Money & Finance

A more focused RBI: Creating capacity to tackle ‘true’ market failure

  • Blog Post Date 10 January, 2024
  • Perspectives
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Large, routine payments to the government by the public lead to a liquidity crunch in the economy, necessitating interventions by the central bank. However, Gurbachan Singh argues that the RBI is better suited to managing true market failures, and suggests that certain functions could be performed outside of the central banking system. To abate routine liquidity crunches, he proposes a solution in which commercial banks could act as the government's bankers, to address this ‘pseudo’ market failure. 

Often firms and individuals make lumpy payments from their banks to the government. This leads to a liquidity crunch in the economy, with some borrowers finding it difficult to get loans from the banks. Subsequently, economic activity tends to suffer. There are at least three instances when a liquidity crunch of the kind mentioned above takes place. First, when the government conducts a big auction to sell some ‘rights’ (such as in the telecommunications sector). Second, around deadlines for when tax payments are made to the government – this can be income tax, corporate tax, goods and services tax, and so on. Third, when the government disinvests from a public sector undertaking. In each case, funds get parked in government accounts with the Reserve Bank of India (RBI), followed by a liquidity crunch in the economy till the government has spent the amount collected in a phased manner. This is a recurring problem. 

When such kinds of liquidity deficits arise in the economy, the RBI intervenes. However, these will include some delays and costs (more on this later). Therefore, it is important to find a better solution. 

True and pseudo market failure

The conventional wisdom is that the functions of a central bank typically include issuing currency, acting as the lender of the last resort, maintaining macroeconomic stability, regulation of banking, managing foreign exchange reserves, maintaining a sound payments system, managing the public debt, and acting as a banker to the government (Mayes et al. 2019). 

In one important way however, this conventional wisdom has already changed over time. The management of public debt is being carried out – or being planned to be carried out – though a separate Public Debt Office (PDO) or Public Debt Management Agency (PDMA) outside of the central bank and the Ministry of Finance.The main reason for this proposal/action is to set aside the conflict of interest between setting the short-term interest rates using various tools of monetary policy and being a seller of government bonds – this arises when the central bank manages public debt and carries out its monetary policy. If the RBI tries to be an effective debt manager, it will sell bonds at very high prices, which will lower the interest rate and leads to an inflationary bias in monetary policy. However, managing public debt was something that could be done outside of the central bank. This was realised over time (see Smith (1936) for more on where to draw a line between what the central bank should and should not). 

There is one more way in which the conventional wisdom can be changed – related to the function of the RBI as the government’s banker. We never know when a macroeconomic or financial crisis (or near-crisis) emerges in the economy. It might just happen in the phase in which the RBI is occupied in dealing with the liquidity crunch owing to the aforementioned lumpy payments to the government. So, it is important that we change how we deal with these routine liquidity crunch so the RBI can stay focused on where it must act, and do so quickly. 

There are important and true market failures which require the RBI’s attention, such as a systemic bank run which would require the central bank to act as a lender of the last resort. In this case, there is really no alternative to the intervention by the RBI, and so it is critical that it looks after these functions. However, it is also important that the RBI keeps away from functions such as taking care of liquidity crunches that can be performed satisfactorily outside of the central banking system (Schwartz 1986). This can keep the RBI focused on true market failures, allowing it to stay away from taking care of pseudo market failures– which seem to be market failures but are not. 

Let there not be any confusion – it is well known that the central bank can and should act as the lender of last resort when the market fails to provide adequate liquidity (Bagehot 1873). However, we need to be careful in applying this principle as all cases of liquidity crunch need not be cases of genuine market failure. In the case of crunch caused by lumpy payments there may be no need for RBI to assume the role of the lender of last resort’ each time. Instead, the RBI can focus on its core activities and deal with true market failures. 

An alternative solution to deal with a liquidity crunch

At present, the RBI acts as the government’s banker, but consider an alternative. What if the government used some commercial bank like the State Bank of India (SBI), or even a well-capitalised and reputed private bank like HDFC Bank as its banker– and not just as an agent for collection of taxes and other payments? In fact, the government could use more than one good commercial bank as its banker and hedge the safety of its deposits. Deposits of the government with the RBI in this context would not be necessary (this is consistent with Smith (1936). 

If there is a need for extra safety, we can even have the status of a senior claimant for the government among the depositors – in the remotely possible event of a bankruptcy of a commercial bank. Such a status may seem unfair to the public, but we already have such a provision in our banking system, though it is implicit. At present, the government keeps its deposits with the RBI. If the latter runs into any difficulty, it can pay the government by simply issuing more money. This can be inflationary – in other words, there is an inflation tax on the public to ensure that the government gets paid by the RBI. All this implies that the government is, de facto, a senior claimant in its deposit holdings, even at present. 

The suggested solution can help avoid the liquidity crunch due to the bunching of large payments to the government. How? Under the present system, bunching of payments leads to a liquidity crunch in the commercial banking system as funds gets parked in the accounts of the government with the RBI. In contrast, under the proposed system, there will merely be a transfer of funds from private accounts to government accounts within the commercial banking network. Consequently, there will be no liquidity crunch within the commercial banking system despite lumpy payments being made to the government. 

It is true that many banks will lose deposits and only a few banks will gain deposits for a while under the proposed system. This can still mean a liquidity crunch for many banks. However, the liquidity-constrained banks can always borrow from the banks which have liquidity precisely at that time, and would indeed want to lend. In fact, the banks which act as the bankers to the government under the proposed policy can, ex-ante, sell a line of credit to other banks. When lumpy payments are made, other banks can invoke their line of credit, and borrow from the selected banks. The details of such arrangements can be left to the commercial banks (Goodfriend and King 1988). On some rare occasions, the inter-bank market might fail to smoothen the crunch despite an ex-ante line of credit arrangement. In such situations, of course, there would be a genuine market failure and the RBI will indeed need to intervene. But this is different from the more frequent interventions that stake claim to RBI’s capacity. 

There is a precedent to this in the past, the current account facility of the RBI was available not only to the government but also to some other institutions. This was eventually removed, when it was decided that quasi-government agencies should have a current account with only commercial banks, and not the RBI (Reserve Bank of India, 2001). The argument in this article is simply an extension of the argument previously made in 2001. In other words, the current account facility should not be used by the government, just as it is now not used by quasi-government agencies. 

Fluctuations in money

Under the present system, liquidity, as measured by the money in circulation with the public, shows significant fluctuations in its long-term growth. This is true whether we consider the narrow definition (which includes currency and demand deposits) or broad definition of money (which includes time deposits in addition to currency and demand deposits). One reason is that when lumpy payments are made to the government, the money supply falls, and when the government spends the funds eventually, the money in circulation gets restored. However, we can improve on this front with the proposed system. 

At present, the money held by the government in its accounts with the RBI is not included in the definition of money in circulation with the public. In the proposed system, money held by the government with the commercial banks will be included alongside money held by the public. 

If government deposits are included in the empirical definition of money, then the fluctuations in the quantum of money will be reduced. Once government funds are in the ambit of the commercial banks, the payments will be included in the accounting definition of money both before and after they are transferred to the government. Only the ownership and distribution of the bank deposits will change from the public to the government.  

Concluding remarks

There are some true market failures, and the central bank needs to play an important role in such cases. It is best that the central bank deals with these issues instead of being involved in dealing with the so-called liquidity crunch in the economy that arises due to lumpy payments to the government. That can be dealt with more simply if it is left to the commercial banking system. 

I suspect that the RBI or the government is unlikely to follow advice of the kind suggested here. However, the role of a research economist is to make an argument based on sound economics and persuade policymakers and the public – what the role of an economist is not, is to only dispense advice which is (immediately) acceptable to policymakers (Philbrook 1953). 

A version of this article first appeared in the PRIME Directory 2023.  The views expressed in this post are solely those of the authors, and do not necessarily reflect those of the I4I Editorial Board.

Note:

  1. Just as merchant banks or investment banks can manage the issue of equity or debt by a company, similarly a PDO or PDMA can manage the issue of debt by the government. Just as an investment bank can raise funds as a part of a market economy, similarly a PDO can perform its function within the parameters of a market economy by reaching out to the investors in the primary market. The genesis of the thinking on an independent debt management office can be traced back to the Committee on Capital Account Convertibility (1997) and the Review Group of Standing Committee on International Financial Standards & Codes (2004).  

Further Reading 

  • Bagehot, W (1873), Lombard Street - A Description of the Money Market (New and revised edition [1901] with notes by E. Johnstone), Kegan Paul, London. 
  • Mayes, DG, PL Siklos and J-E Sturm (eds.) (2019), The Oxford Handbook of the Economics of Central Banking, Oxford University Press. 
  • Philbrook, Clarence (1953), “‘Realism’ in Policy Espousal”, American Economic Review, 43(5): 846-859. 
  • Schwartz, A (1986), ‘Real and Pseudo-Financial Crises’, in F Capie and GE Wood (eds.), Financial Crises and World Banking Policy
  • Smith, VC (1936), The Rationale of Central Banking and the Free Banking Alternative, [1990], Liberty Press. Available here.

 

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