Y V Reddy: Fiscal policy and economic reforms
Address by Dr Y V Reddy, Governor of the Reserve Bank of India, at the National Institute of
Public Finance and Policy (NIPFP), New Delhi, 26 May 2008 (edited transcript).
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Respected Professor Govinda Rao and distinguished scholars,
I am honoured by my friend, Prof. Govinda Rao's, kind invitation to me to visit the National
Institute of Public Finance and Policy (NIPFP). I had the opportunity of working very closely
with the NIPFP on several occasions. Apart from my personal affinity to the NIPFP, there is a
close relationship between the Reserve Bank of India (RBI) and the NIPFP, from an
institutional point of view also. For instance, Prof. Govinda Rao is a Member of the Southern
Local Board of RBI.
Initially, I thought of speaking on fiscal policy and economic reforms from a central banker's
perspective. I realised later that while I have been working as a central banker over the last
one decade, I had worked for most parts of the three decades prior to that in the Ministry of
Finance, in the Government of India as well as in the Government of Andhra Pradesh. So it
was a difficult choice for me as to whether I should give a fiscal view of the monetary policy
or a monetary view of the fiscal policy. I have worked for a short period in the World Bank,
which gives a global governments' view and also in the IMF, which gives a global monetary
authority's view. As a via-media, I have opted to give a practitioner's perspective of fiscal
policy, and economic reforms.
India's fiscal situation: a brief prelude
Broadly, during the first 30 years of independence, between 1950 and 1980, the fiscal
deficits of both the central and the state governments were not excessive. This was a period
of revenue surplus in general. However, automatic monetisation of government deficit by the
RBI, which started as an exception during the mid 1950s, became a regular practice
thereafter. Simultaneously, there was also a distinct shift in the management of the financial
sector with the nationalisation of major commercial banks in 1969 and 1980. These two
developments had a significant bearing on the relationship between the monetary authority
(RBI) and the fiscal authority (Government).
There was a significant deterioration in the fiscal situation in the 1980s, accompanied by
large and automatic monetisation of government deficits. The process involved issue of
adhoc Treasury bills at rates initially on par with 91-day Treasury Bills. Since July 1974, the
adhoc Treasury bills were offered at off-market discount rate of 4.6 per cent which was less
than half of the prevailing market rates. There were two immediate consequences. One,
when large government deficits were monetised, there was excess liquidity in the system,
which prompted the monetary authorities to increase the cash reserve ratio (CRR) for banks
at regular intervals with a view to mop up the excess liquidity. Two, to facilitate the central
government to borrow comfortably, the monetary authority, which is also the debt manager
for the government, periodically increased the statutory liquidity ratio (SLR) to be maintained
by banks. This process went on to an extent that CRR and SLR, together, pre-empted more
than 50 per cent of banking sector liabilities, for a period. In other words, more than 50 per
cent of the resources of the banking sector were pre-empted to primarily finance the budget
deficits of the governments. Further, the deposit and lending rates of banks were, for most
part, administered. This situation impacted the health of the banking system and the
consequential adjustments during the banking sector reform process were, naturally,
somewhat complex.
The large fiscal deficit and its monetisation had some spill-over effect on the external sector,
which reflected in the widening current account deficit in the late 1980s and early 1990s.
Triggered by the balance of payments crisis in the early 1990s, when our foreign currency
assets depleted rapidly to the extent that it could barely finance just two weeks of imports, we
started the reform process in 1991-92. A credible macroeconomic structural and stabilisation
programme encompassing trade, industry, foreign investment, exchange rate, public finance
and financial sector was put in place, which created an environment that was conducive for
the expansion of trade and investment. Simultaneously, several reform measures towards
the marketisation of government borrowings were initiated.
At the instance of Dr. Rangarajan, one of my illustrious predecessors as Governor, the RBI
entered into the first agreement with the government in 1994 to place a limit on automatic
monetisation. The First Supplemental Agreement between the RBI and the Government of
India was signed in 1994 setting out a system of limits for creation of ad hoc treasury bills
during the three-year period ending 1996-97. Then in 1997, soon after I moved to the RBI,
the second agreement with the government was signed, where Mr. Montek Singh Ahluwalia
represented the government. In pursuance of this Second Supplemental Agreement between
the RBI and the Government of India on March 6, 1997, the ad hoc Treasury Bills were
completely phased out from April 1997, replaced by a scheme of Ways and Means
Advances, subject to limits. In order to smoothen the transition, the Government of India was
allowed to incur also an overdraft, but at an interest rate higher than the rate applicable for
Ways and Means Advances (WMA). With effect from April 1, 1999 these overdrafts were
allowed only for a maximum of ten working days. These features placed the Central
Government on par with the State governments which were brought under an "Overdraft
Regulation Scheme" since 1985. Furthermore, it was agreed that the RBI would trigger fresh
floatation of Government securities whenever 75 per cent of the WMA limit was reached. It
was also agreed that the government's surplus cash balances with the RBI, beyond an
agreed level, would be invested by it in government securities. While the transition to a
fullfledged WMA and overdraft mechanism was gradual, non-disruptive and consensual, the
successful implementation of this mechanism made it possible to incorporate some of these
practices into a law - the Fiscal Responsibility and Budget Management Act (FRBM Act). It is
noteworthy that this law also practically prohibited RBI from participating in primary issues of
all government securities.
As a result of the concerted efforts to restore fiscal balance through tax reforms, expenditure
management, institutional reforms and financial sector reforms in the first half of the 1990s,
there was significant reduction in the magnitude of fiscal deficit and the proportion of debt
relative to GDP during the period 1991 to 1997. However, during the period 1997 to 2003,
there was a reversal in the trend of fiscal consolidation, and the cumulative impact of
industrial slowdown, fifth pay commission award, and a lower than expected revenue
buoyancy culminated in fiscal deterioration. This deterioration in the Indian fiscal position
happened at an inopportune time when there was fiscal improvement the world over and
India was trying to globalize. It is important to remember that India's fiscal situation has been
significantly divergent from the global fiscal situation and continues to be so even now. I
think, this is the background we have to keep in view whenever we discuss the pace and the
content of economic reforms in India. The coming into force of the FRBM Act, 2003 on July
5, 2004, which established a framework for a rule based fiscal consolidation, should be
viewed in this background.
In the period subsequent to 2003, the central government's fiscal position has been
improving, though there are several underlying fiscal pressures that are not entirely evident
in the numbers, as will be explained later. The states' fiscal positions have also improved
significantly during this period and their revenue deficits are close to being virtually
eliminated. However, as in the case of the Centre, there are some underlying pressures that
are not reflected in the fiscal numbers of the States.
Despite considerable improvement in the fiscal scenario, both at the centre and in the states,
India's combined fiscal deficit (centre and state), as a percentage of GDP, still continues to
be one of the highest in the world. Prof. Rao would also be able to explain to you separately
in detail that India's public debt, including the external debt, as a percentage of GDP, is one
of the highest in the world. In this context, the U.K. based weekly the Economist (dated
November 17, 2007 - Pages 75-77) ranked India, along with Turkey and Hungary, as the
riskiest economies among select leading emerging market economies. The Economist based
its conclusion on standard parameters such as current account balance, budget balance,
inflation and growth in bank lending, for assessing the degree of risk. One cannot disagree
with the relevance of these parameters in assessing risks. Yet it is noteworthy that most of
these risky elements were present in the Indian economy for several years, almost all
through the reform period, and yet the economy exhibited macro-stability and impressive
growth even while withstanding some significant domestic and global shocks. In view of this
evidence, we need to explore the reasons for such risks not de-stabilising our economy so
far; and the measures that are needed, in future, for insulating the economy from such
destabilising effects, to the extent feasible. I think it is important that this big picture be
reckoned while we analyse the pace and intent of reforms, despite some agreement on the
destination as well as direction of economic reforms.
Role of RBI in fiscal reforms
Now, let me briefly explain the role of RBI in fiscal reforms. As a central bank, we are
generally sensitive to the fiscal situation. It is not true that the RBI was not aware of the
implications of what was happening on the fiscal front during the first three decades (1950 to
1980). Given the institutional arrangement, the RBI's primary objective is to maintain
monetary stability. It was clear that the fiscal situation was something that was decided and
determined by the sovereign. Once the fiscal situation was decided and determined by the
sovereign, it was the central bank's responsibility to ensure that monetary stability was
maintained and the government's borrowing programme was managed with minimum
disruptions, in terms of stability. Some argue that accommodating the fiscal pressure through
monetary action is like, what some people call, a soft-budget constraint.
Let me revert to the reform process and how we got rid of the remnants of automatic
monetisation of the previous years. The stock of ad hoc Treasury bills, when we put an end
to issue of such bills, was over Rs. 1,00,000 crore. This stock was in fact public debt in
perpetuity, held by the RBI, bearing a discount rate of 4.6 per cent though the market rates
were far higher. In coordination with the government, it was agreed that these papers will be
converted into dated marketable securities at market related rates, in phases, depending on
the market conditions warranting open market operations by the RBI. Thus, the stock of the
ad hoc treasury bills has been wiped-out. This is an evidence of the varieties of ways in
which the RBI conceives and implements the process of reforms, in a non-disruptible
fashion, in coordination with the government.
Let me share a story related to the FRBM Act with you. One day, Governor Jalan said that
the Finance Minister is making an announcement on introduction of Fiscal Responsibility Bill
(which was the then proposed nomenclature). Governor Jalan said that he had discussed
with the Minister and that they had decided that I will be named the Chairman of a
Committee that would draft the Fiscal Responsibility Bill. I submitted that the government
officials should be working on the legislation relating to fiscal issues and that the RBI should
not be involved, as the ownership of the Fiscal Responsibility Bill should be with the
government. Governor Jalan did not relent and said "No, it has been decided that you do it".
So finally, we arrived at a compromise. A main formal Committee was set up in 2000 with the
then Secretary, Economic Affairs, Dr. E.A.S. Sarma as the Chairman and Dr. Ashok Lahiri as
one of the members; and a working group comprising of RBI officials was set-up under my
Chairmanship to provide technical assistance to the main Committee on several aspects for
drafting the Fiscal Responsibility Bill. The RBI Working Group was actively involved in the
Sarma Committee to draft the Fiscal Responsibility Bill. Mr. Prem Chand of the IMF, at our
invitation, spent some time advising us on the international best practices in this regard. At
this stage, we advised the Government that without incorporating transparent budget
management rules and medium term fiscal framework, the objective of fiscal responsibility
would not be achieved. Therefore, the name of the Bill was changed to "Fiscal Responsibility
and Budget Management Bill" incorporating additional features. In short, I am illustrating that
the RBI has been actively collaborating with the government, whenever sought, but with
appropriate propriety.
Our experience shows that the FRBM Act has a positive effect of focusing attention on fiscal
issues. At the same time, it may, sometimes, unintentionally lead to increased recourse to
expanding off-budget fiscal liabilities. Such a practice is not entirely uncommon in many
countries, but the magnitudes involved and the persistence in resorting to off-budget
liabilities in India are noteworthy. The issue is not merely one of transparency in fiscal
operations or a de facto larger borrowing programme of the Government than admitted, but
one with significant implications for the Government debt market and monetary management.
Past experience clearly suggests that recourse to such off-budget items is not ad hoc or
onetime only. The repeated recourse to issue of Government bonds has been exercised not only
for fuel, food and fertilizers for financing subsidies, but also for financing deferred liabilities in
regard to bank loan waivers and contribution to the capital of public sector banks. Hence,
unless there is a noticeable change in global prices or a change in policy towards recurrent
subsidies and deferred liabilities, continuation of such special bonds may not be ruled out.
The significant quasi-fiscal transactions to finance recurrent revenue expenditures through
de facto borrowings pose challenges in managing the links between fiscal, external and
monetary management.
The RBI has rendered advice on FRBM to the state governments also. A forum has been
provided by the RBI, which brings together the Finance Secretaries of state governments, for
exchange of ideas and sorting out the issues. The bi-annual conference of State Finance
Secretaries hosted by the RBI, initiated in 1996, is also attended by the Secretaries in the
Ministry of Finance, Government of India, representatives from the Planning Commission,
the Comptroller and Auditor General of Accounts (CAG) and the Controller General of
Accounts (CGA). The deliberations in these bi-annual conferences have proved very useful
in identifying the common issues and developing best practices in regard to state
government finances. A number of important initiatives relating to ways and means
advances, approach to market borrowing programme, investment of surpluses, ceilings on
state government guarantees, model scheme for state level fiscal legislations, apart from
changes in the content and format for reporting budget related documents to ensure
transparency etc. have emanated and taken shape as a result of interactions in these
meetings. The RBI has, through this forum, also helped the state governments prepare the
state level FRBM legislations.
Incidentally, the first research and policy paper on pension funds in India was prepared by
Dr. Urjit Patel, who used to work with us. In those days, it was so hard to get any data that
we had to tap our informal links in the various offices in Delhi, including some of my old
colleagues, to give him some access to relevant information. Dr. Urjit Patel did a very good
job and then he published an article in the Economic & Political Weekly. Thus, the public
policy on pensions was, in a sense, triggered by the work done by a consultant in RBI, at our
request. RBI also worked on a Report on Pensions for state government employees. This is
another evidence of the collaboration between the RBI and the governments and often our
views are accepted. Now, let me come to the fisc and monetary management issues.
Fisc and monetary management
Let me clarify the general approach of RBI in its relations with the government on matters
relating to monetary management. As illustrated in the case of preparation of the Fiscal
Responsibility and Budget Management Bill, coordination between the government and the
RBI is essential for structural reforms, especially when legal and institutional changes are
involved. In regard to operational issues relating to monetary policy, there is some element of
freedom but, in view of the fiscal dominance in the economy, the overriding approach has
been harmonization of monetary policy with fiscal policy for ensuring stability. Within this
framework, through mutual cooperation, several reform measures have been undertaken by
the government and the RBI and I will provide a few illustrations.
First, the Statutory Liquidity Ratio (SLR) has been gradually reduced to the then statutory
minimum of 25 per cent, effective October 21, 1997. Also, the CRR has been reduced
gradually, depending on the liquidity conditions, as a first step, with the objective of ultimately
reducing it to the statutory minimum of three per cent. In the meantime, RBI's commitment to
the removal of the statutory prescriptions of minimum reserve and liquidity requirements was
demonstrated by its proposal to the Government for legislative amendments to remove the
minima. These legislations have since been passed. Now, there is no minimum statutory
stipulation for SLR and CRR.
The challenge now is to reduce the CRR and the SLR stipulations, as we go along. The
reduction in CRR will be contingent upon liquidity conditions and the need for using it as an
instrument of sterilisation along with other instruments. The reduction in SLR will primarily be
governed by the fiscal situation of the government. The issue is not one of desirable
destination but one of negotiating the path in an optimal way. RBI has two options for
proceeding in this regard. Either we accept the fiscal situation and wait for it to improve, to
effect any further reductions in SLR or reduce prescriptions gradually consistent with fiscal
situation and market development. So that is the type of choices we are facing at this
juncture and RBI prefers to assess the fiscal situation and proceed with the reductions in a
cautious manner.
Second, an issue that has come to the fore in the recent period pertains to higher volatility in
government's cash balances maintained with the RBI, which impacts the liquidity conditions
in the financial markets. Volatility in Government's cash balances is not unique to the Indian
situation and is an issue even in other countries, but in our situation, it has become
increasingly prominent now. It so happens that, at times, government's cash balances and
the external situation move in different directions and they create very little net impact on
liquidity from the perspective of overall monetary management. However, there are
occasions when they move in the same direction, in which case the volatility in the liquidity
conditions is much higher. This is one major current issue in monetary management which
could be linked to cash management in the government. The link becomes critical for
maintaining orderly liquidity conditions in the money market and effectively using short term
overnight interest rates for monetary operations.
Third, the magnitude of the combined fiscal deficit of the centre and the states is close to half
of the households' financial savings, which is the largest component of domestic savings. If
fifty per cent of households' financial savings are taken away by the government sector, it
has vital implications for ensuring stability in the financial markets because the demand for
funds from the non-government productive sectors of the economy has to be met
simultaneously.
Fourth, India is still a bank-dominated system and about 70 per cent of our banks (in terms of
business) are owned by the government. Thus, we could have a situation when the objective
of monetary policy and the objective of broader public policy dealings with banking converge,
in which case the monetary policy could be very effective. Sometimes, it could happen that
the objective of monetary policy and the objective of broader public policy may not converge,
in which case monetary policy may not be that effective. In other words, the effectiveness of
the monetary policy depends not only on the actions of the monetary authority, but also on
other public policy postures. This certainly complicates monetary management. Of course,
the issue of conflict of interest in public sector banking and government ownership is yet
another issue. The issue of conflict of interest in private sector banks arises when the owner
of the bank borrows from his own bank. The single largest source of borrowing for the
government being the government-owned banks themselves, this conflict is rather apparent.
Fifth, one of the factors imparting rigidity to the interest rate structure in India is the
administered interest rates, particularly on small savings instruments. In this context,
administered interest rates fixed by the Government on a number of small saving schemes
and provident funds are of special relevance as they have generally offered a rate different
from those on corresponding instruments available in the market, in some cases along with
tax incentives. The administered interest rates significantly impact the level and allocation of
savings. On the lending side also, there are some administrative prescriptions for banks.
Depending on how it is calculated, on both the savings and the lending sides, the
administered structure of interest rate would apply to about 25 to 40 per cent. In this context,
it is pertinent to note that the monetary policy mainly operates through interest rates and
interest rate signals, and constraints posed by administered interest rates have to be duly
recognized while dealing with issues relating to monetary policy transmission mechanisms.
Sixth, theoretically it is well recognised that monetary policy is generally a more effective
counter-cyclical policy instrument than fiscal policy because interest rate changes can be
made and reversed quickly. However, monetary policy adjustments may take longer than
fiscal policy adjustments to affect aggregate demand. It is also recognized that fiscal policy
contributes to broader-based stabilization through the impact of taxes and government
spending on income-sensitive (in addition to interest-sensitive) components of aggregate
demand. When monetary policy is thus constrained in responding to output variations, fiscal
policy should normally take a more central role. Thus, effective co-ordination between the
fiscal policy and monetary policy is important. At a more aggregate level, in the context of our
capacity to respond to global developments, if we have a counter-cyclical policy approach,
not only the monetary policy but also the fiscal policy should be counter-cyclical. If the fiscal
policy continues to be uni-directional, as we have in our case, with persisting deficits, then
the fiscal policy is not in a position to produce a reasonable counter-cyclical impact. In these
circumstances, the monetary policy has a challenge in designing and implementing
appropriate counter-cyclical policies, that has the added burden of off-setting the impact of
the fiscal policy. Well, despite these challenges, the RBI has managed the situation
reasonably well and we have the confidence that we would be able to continue to manage.
However, it is important to recognize that, at times, unorthodox policies have assured the
stability of the Indian financial system despite fiscal stress, which is a desirable outcome
rather than achieving ritualistic compliance with pre-set rules.
By and large, these are some illustrations of the links that exist between fiscal and monetary
management. We are continuously refining the monetary policy framework and the conduct
of the monetary policy, taking into account the progress in fiscal consolidation. The reform of
the monetary policy framework and the conduct of monetary policy have to recognise the
fiscal, and the related institutional as well as policy constraints. That is the limited point I want
to make to those who are impatient with the current monetary management framework.
Now let me go to fisc and the financial market.
Fisc and financial markets
First, the foremost link between the fisc and financial markets is through the government
securities market. As has already been explained in detail, the central government's
borrowing programme was significantly monetized in earlier days. It may be of interest to all
of you to know that since a large part of the borrowing programme has to be completed in the
first half of the fiscal year, in view of seasonality of demand for credit on private account, the
monthly average gross market borrowings by the centre is around three-quarters of a percent
of GDP in recent years. Despite this high level of government borrowing programme, the
RBI, as debt manager, has been able to successfully complete the market borrowing
programme, over the years, while pursuing its interest rate objectives without jeopardizing
external balance, by taking recourse to several initiatives in terms of institution, instruments,
incentives and strategies.
Second, an important issue that remains is that we cannot claim that there is a genuine
market for government securities in India, when we have a statutory liquidity ratio
prescription of 25 per cent. The question is that can we really proceed on the assumption
that there is a genuine government securities market, and hence reinforce more
marketisation by rapidly reducing SLR or do we ensure a viable market borrowing
programme and reduce SLR in tandem? Here again RBI has to assess the sensitivity of the
fisc to interest rate burden, in case SLR is reduced rapidly? The importance of SLR status for
bonds issued by government has come to the fore recently when oil bonds issued by
Government of India turned out to be illiquid despite carrying a higher yield of 25 basis points
over SLR-eligible bonds of similar maturity. The reform of debt markets in India, as we go
along, should recognise these realities.
Third, in the case of state governments, when we tried to marketise the individual state's
borrowing programme, many of the states were not comfortable. They were not sure whether
they would be able to get subscriptions for their bonds unless RBI manages the borrowing
programme of all the states in a coordinated fashion with uniform terms and conditions for all
states. Knowing that banks cannot be compelled to subscribe to the programme, RBI
provides the investors a higher yield for states' paper over the centre's paper of comparable
maturity. Subsequently, we encouraged some states to go through auction route on a
standalone basis. Now it has become possible for the RBI to conduct the borrowing programme of
each state without serious disruption in the markets, through the auction route. As a result,
some states have also begun to take initiatives to improve their fiscal profile and discharge
their liabilities promptly to banks, and, consequently, gain comparatively favourable treatment
in the debt market. It took about six to seven years for RBI to equip the state governments
and the markets to get used to this kind of discipline. This was perhaps possible because
RBI commands the trust of state governments as an apolitical and a professional public
institution.
Fourth, another aspect worth exploring is the fiscal implications of failure of financial
institutions and markets. The RBI, as the central bank of the country, is also responsible for
ensuring financial stability. Broadly, one can say that when a country's fiscal position is
strong, its capacity to take on the risks arising from the failure of financial institutions is
higher. On the other hand, with a weak fiscal situation, the capacity to take care of a financial
or banking crisis is rather limited. More important, whenever pockets of vulnerability arise in
the financial sector, the headroom available in the fiscal position to provide succour to
financial entities needs to be assessed. In this context, one important source of strength as
well as vulnerability remains the publicly owned financial institutions, which may have fiscal
implications. They contribute heavily as a source of tax revenue. Another source of linkage is
the cross subsidies and we have to identify the areas of maximum cross subsidies in public
sector entities. The sources of indirect subsidies through and by financial intermediaries are
also important. A reading of the several budget speeches of the Finance Ministers in recent
years would show the extent to which activities of public sector financial intermediaries
operate as instruments of fiscal policy though these entities are competing in the market with
private sector on all fronts. These public policy oriented operations of the public enterprises
at the instance of fisc seriously limit the efficient price discovery, depth and vibrancy in
different segments of the financial markets. Thus, it is evident that while analysing the link
between the fiscal and the public sector, perhaps, one should not confine to public sector
borrowing requirements only.
Fifth, as regards further reforms in the financial markets, it is very clear that the development
of insurance and pension sectors are very important especially for the government debt
market and the corporate debt market. However, there are some challenges in this regard.
The tax treatment of investment in debt and equity is quite asymmetrical in India with a
favourable tilt towards investment in equity. There are limited incentives for encouraging
contractual savings. Hence, some of the areas that have to be looked at, as we move
forward, relate not only to the demand side which advocates development of financial
markets, but also to the supply side through policies that promote contractual savings,
especially through pension and life insurance funds.
Now let me move to the fisc and the external sector.
Fisc and the external sector
In the context of the external sector, there are certain issues from the perspective of fiscal
policy that are of contextual relevance.
The first issue pertains to the opening-up of government debt market to non-residents
through, what we may call foreign currency sovereign debt. In fact, about a decade ago,
several arguments were put forward in favour of issuing foreign currency sovereign debt
when the government's intention to take recourse to sovereign borrowings in the international
markets was formally announced by the Hon'ble Finance Minister. Several academics
argued in favour of the proposal since they felt that it may be more economical for the
government to raise funds abroad. However, such borrowings may entail foreign currency
exposure and hence the foreign currency risk, which was not built into the analysis of
benefits. Another line of argument that was put forward in favour of foreign currency
sovereign borrowings was that the government's borrowing abroad would help develop a
benchmark for the private sector foreign currency debt. However, now weightage for
sovereign risk is assigned to a private sector debt even without the sovereign benchmark,
after taking into account the sovereign risks. Moreover, the issue is that there are always
political and economic temptations, as happened in many other countries, to raise foreign
currency sovereign debt, when credit market sentiment is favourable probably without
factoring-in the likely situation that may prevail when the sentiment turns unfavourable.
The RBI worked along with the government when this issue came up and came to the
conclusion that, at that point of time, it might not