If recent events are to be believed, India is well on its way to modernize its monetary and fiscal framework. On 20 February, the Union government and the Reserve Bank of India (RBI) signed an agreement that gives the central bank an inflation target. The Finance Bill has detailed provisions for a Public Debt Management Agency (PDMA), taking away the debt management function away from RBI. In addition, the Bill also makes crucial changes to definitions in the RBI Act, 1934 and the Securities Contracts (Regulation) Act, 1956, paving the way for creating a deeper bond market. For the moment, this has been put on hold after RBI expressed its discomfort to the government. Had this gone ahead, the regulation of the interbank bond market, an important part of liquidity/monetary management, would have been taken out of RBI’s hands.

On paper...



These measures are indeed progressive. It is archaic to consider RBI as the banker to the government. In a modern economy ensuring price and financial stability is a complex job and requires a reduction in the objectives of the central bank so that it has sufficient instruments to achieve them; increase the number of objectives and you will get conflicts of interest in managing them. As the government’s debt manager, RBI is expected to raise money at low interest rates. As a central bank fighting inflation in a perennially supply-constrained country, it has to increase interest rates. The way to end this conflict is to create a PDMA.

Similarly, the agreement on the inflation target was much-needed. Bringing inflation below 6% by January 2016 and 4% for 2016-17 puts RBI firmly in the direction of inflation-targeting. This is what a central bank should be doing: fighting inflation.

The decision to take away the regulation of interbank government bond market from RBI and handing it over to the Securities and Exchange Board of India (Sebi), is also (allegedly) a modernizing step. India’s inability to fund big infrastructure projects is due to the absence of a deep and liquid bond market. Banks cannot be the source for funding these projects as asset-liability mismatches prevent them lending prudentially beyond a point. A well-developed bond market is the only option for financing the unmet demand for infrastructure.

...In reality



All these steps show the government’s barely concealed appetite for more money. It is not just the Bharatiya Janata Party (BJP) but all governments in New Delhi that think of RBI as a roadblock in their spending plans. Ideally, any government would want RBI to keep interest rates low and win the next election. The Congress may dish out dole while the BJP may give a gloss of responsibility by spending on infrastructure. The end result is the same: more expenditure.

The BJP has gone even one step further than Congress. Revisit the events of some years ago and you will remember the constant jostling between finance ministers and RBI governors. While a D. Subbarao caved in, a Y.V. Reddy could resist government pressure to let loose the monetary taps. In these cases fiscal dominance was a matter of circumstance and not a foregone conclusion.

With the three measures discussed above, fiscal dominance will become a legal, permanent feature of the economy. Consider the following:

1)The inflation-target agreement has a dual mandate: price stability while keeping in mind the objective of growth. This leaves open the room for quasi-fiscal pushing of the bank.

2)PDMA will allow the government to issue as much debt as it wants. In theory, the interest rate a government will have to pay on the bonds it issues will be determined by an assessment of its future tax revenue by those who buy the bonds. In practice, it can force the banks to buy as many bonds as its wants and at the price it wants. (the government owns public sector banks). If it wants to sell bonds, then at the very minimum, the statutory liquidity ratio should be brought down to 5% from the current 21.5%. Otherwise, creation of a liquid bond market is a polite fiction.

3)The shift in responsibility for regulating the interbank bond market from RBI to Sebi is even more curious. If repo and reverse repo securities are to be regulated by the markets regulator, then that takes away a big monetary policy instrument from the central bank. This step has more to do with turf wars between regulators than any macroeconomic logic. Last year, RBI governor Raghuram Rajan had questioned this very move. “Is the regulation of bond trading more synergistic with the regulation of other debt products such as bank loans and with the operation of monetary policy (which requires bond trading) than with other forms of trading? Once again, I am not sure we have a compelling answer in the FSLRC report. My personal view is that moving the regulation of bond trading at this time would severely hamper the development of the government bond market, including the process of making bonds more liquid across the spectrum, a process which the RBI is engaged in." (Comments made in Mumbai on 17 June)

The BJP may be fiscally responsible (we don’t know that yet) but India’s political space has outfits who think the government can do what it wants. By these steps, the BJP is propagating the myth of a fiscal Leviathan. That is reckless.

Siddharth Singh is Editor (Views) at Mint. Reluctant Duelist takes stock of matters economic, political and strategic—in India and elsewhere—every fortnight.



Comment at siddharth.s@livemint.com. To read Siddharth Singh’s previous columns, go to www.livemint.com/reluctantduelist



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