a few years ago) introduced new-fangled instrument called Market Stabilisation Scheme (MSS) bonds. These bonds were conceived of to mop up the liquidity created by the RBI’s dollar support operations. Overwhelmed by capital inflows, which threatened to convert to rapid rupee appreciation and derail traditional exports, the central bank had no choice but to step in, creating, in the process, excess liquidity. MSS bonds were thought of to drain this.

The bond proceeds are not available to Government unlike those of normal bonds. They lie with the RBI. In other words, they are completely sterilised. (But Government still has the obligation to pay interest on the bonds). On maturity, the RBI will repay using the sterilised funds lying with it.

The central bank’s credit to Government is defined as its holdings of Government securities less Government’s cash balances with it. Since the proceeds of MSS bonds are in the RBI’s custody, they are deducted to arrive at net RBI credit to Government. MSS bonds outstanding were almost Rs 170,000 crore in March 2008 compared to only Rs 63,000 crore in March 2007 – an increase of over Rs 100,000 crore. This more or less corresponds to the fall in RBI credit to Government in the last financial year.

Thus, the reported reduction in Government’s RBI borrowing is accounting fiction, arising purely from the increased resort to MSS bond issues to absorb surplus liquidity and parking these funds with the RBI. As Mr Venkitaramanan remarks, a comment on or an analysis of this point (in an otherwise superlative document) might have helped.

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