It is paramount that the central bank’s balance sheet should be perched on the highest hill.

--BY SUJIT MUNDUL

There is a long-standing debate if fiscal dominance is more important than fiscal stability in the emerging economies.  I will make an attempt to appreciate this issue with reference to India, as a leading economy not only in the SAARC region but also globally.  Readers will make their own conclusions whilst drawing parallels with Nepal’s financial eco-system and the economy as a whole, despite its smaller size.

Fiscal dominance normally refers to a relatively large fiscal deficit, especially revenue deficit-to-GDP ratio, directly impacting the country’s monetary policy. Dr Viral Acharya, the CV Starr Professor of Economics at New York University’s Stern School of Business and ex-deputy governor of RBI, considers that fiscal dominance provides the basis for a “theory of everything” that impacts financial stability in the domain of the Central Bank.

This, inter alia, includes banking regulations, debt management, market regulation, timely disclosure of defaults, capital flow measures, and profit transfers of Central Banks.

It is to be remembered that the solutions offered by renowned economists including Dr Acharya that the central bank should play a pivotal role, at all times, in ensuring that the financial stability of the economy is not compromised, in the face of imminent government pressure driven by a shorter time frame.  However, in order to alleviate the fallouts of Covid-19 which has given rise to a situation whereby the central government perforce has to spend money well beyond the estimates.This may not necessarily be impacting the fiscal stability in the nearer term, but may take a much longer time for correction.

Nevertheless, the central bank has to ensure the safety of bank deposits.  Also as a monetary authority, they need to manage price stability and the currency’s excessive volatility.  These are imperatives.

Following are the areas which Dr Acharya has pointed out where and how fiscal dominance comes into operation in the Indian financial sector and the economy as a whole.

Re-capitalisation of banks, mainly public sector banks (PSBs), and regulating them is one of the major responsibilities of the central bank.  In the Indian context, the underlying reason being the major ownership of PSBs is with the central government. PSBs account for almost 63 percent of deposits of the banking system.

Prudential regulatory norms required for financial stability as they should be, will absorb a massive amount of money by way of re-capitalisation of the PSBs.  This will obviously lead to a stress on the fiscal deficit.  As a result of this, government will seek regulatory forbearance, not only for the PSBs but also for the private sector banks as the prudential norms are applicable to all the commercial banks.

It can be clearly mentioned that timely disclosures of defaults improve market discipline and assist the rating agencies in more accurate risk assessments.  The Indian scenario is that despite a clear recommendation from an independent committee and serious efforts of the securities market, there has been resistance to providing information on one-day bank loan defaults, probably due to the fact that availability of such information may cause a down gradation of the ratings leading to the requirement of larger provisions and higher capital requirement.  This is an imperative for clearing the “financial mess”.

Another important issue is market regulation.  The accounting treatment of government bonds by the central bank is somewhat confusing in that the treasury gains are transferred for the most part as soon as bond prices rally, whilst treasury losses are allowed to be recognised over several quarters.  This accounting treatment creates an undue pressure on fiscal deficit through the distortion of banking balance sheets.  Dr Acharya has suggested that “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 the above – market prices”.

Effective rate management is another important aspect in the monetary policy formulation.  Rate cuts result in treasury gains and governments are encouraged to push for this as it would reduce the quantum of re-capitalisation needs and lower the cost of rolling over government debts when rate hikes take place, the efforts would be the opposite.

Measured capital flows are required to ensure that sudden stops and outflows do not disrupt the forex markets and threaten financial stability.  These measures must be calibrated as a long term strategy that is honed in relation to the forex reserves of the country.  The central bank should be in a position to maintain on its balance sheet adequate forex to defend the currency against sudden outflows.

In India as government dissaving has in the recent years exceeded the net savings of the rest of the economy, it has become more reliant on external funding to finance its deficits.  This obviously creates a pressure to relax controls on capital-flows for meeting the short-term financing needs of the government, thus hurting the fiscal stability.

Effects on central banks’ (in this case RBI’s) balance sheet could be observed from the demands made by the central government to transfer what are considered excess reserves in its balance sheet, the government is driven by the fiscal imperative.  Dr Acharya in his recent publication argues that, “Given India’s external sector  vulnerabilities, it is paramount that the central bank balance sheet should be perched on the highest hill; it should remain untouched and unperturbed in the midst of almost any macro-economic storm”.  It is a time-tested fact that the erosion of the central bank’s capital to pay dividends leads to increasing compromise of the severity of stress scenarios it can withstand in future, especially when the sovereign rating of the country is not of the highest quality.

Another important point is that in the current times, the major global economies are limping and will take at least a couple of years to get back some rhythm towards recovery.  The Indian economy is no exception.  Covid related lockdowns have added to the already big pile of non-performing assets (NPAs) of banks and financial institutions including the private sector.  There is growing pressure for regulatory forbearance and restructuring.  Although it is extremely important that credit support, rather credit transmission is provided for resuming operations and economic activity, there is a need to pay attention to the stimulus announced to deal with the already heavy NPA problem while dealing with the Covid-induced scenario, otherwise the country’s financial stability may be threatened seriously.

The above observations about the Indian economy in the current situation may be helpful to some extent for other emerging markets, especially in the SAARC region.

Mundul is Former Director of Standard Chartered Bank Nepal Limited.