Fiscal dominance over monetary policy

The Reserve Bank of India (RBI) Governor, Dr D. Subbarao, while addressing the Second International Research Conference (SIRC) organised by the RBI on February 1, raised concerns on the ‘new trilemma' — price stability, financial stability and sovereign debt sustainability. In this context he has raised a pertinent question, “Are we seeing a return of fiscal dominance of monetary policy?'' In the Indian context, the answer is ‘yes'.

This article, while analysing the contributory factors to fiscal dominance of monetary policy, also sets out a few policy options.

Contributory Factors

Large revenue deficit: The Fiscal Responsibility and Budget Management (FRBM) Act has lost its relevance as the revenue deficit is not showing any signs of containment. As a result, borrowings are being resorted to, resulting in a higher fiscal deficit.

This is clearly evident in the fiscal position during the first nine months of the current fiscal, as reported by the data released by Controller General of Accounts (CGA). There has been an overshooting of revenue deficit (93 per cent of budget estimates) and fiscal deficit (92 per cent). These levels were substantially higher than the mid-year FRBM benchmarks of 45 per cent of Budget estimates.

There has been a large recourse to market borrowings (the budgeted net amount was increased by Rs 92,872 crore, first by Rs. 52,872 crore, and subsequently by Rs. 40,000 crore) in the event of negative net collections from the small savings schemes.

The budgeted target of key deficit indicators will definitely not be adhered to and there will be a substantially higher fiscal deficit, questioning the letter and spirit of the FRBM Act.

RBI financing of fiscal deficit: A substantial upward revision of market borrowings from the budgeted level was not adequate to finance increased levels of fiscal deficit. Accordingly, there has been unabated recourse to Ways and Means Advances (WMA) from RBI at higher levels. Under the FRBM Act beginning April 2006, RBI was prohibited from participating in the primary market auction for market borrowing.

In order to smoothen the transition, the WMA limits were enhanced for that fiscal. It is unfortunate that what should have been a one-time relaxation, however, emerged as a permanent feature. As per the latest available data in the public domain on January 20, 2012, RBI's accommodation was Rs. 16,177 crore, which could have included Rs. 6,117 crore of overdraft from RBI, besides WMA of Rs. 10,000 crore, unless the WMA limits have been revised otherwise.

WMA, which is meant to be used for temporary mismatch in the receipts and expenditure of the government, has been used as a resource. This leads to monetisation of the fiscal deficit.

Market borrowing and Open Market Operations (OMO): It has been decided that there would be simultaneous market borrowing (Rs. 13,000 crore) and OMOs (Rs. 10,000 crore) on February 3, 2012. On the face of it, this action could be justified in the present liquidity deficit situation. However, this development reflects fiscal dominance over monetary policy.

As the Governor, in his speech, has aptly remarked, “Central banks do, of course, resort to open market operations (OMOs) — buying and selling government paper — for purposes of liquidity management.

But if the motivation for the OMO is to help out a fiscally vulnerable sovereign or to reduce the cost of borrowing for the sovereign, central banks could end up holding price stability hostage to sovereign debt concerns”.

From this, it could be concluded that fiscal dominance of monetary policy has resurfaced in the Indian context.

It was expected that with the abolition of the instrument of ad hoc Treasury Bills and implementation of FRBM Act, there could be relief from fiscal dominance of monetary policy. But recent trends showed contrary evidence. There is an urgent need to free monetary policy from fiscal dominance to ensure price stability, financial stability and sovereign debt sustainability.

POLICY OPTIONS

How does one get rid of the fiscal dominance of monetary policy? It is certainly a difficult task as democracy has a built-in fiscal deficit bias. However, as the Governor has rightly observed: There is an inflexion point beyond which fiscal deficits militate against growth. Government borrowing is not bad per se , but excessive borrowing is. Thus, the following policy options could be considered in the forthcoming budget of the central government.

First, cap the total public debt as a proportion of GDP, including a cap on net market borrowing of the government.

Second, revisit the public account borrowing, particularly, small savings.

Third, the revised FRBM Act may include the quality of public expenditure. To quote the RBI Governor: “If the government borrows and squanders that money away on unproductive current expenditure, both fiscal sustainability and growth would be jeopardised.

Governments need to spend on merit goods and public goods, in particular on improving human and social capital and on physical infrastructure.”

Fourth, the RBI and central government may consider appointing a working group under the institutional framework of Cash and Debt Management Committee to review the entire WMA System.

(The author is Professor and Dean at the Institute of Management Technology, Hyderabad.)