A theory of fiscal dominance in India

Dr Viral Acharya, Deputy Governor of RBI from 2017 to 2019 has brought out the speeches and monetary policy minutes that he had delivered while in service in a book “Quest for restoring financial stability “ with a freshly written preface titled ‘Fiscal Dominance—a Theory of Everything in India’.

The essential theme is that fiscal dominance over monetary and financial sector policies leads to sub-optimal public policy outcomes. While normally fiscal dominance refers to relatively large fiscal deficit (especially revenue deficit) to GDP ratios impacting monetary policy, Viral Acharya argues that fiscal dominance provides the basis for a “theory of everything” that impacts financial stability in the domain of the Central bank. These include banking regulation, debt management, timely disclosures of defaults, market regulation, capital flow measures and Central bank profit transfer.

Solutions offered by him are based on his firm conviction that the Central bank must at all times ensure that financial stability is not compromised, especially in the face of imminent government pressures driven by a shorter time horizon. As a banking regulator, the Central bank has to ensure the safety of bank deposits and as a monetary authority, price stability and managing the currency’s excessive volatility are part of its long-term mandate.

His arguments of how fiscal dominance works in all areas of the Central bank’s mandate are as under

• Bank recapitalisation and regulation. Government is the dominant owner of public sector banks in India that account for 63 per cent of deposits of the banking system.  Prudential regulatory norms required for financial stability, if applied as they ought to be, will lead to a huge need for the government to recapitalise the banks and this would put stress on the fiscal deficit. Hence there is pressure from the government for regulatory forbearance, not only for public sector banks but also for private sector banks - as the prudential norms are ownership neutral.
• Timely disclosure of defaults improves market discipline and helps rating agencies provide more accurate credit assessments. In spite of a clear recommendation by an independent committee and earnest efforts of the securities market regulator, there was resistance to providing information on one day bank loan defaults to markets presumably because downward rating migrations would imply larger provisions and more demands on the budget for recapitalisation and pressure on the fisc.
• In the case of the monetary policy, rate cuts result in treasury gains and are pushed for by the Government as this leads to a reduced amount of bank recapitalisation needs and lower cost of rolling over government debt. Likewise, rate hikes are resisted as this would imply larger provisions for fixed income securities and a consequential impact on capital. “In fact, once sufficiently fiscally dominated, the liquidity policy can control most of the government bond yield curve and prices, rendering the rate-setting process of monetary policy authority effectively irrelevant.”
• On market regulation, the mark-to-market accounting treatment of government bonds by the Central bank is nudged for being set as asymmetric: treasury gains are transferred for the most part as soon as bond prices rally; in striking contrast, treasury losses are allowed to be recognised over several quarters. The end result is another form of deep interference of fiscal deficit pressures on the accounting treatment of banking balance sheets. “Public sector banks and other government-owned entities in the financial sector can be, and are, required—through moral suasion—to buy up entire issue amounts in individual auctions at above-market prices. “
• Capital flows measures are required to ensure that sudden stops and sudden outflows do not disrupt the forex markets and threaten financial stability. Hence, these measures must be calibrated as a long-run strategy that is fine-tuned in relation to the stock of foreign exchange reserves that the Central bank has—and is likely to be able to maintain—on its balance sheet to defend the currency against sudden outflows. As government dissaving in India has in recent years exceeded the net savings of the rest of the economy, it is increasingly reliant on external finance to fund its deficits. Thus, there is a pressure to relax controls over capital inflows to meet the shorter term objective of financing government borrowing and this can go counter to financial stability.
• Central bank balance sheet. The demands made on the Central bank to transfer what are considered excess reserves in its balance sheet to the Government is driven by the fiscal imperative. “Given India’s external sector vulnerabilities, it is paramount that the Central bank balance sheet be perched on the highest hill: it should remain untouched and unperturbed in the midst of almost any macroeconomic storm.” The erosion of the Central bank capital to pay dividends leads to increasing compromise of the severity of stress scenarios it can withstand in future, especially when the sovereign rating is not of the highest quality.

Since the reform process started in mid 90s, the author notes that progressive steps limiting fiscal dominance were undertaken in an economic environment of consolidating government debt and fiscal deficit trajectories, high economic growth, and a rise in household financial savings. But he laments that fiscal dominance has once again taken hold of the Indian economy as these conducive factors have gradually reversed.

The COVID-related lockdown has likely added and will continue to add to the already big pile of NPAs of banks.

The solutions Viral Acharya offers are many and policy makers would do well to have a closer look at the fairly long list provided in the various chapters of the book. These range from principles for Central bank governance and appointments, upholding Basel capital and liquidity norms in letter and spirit, forbearances if at all to be subject to a ‘sunset clause’ of no longer than six months, strong PCA framework, timely default disclosure for even one-day, setting up of a Public Credit Registry, annual Asset Quality Review for banks and NBFCs, resolution of large NPAs and so on.

In the current scenario, the COVID-related lockdown has likely added and will continue to add to the already big pile of NPAs of banks. There is growing pressure for regulatory forbearance and restructuring. It is extremely important that credit support is provided for resuming operations and economic activity. But given the legacy problems so eloquently brought out by Dr Acharya, there is a need to pay attention to the package of measures that are recommended to deal with the NPA problem while dealing with the current COVID induced scenario.  “Kicking the can down the road” can seriously threaten financial stability.

Anyone who has heard or read Viral Acharya’s speeches/submissions will acknowledge that these are very well researched and his arguments are based on solid analysis. The preface weaves in the academic research and practical experience in each of the chapters in the book to bring out in a masterly style the different aspects of the inter linkages between the fisc, monetary policy and financial stability. At the same time, his commitment and passion come through the erudite intellectual discourse.

At times, to drive home his point, there is a tendency to make some sweeping generalisations.  For example, while growth considerations may have compelled pressure on RBI to lower rates, to attribute it to enabling treasury gains in banks to reduce the pressure on the fisc to recapitalise is a bit far-fetched. Similarly, one may have a difference of opinion on some of the arguments relating to debt management or market regulation. Nevertheless, there is no doubt that he has touched the core issues involved in the relationship between the Central bank and the government that can threaten financial stability and these do need to be heeded.

The book is extremely readable and a must for students of finance and banking, academics, market participants, policy makers and the informed citizen. 

(The writer is a former deputy governor of the Reserve Bank of India)