He said central banks in many emerging markets are resorting to such strategies and disagreed with votaries of the “modern monetary theory” who support this, making it clear there are no free lunches. “The RBI has been expanding its balance sheet and it has been buying government debt. But effectively, in that process, what it is doing is borrowing from the banks at the reverse repo rate and lending on to the government,” Rajan said at a conference organised by DBS Bank.
At present there is excess liquidity in the system as people get more risk averse and save more and the demand for credit is sluggish. Banks are parking the money with the RBI in the reverse repo window, earning very less. Monetisation of the fiscal deficit is a suggestion put forth by a slew of experts as a prescription to tackle the current environment. Rajan said there are limits to monetisation and the process can go long only for a limited period of time. “When does this process end? When people start fearing the extent of monetisation that is going on, when they start worrying about inflation, when they start worrying about whether the debt that has been accumulated will be paid back. Or, once growth starts picking up and banks find other uses for the money than passively holding on to central bank reserves,” he explained.