How long can govt be on RBI life support?

The Reserve Bank of India has joined the ranks of central banks intent on saving the country - and the world - from collapse by printing money. The RBI is the fifth big central bank to finance fiscal deficits through bond purchases, the other four being the Fed (US Federal Reserve), ECB (European Central Bank), BOJ (Bank of Japan) and the BOE (Bank of England).

[caption id=“attachment_202121” align=“alignleft” width=“380” caption=“Reuters”]  [/caption]

Indian equity, bond and currency markets are cheering the RBI’s move to purchase more government bonds to finance a burgeoning fiscal deficit. January 2012 saw Indian equities gaining 10 percent, the rupee gaining more than 5 percent against the US dollar and Indian bonds rallying 30 basis points on the back of a CRR (Cash Reserve Ratio) cut and government bond purchases by the central bank.

While markets will continue to cheer the actions of the five musketeers, the question rational people are asking is, what are the repercussions down the line?

More from Economy

Budget 2024: These are the many hopes and aspirations of India's social development sector Is the United States in recession? Signs to watch out for

Table 1 shows the expansionary policies of the five musketeers since the credit crisis of 2008:

Central bank balance sheet growth

[caption id=“attachment_203324” align=“alignleft” width=“600” caption=“Table 1”]  [/caption]

The RBI has expanded its balance sheet the most among central banks in the aftermath of the 2008 credit crisis, and is set to expand it further in 2012 as the government looks to the central bank to fund its fiscal deficit.

Table 2 shows RBI financing of the fiscal deficit in the past three years.

[caption id=“attachment_203323” align=“alignleft” width=“559” caption=“Table 2”]  [/caption]

Central bank support becomes addictive

Central banks may have the best intentions at heart - to provide liquidity support to the government and markets -but the liquidity support soon becomes an addiction.

The government starts depending on the central bank to fund its fiscal excesses, while markets depend on the central bank to provide a cheap source of funds. The addiction becomes irreversible as any kind of withdrawal of support threatens the system.

The unlimited funding offered to banks in Europe by the ECB, under which banks drew 489 billion euros at 1 percent for three years is a good example of how markets can get addicted to central bank support.

Banks borrowed from ECB and bought bonds of eurozone nations, not caring about the fiscal conditions of these nations. The markets had punished nations like Italy and Spain for running high deficits by taking up bond yields by 300-350 basis points and that was forgotten once the ECB came in to lend money to the banks - the same entities that had sold bonds of Italy and Spain bought the bonds at 300 basis points below the highs.

How long can this continue?

Indian bond market sold off by 25 basis points after the RBI’s CRR (Cash Reserve Ratio) cut, as they feared that the RBI would discontinue its bond purchases.

The central bank had bought Rs 70,000 crore of bonds in November, December and January to shore up liquidity and support a higher than budgeted government borrowing.

Bond yields threatened to rise further before the RBI announced further bond purchases. That led to bond yields falling sharply by 25 basis points.

The government also relies on the central bank when it attempts to bolster growth by cutting taxes and increasing public spending.

Hence, central banks are, in a way, funding lower taxes and wasteful government expenditure by expanding balance sheets. The repercussions of withdrawing liquidity support is the sharp fall in public spending as markets punish the government for its excesses by taking up bond yields to levels where servicing debt becomes unsustainable.

What is the solution?

There is none when there is no political will to find the solution.

A market collapse is seen as unacceptable in the rush to calm markets when things take a wrong turn.

A solution through a natural course of growth gaining momentum on the back of government spending becomes wishful thinking when the problem is too large to solve.

Japan is a case in point, where despite interest rates at zero percent and the government running up huge debt funded partly by the BOJ, growth rates are abysmal and not anywhere close enough to bring down overall deficit ratios.

Markets will continue to drive higher on central bank support, tumble when the central bank show signs of withdrawing support and go up again when governments arm-twist central banks to lend support again.

One day this cycle will collapse, but until then, make hay while the sun shines.

Arjun Parthasarathy is the editor of www.investorsareidiots.com, a website for investors.