So is this a free lunch for the government?
“RBI direct financing is sometimes called money printing and is thought to be free,” but Rajan says this is “misleading.” The reason is because the government finances itself from RBI, while RBI finances itself from banks at a reverse repo rate of 3.75%.
This represents a loss to the government in two ways: first, a reduction in the annual dividend that RBI pays the government. Second, banks get 3.75% instead of the 6% they could get by buying government bonds directly. And since the government owns 70% of the banking sector, its dividends from public sector banks also decrease proportionally.
Will it fuel inflation?
Such direct financing “is not inflationary per se”, as long as banks are reluctant to lend more to companies or consumers. However, Rajan points out that as normal times return, RBI will have to pay a higher rate for excess reserves, or sell its government bond holdings and extinguish excess reserves, otherwise it will risk excessive credit expansion and inflation.
Rajan says that if the fiscal deficit and public debt growth are deemed unsustainable, “investors and rating agencies will be scared.” Therefore, he calls for measures that guarantee “we will return to fiscal health in the medium term.”