Why Centre can’t make cash transfers to households amid Covid, explains Viral Acharya

SUNNY VERMA: In recent years, the faith and trust of people in the Indian banking system have been shaken to a great extent. What is the way out?
There are two ways to create this trust. One, you have a blanket deposit insurance, which is that no matter how large the deposits are, there is some government agency which is backing it up. Government resources are limited and so deposit insurance is not up to the highest possible level. And second, therefore, to substitute for public depositing insurance, you have to create a private deposit insurance. This is actually creating large amounts of equity capital in the bank so that the loss absorption capacity is tremendous. The onus on the regulator, therefore, is to maintain very high levels of bank capital at all points.

What the world is learning over a period of time is that you need three mechanisms in place at once. You require a certain amount of deposit insurance provided by the country, but because of funding constraints, that is not possible 100%. Second, you need adequate levels of bank capital, and the global best practice here after the global financial crisis is that you have to do a stress test. You have to visualise: can the bridge withstand cyclonic levels of wind or collapse. The same way, you have to visualise what kind of macro-economic stress, sectoral stress or asset-quality stress can arise and can banks withstand it. You need to shore up the capital levels high enough so that the stresses can be handled without damaging the entire construction.

And third, despite these measures, if the losses still arise, you need to respond to the deterioration of the bank balance sheet ahead of depositors actually showing up and asking for their money. So, the regulator has to act preemptively to put the bank into what one can consider as sort of repair. This may involve selling the bank to a new set of equity owners who can bring in the capital, it may require changing the management of the bank, it may require putting restrictions on the ability of the bank to lend until certain underwriting and risk-management practices are put in place.

GEORGE MATHEW: The conflict between the government and the Reserve Bank of India also seems to be growing. Why is that?
What I am trying to explain in the book too is that there is actually a very deep reason as to why this conflict is rising. The reason is that the government has not stuck to its fiscal targets. They are trying to do too much in the short run. They want to take on more and more revenue expenditures of various types without first putting the economy on a sustainably high growth rate path. Given the nature of our political cycle, some election or the other is always around the corner, and then there is a desire in the entire administration to start showing high growth numbers in one way or the other. So we set ourselves these short-term targets instead of building structurally an economy that is going to be right for the next decade. What happens then is that if you have had a growth slowdown, then it becomes even more imperative that you focus on the structural and transformational changes because that will arrest the growth slide.

Those measures are hard, they require clarity of thinking, they require a little bit of conviction, and they require some political capital to be pushed through. But instead, there starts this movement where everyone wants to turn to the central bank to solve their problems by accommodating all kinds of requests. There is request for coercively monetising the debt for dividend or deficit monetisation. And, at the other end, they want to simply relax bank capital requirement because they want public sector banks to lend and create short-term boosts to growth, what I call as credit-led stimulus. It is very expedient to turn to the central bank all the time to accommodate what are in my view deeper fiscal and structural issues.

I think the way out is a two-pronged attack. First, we have to get the fiscal house, the fiscal debt back in order. We have been slipping even in normal years… You have to demonstrate adherence to targets in a true economic sense. I think we now need institutional reforms to make this happen. And second, we really need to invest in financial stability in a long-term sense.

There is always a tendency to want to turn to the central bank and relax rules it has in place for financial stability. I think this is the primary reason why conflicts are arising. The central bank which is trying to do its job for fulfilling long-term objectives is then constantly getting pulled to fulfill short-term demands, which is not always in the long-run interest of the economy.

HARISH DAMODARAN: You have been emphasising a lot on fiscal dominance and how it is constraining the autonomy of central banks etc. But look at what is happening in the world. The rich economies are talking of some four trillion dollars, five trillion dollars… Every central bank is being asked to monetise the government’s deficits. There is so much liquidity but no inflation. So, what is happening?
There are three aspects to it. First, these are countries that have grown well for long stretches of time. Their per capita income is very, very high. Second, from a legal, institutional and financial infrastructure sense, these are developed markets. They have an automatic stabiliser, which is that when events such as the global financial crisis and Covid-type shocks arise, the world’s savings have a tendency to migrate towards these hard currencies. I think we need to distinguish these countries from emerging markets which have not grown in a robust way for long periods of time.

And third, I would say that they are not hard currencies in the sense that while each individual country might not necessarily have defaulted, over a period of time, countries that have these characteristics have a tendency to not repay the foreign creditors and want to save the taxes for domestic expenditures. So there is a reason why investors worry about these kinds of situations arising that have punctuated the histories of these countries over a period of time. Now, there is a sense that India has never defaulted. But we were very close to having a serious balance of payments crisis in the early ’90s and assistance from the International Monetary Fund helped us tide over it. So this difference has to be kept in mind.

P VAIDYANATHAN IYER: As the pandemic continues, the fiscal assistance for the distressed by the RBI and Government of India has been marginal. Our own calculation suggests that it is not more than 1-1.2% of the GDP. Also, much of what has been done remains on the monetary side, through liquidity infusions etc. Do you think our response could have been better?
It’s not an easy situation for any of the policymakers. It is a very large, unprecedented shock. Battles are being fought not just on the macro-economic front, but also on the health front… There are a few points. Why was our initial condition such that we did not have much fiscal buffers left? We need to have a conversation, a debate about that point. We have kept slipping in normal times. And not only have we slipped on the Fiscal Responsibility and Budget Management (FRBM) targets in the sense of the official deficits, but if you look at the real deficit, or the unofficial deficit, the full public sector borrowing requirement, we have actually slipped by much more. We get borrowings done through public sector enterprises, we have debts which are secured, for instance, for the Food Corporation of India through small savings schemes. Many of these are extra-budgetary borrowings which are not even fully recognised in our Budget. So actually the true fiscal slippage was far worse than what has been acknowledged in an official sense. This has clearly constrained the policy space for response and once again the central bank has ended up doing the heavy lifting, having cut rates and injecting massive pools of liquidity, even at a time when the inflation in the country is actually high.

…Also, while it is not on the table, I think we need an independent fiscal council that holds a mirror to the government on its expenditures and that vets every budget before it is announced. A lot of our budgets seem to show adherence to FRBM norms simply through two things — extraordinary growth assumptions and this category called disinvestment which is just a residual category. Whatever is the hole in the budget, they are going to put that number into the disinvestment category. We need these practices to be better.

RAVISH TIWARI: Could the RBI’s communication with the government have been better, like, in the recent years, if those at the helm, including you and Urjit Patel, had built allies in the government system?
Criticism is most welcome and there are things that could be done differently… To everyone who says we do not know how to work tactfully, we do not know how to communicate, we did not build allies, we did not bring everyone on board, my question is when things were being done in that manner, do you have evidence to show me that the next 10 years of India’s growth were great? And I am fundamentally questioning the thesis that when the central bank toed the line, and the way to do things was to strike backdoor compromises, the way to move forward was to agree to relaxations, recognising that there were political short-term pressures, in my view, we are paying the cost of that right now.

Why are we not able to take the necessary expenditures and transfers that perhaps need to be made to households in the midst of Covid, is because we have not had an open debate about the fiscal situation of the country. A number gets announced as the real deficit and everyone is happy… everyone in the system says oh how can we question the real official statistics of the government. But when they are not right, they are not right. I want to fundamentally disagree with the thesis that those who agree have been able to pave a better outcome for the country.

RAVISH TIWARI: Raghuram Rajan, Arvind Panagariya, Arvind Subramanian, Viral Acharya and Urjit Patel are competent professionals who could not find the value for their time and effort in the Indian system. How would you describe your experience and would you still advise your peers to work in this system?
We should not interpret exits as a problem. In my view, we should interpret exits as a form of voice, as a form of dissent that the system requires to have the right public debates and get to the right path… In my view, the government and the bureaucracy are stuck in the old mode of functioning, even though the Indian economy is no longer a nationalised era economy. They are regressing… they need to embrace a more market-based economy.

I encouraged everyone who contacted me to apply for the deputy governor’s position when I left.

ANIL SASI: If you zoom out and look at the government-central bank relationship, there also seems to be a symbiotic relationship there. Governments periodically run large revenue deficits, with the central bank subscribing to its bonds in open market, getting interest on it, which becomes its profit or surplus, and then there is pressure from the government to get that back as dividend. Is this a vicious cycle and is the government winning in how the relationship is panning out now?
The central bank balance sheet should be viewed in a consolidated manner with the government balance sheet. This is because the central bank’s profit at some point or the other is ultimately going to go back to the government. So, when the government is trying to get more out of the central bank, all that it is doing is trying to move forward, what is going to come to it later…

…The main difference between deficit financing and market borrowing is that no signals will be generated about at what cost you are borrowing this in the market. Because the central bank is essentially doing it as an off-market transaction or buying these bonds from the government. In my view, the desire for the central bank balance sheet comes essentially from this myopia and wanting to say that we are meeting short-term targets. But ultimately this is the consolidated debt of the public exchequer. Whatever deficit you have incurred, whether it is funded by the central bank or the markets, it is the debt of the public exchequer. And you get some temporary benefit because the cost of borrowing is not at the market rates. But if precisely because you are not borrowing at market rates, the market discipline is lost, and the debt sustainability actually starts slipping, ultimately you could have a bigger long-term problem on your hand even though you kept your short-term borrowing cost to be fine.

This is the essence of why the central bank is supposed to be independent, why deficit monetisation is not always favoured, why the FRBM Act of 2003 explicitly prevented the RBI from buying the ad-hoc treasury bills directly in the primary market. These things are not getting enough attention.