By Viral Acharya
No country can take growth for granted. Even taking account of the near infallibility of such a platitude, the continuing softness of India’s growth in the past few years has been extraordinarily humbling. There’s no shortage of proximate causes; one, however, that most agree on is that our financial sector hasn’t been healthy for most part of a decade.
As I explain in my recently released book on restoring financial stability in India, not only is the country not constantly engaged in securing the financial sector’s health to its macroeconomic shores with hoops of steel, it routinely jettisons it for myopic adjustments in government expenditures; the need for such adjustments is accentuated at specific points of the electoral cycle when economic growth must be postured as being high.
This is achieved by governments seeking concessions from financial regulators, notably RBI, in the form of (i) loose standards for bank regulation such as delayed recognition of loan losses to reduce the government recapitalisation bill for PSBs; (ii) easy monetary policy, ie low interest rates and high liquidity, to help with the rollover of government debts even when retail inflation risks loom large; (iii) overly favourable treatment for holding of government bonds by the financial sector relative to that for private sector financing; (iv) erosion of RBI’s balance sheet strength for dividend payouts.
Given the all-purpose nature of India’s central bank and the sky-rocketing nature of its fiscal deficit, such dominance of the RBI has become pervasive. I refer to this as “Fiscal dominance: A theory of everything in India”. Put simply, “phone banking” or behest lending has partly paved way for “phone central banking” as an all-encompassing arrow from the government’s quiver directed towards short-term growth stimulus with back-loaded macroeconomic misdirection.
Let me highlight three salient risks of a central bank’s policies being fiscally dominated.
First, the central bank is kept distracted away from achieving its long-term objectives of price stability and financial stability; in turn, runaway inflation and chronically weak bank lending create stagflation (stagnant growth and high inflation), occasionally spooking external sector investors, and worse, at times even bank depositors and market investors in the financial sector.
Second, the economy becomes more and more centralised as government’s balance sheet gets larger and larger, but that of the private sector shrinks as it is crowded out in borrowing markets. Now, the private sector – reduced in productive capacity and investment appetite – is distracted away from focussing on value creation and opts for rent extraction in the form of lobbying and hyperactive consulting with government and regulators.
Third, the government funding programmes become so large relative to domestic savings that interest rates in borrowing markets are determined increasingly by the supply of government paper. This renders the central bank’s interest rate setting process ineffective in reaching households and corporates; it primarily benefits the public exchequer. The presence of under-capitalised PSBs only makes this problem worse.
When India was a less open economy and the private sector – including the financial sector – was smaller, the central bank could uphold financial stability even in the face of fiscal dominance by engaging in high levels of financial repression, directing savings from PSBs to fund fiscal deficits.
Former RBI Governor YV Reddy observes wittily in my book’s foreword that the government, the central bank, and the PSBs behaved in the 70s and 80s like a “Hindu undivided family” where no one kept anyone’s proper accounts. Unsurprisingly, this was OK for attaining and maintaining the Hindu rate of growth of 3% (even that fell apart in the end). Such mediocrity of growth outcomes is not an option any more. India needs to build a fast growing economy that can meet the aspirations of its young demographics. This requires the private sector to thrive in both real and financial sectors; hence, financial stability needs to be safeguarded in tune with the liberalisation reforms that started in the 90s.
In the 70s Bollywood classic Deewaar, scriptwriters Salim-Javed have Vijay (Amitabh Bachchan) observe poignantly that “Haath ki lakeerein meetane se aadmi ki taqdeer to nahin badal jaati” (a man’s fortune doesn’t change just by destroying the creases on his palm). I observe with as much pathos that redrawing boundaries of fiscal and bank accounting won’t improve their fundamental health and prospects.
A system-wide correction is what is called for. One, government needs to commit to medium-term fiscal restraint, for example by appointing an independent bi-partisan fiscal council to improve budgetary assumptions and adherence to targets, and undertaking economically meaningful divestments. Two, RBI needs to put financial stability first and resist fiscal dominance, eg by adopting more rule based decision making and providing public reports on any rare exceptions, especially in bank regulation and supervision. The institutional design of flexible inflation targeting framework appears a useful one to carry over to other central bank policies. I provide in the book a more detailed plan to strike the right balance.
All this is especially germane now – in the midst of Covid outbreak – as the need to undertake essential government expenditures has risen, economy is in contraction, expected bank losses are mounting, and yet, we must not let all this evolve into a perfect storm in the near future. If we can restore fiscal and financial stability on a durable basis, the country can hopefully devote some serious effort in implementing the next set of structural reforms in land, labour and agriculture, all of which are now long overdue.