The fiscal conundrum of the Reserve Bank of India
PremiumIf RBI defends the rupee, interest rates will rise, making borrowing expensive for the government. However, if RBI wants to keep rates low, it cannot defend the rupee. This is the dilemma.
The fiscal deficit number for April 2021 to February 2022, the first 11 months of FY22, suggests that the central government is likely to meet the fiscal deficit target it had set for the year. The deficit for the 11-month period stood at ₹13.17 trillion against the budgeted estimate of ₹15.07 trillion and the revised estimate of ₹15.91 trillion for the whole of FY22. Fiscal deficit is the difference between what a government earns and what it spends during a year.
It’s the first time in six years that the central government is likely to meet its fiscal deficit target. From FY17 to FY21, in each year, the actual fiscal deficit in absolute terms was higher than the budgeted one, though the difference was very small in FY17.
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In FY20 and FY21, the difference between the budgeted and the actual deficit was huge. This was primarily on account of tax revenues collapsing as the covid pandemic spread. In FY21, the budgeted fiscal deficit was ₹7.96 trillion and the actual deficit came in at ₹18.18 trillion.
The government finances a bulk of the fiscal deficit by borrowing money by selling bonds. When the government borrowing during a year jumps, it leaves lesser money for others to borrow. This is referred to as crowding out and it pushes up interest rates.
Despite the government borrowing more, interest rates in India have been low since the beginning of 2020, because the Reserve Bank of India (RBI), which among other things also manages government’s debt, printed and flooded the financial system with a lot of money. With excess money in the financial system along with a slowdown in lending, interest rates automatically fell, helping the central government to borrow at low interest rates.
In FY22, the central government is likely to meet its fiscal deficit target. Despite this, the fiscal deficit of ₹15.91 trillion (revised estimate) or at 6.9% of the gross domestic product (GDP), is huge.
So, is the budgeted fiscal deficit for FY23, the current fiscal, which stands at ₹16.61 trillion or 6.4% of the GDP. The government plans to borrow a total of ₹14.31 trillion this year to finance the fiscal deficit.
Of this, it plans to borrow ₹8.45 trillion during the first six months. The question is how RBI will go about supporting the government this year. Or can it?
Central banks across the rich world are likely to continue raising interest rates to tackle inflation which is at a multi-decade high. Hence, money brought in by the foreign investors is likely to leave India and go west.
When foreign investors leave India, they sell rupees and buy US dollars. This leads to an increase in the demand for the dollar and the depreciation of the rupee. A fast depreciating rupee can push up inflation given that India imports 85% of the oil and half of natural gas, it consumes.
In this scenario, RBI can sell dollars from its foreign exchange reserves and buy rupees, something it is already doing.
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When RBI buys rupees, the amount of rupees floating around in the financial system comes down. This puts a stop to the depreciation of the rupee and if not that, it at least slows it down.
This is where RBI faces a conundrum. If it keeps defending the rupee, there will be lesser money going around in the financial system. This will lead to an increase in interest rates making borrowing expensive for the government. On the flip side, if RBI wants to keep interest rates low, it can’t defend the rupee as well. Let’s see which way the wind blows.
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