When the fiscal deficit of the government is financed by the central bank by printing money, instead of taking a debt to be repaid at a future date, it is called monetization of fiscal deficits. So, it is a form of "non-debt financing" instrument which does not result in increase in net (not gross) public debt. In India, under the Fiscal Responsibility and Budget Management (FRBM) Act, 2003, the RBI was completely barred from subscribing to the primary issuances of the government. However, the FRBM Act as amended in 2017 contained an escape clause which permits monetisation of the deficit under special circumstances. Experts all over the world are divided on the use of ‘monetization of deficit financing’ as a tool.
Negative impact
• Rise in inflation in the long-term: As opposed to temporary expansion in money supply through Open Market Operations (OMOs), monetization of deficit creates a more permanent impact which can lead to inflation; as more money is being pumped into the economy which will stimulate demand/spending.
• Devaluation of currency: Aggressive monetization could devalue the currency, causing foreign investors to lose confidence and pull out money, putting the existing fiscal financing plan at risk.
• Possibility of inefficient spending: Usually fiscal profligacy is seen among governments when money is easily available to exploit and it may also lead to rise in corrupt practises.
Positive impact
• Sovereign ratings: Worsening public debt and debt-to-GDP ratio could lead to a downgrade of sovereign rating status leading to flight of capital from the country. Monetization being a non-debt creating instrument can prove useful in this situation.
• Prevents crowding out effect: In faltering demand situations, the government needs to increase spending. But, large scale domestic borrowing by the government can make it harder for the private sector to raise money and interest rates can also rise because of such competition. Monetisation helps prevent this crowding out effect of capital.
• Less risk of inflation in immediate term: In certain cases, like that of India, transmission of base money (M0) to broad money (M3) is likely to be slow because of slower credit growth which leads to lower velocity of money (frequency at which one unit of currency is used to purchase domestically- produced goods and services within a given time period). This low velocity and lesser transmission reduce the inflation risk.
Given the pandemic situation, demand is already low and unemployment is high, so, it is argued that monetization is not likely to create negative effects as it does in normal situations. Rather, it has the possibility to set off a virtuous cycle of liquidity easing, leading to a reduced level of insolvency and also a positive impact on the economy which will reduce the debt-to-GDP ratio. In this situation, monetization of deficit financing can be considered as one of the options to increase government spending.
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