The critics of the Reserve Bank of India’s (RBI) monetary policy fall in two camps. One camp casts monetary policy as powerless while the other side vests it with omnipotent powers. Needless to say, both the camps get it only partly right. The missing piece is the fiscal dominance of monetary policy.
In economics, fiscal dominance has a specific connotation and it may seem odd to talk about it when the key macro indicators are within bounds. CPI inflation has averaged less than 4 per cent over last four years and general government deficit has fallen by nearly 1 per cent of GDP over last six years. With the RBI barred from directly funding the government’s fiscal deficit, textbook conditions for fiscal dominance are not present. However, I argue that fiscal dominance is hidden but pervasive in India and has affected institutional design, regulatory choices and market development. Thus, indirectly, fiscal policy has constrained the role of monetary policy in India.
India’s fiscal deficits and debt/GDP remain large and could be understated. In recent years, the central government has been able to shift some spending off Budget by tapping small savings funds, guaranteeing PSU bonds and issuing recapitalisation bonds. Similarly, states’ fiscal management has also become profligate and opaque. Properly accounted ‘true’ general government deficits may be closer to 7.0-7.5 per cent of GDP, rather than the ‘official’ 6 per cent over the last three years. One can say an optical illusion or ‘maya’ of fiscal consolidation has been built up even as the reality is different. Investors, analysts, rating agencies, the government and the RBI all have been participants in this illusion.
Once we realise that fiscal dominance is indeed a reality, then the question is how to mitigate the problem. The answer is to think in terms of institutional and process improvements to ensure a sustainable solution. The government and the RBI will both have to strike a bargain to come up with improvements. Since the problem originates in government finances it is up to the government to take the first step. The FRBM Act has been rendered toothless and even the new debt and deficit rules drawn as per the FRBM committee recommendations don’t inspire confidence. I propose three steps to effect structural changes to the fiscal consolidation process.
The first is the creation of a Fiscal Council as recommended by the FRBM committee. This would be an independent body akin to the Congressional Budget Office in the US and the Office for Budget Responsibility in the UK. Crucially, in India, the Fiscal Council should be set up as an adjunct of the Comptroller and Auditor General and made accountable solely to Parliament. The council should be tasked with evaluating the central government’s Budget proposals and to issue quarterly fiscal evaluations. This will bring some rigour and credibility to the budgeting process and its analysis. The council should also be made to draw five-year and 10-year fiscal sustainability projections at least once a year. Such projections should also be made whenever the government announces any large spending proposals (for instance: Food Security Act, Ayushman Bharat) or tax proposals. The Council can serve as an independent sounding board for the government, Parliament, the RBI and other stakeholders to analyse and debate fiscal issues. The council should be staffed with experts in public policy. Once the council is well established it can also be tasked with evaluating fiscal positions of the states by creating regional offshoots.
The second is the adoption of a ‘deficit neutral’ rule by the government. This will prevent the government from committing to any new spending or tax cut proposal unless it is deficit neutral, whenever fiscal deficit is above the FRBM mandated long-term target. That is, when the deficit is above the target, the government of the day voluntarily accepts to find matching spending cuts or revenue sources before announcing any new outlay. To make the rule reasonable it can be made binding only above a certain threshold, say 0.1 per cent of GDP. Such a rule would be akin to the ‘PAYGO’ rule that has been in vogue in the US since the nineties. Committing to such a constraint would improve the credibility of the fiscal targets. It would also check the propensity of political parties to promise new entitlements or announce farm loan waivers. Further this rule will incentivise governments to pursue counter-cyclical fiscal policy during booms.
Lastly, at the time of presenting the Budget the government should propose a ceiling on market borrowings for the year. This would be a variant of the debt ceiling which is in vogue in some countries. By doing so, the government would send a signal to the financial markets that the borrowing schedule is sacrosanct. In case of major fiscal deviations and recourse to extra borrowings, it will be incumbent on the government to take Parliament approval before approaching the market.
Taken together, these changes amount to placing significant restrictions on the government. But these changes embody the spirit of India’s fiscal legislation, which, after all, is a self-imposed restriction on the sovereign. Should the government, after bipartisan consultations, carry out these changes, it would be incumbent on the RBI to reciprocate with substantive reforms of its own. These could include stripping away debt management from the RBI, a roadmap for deep SLR cuts and greater transparency about its bond holdings. The groundwork for some of these reforms is already in place.
When the government and the RBI agreed to inflation targeting, the implicit deal was to chip away at the fiscal dominance of monetary policy. To achieve that, it is important to focus on institutional design and process improvements in addition to numerical targets. Such improvements would speed up the journey towards a credible and sustainable fiscal situation and a smaller footprint of the government in the bond market. This will go a long way in tempering the fiscal dominance of the monetary policy and the banking sector and make monetary policy truly effective.
The author is head, fixed income research, ICICI Securities PD
via Time to improve the fiscal architecture | Business Standard Column