The Power Of I 2020

The need of the hour — both fiscal and financial stability

Only a fine balancing act will help India survive COVID-19  

As we stand today, India’s COVID-19 infection curve does not look like it has peaked. The superhuman efforts of healthcare personnel have kept fatality rates low. However, households are cutting back on discretionary spends because they fear they may have to spend on medical care. Therefore, even after containment measures have been gradually relaxed, economic activity has not rebounded strongly. We still do not know when the curve will subside uniformly across the country. Nonetheless, we must strive to look ahead, however thick the fog of uncertainty.

In the short run, we need government expenditures to provide relief to the most affected citizenry and states. For the long run, we need government capital investments for the universal provision of public goods such as health, education and infrastructure. Both are essential to put India on a sustainable growth trajectory. In this journey, the private sector’s entrepreneurial spirit and productivity must be utilized, especially in the provision of non-public goods, within desirable standards of governance and transparency. All this must be accomplished without taking undue macroeconomic and financial sector risks so that we avoid the mistakes of fiscal stimulus with poor credit underwriting that took hold after the global financial crisis.

This is a tall order, no doubt. But can we make it happen in spite of the enormous challenges on the fiscal and financial stability fronts? I believe we can. Clearly, much work is needed on the real side of the economy through structural reforms, especially in terms of land and labour. Thus, I propose a possible way out. There are likely better ideas. Hopefully, the system can find and proceed with the best ones.

Need for immediate fiscal institutional reforms: In order to undertake relief-related transfers and long-overdue capital investments, the government needs to create fiscal space and even stretch the ‘fisc’ a bit for now, without losing credibility with investors and markets on the sustainability of its medium-term debt levels. To this end,  

1. A fiscal consolidation path needs to be earnestly set to achieve reasonable three- to five-year debt-to-GDP and fiscal deficit targets, recommended by the Fiscal Responsibility and Budget Management (FRBM) Act (2003) and its Review (2016). Several analysts estimate that even mild stress assumptions on the post-COVID growth trajectory imply debt-to-GDP numbers in the range of 80%-90%. This would take us close to thresholds beyond which adverse growth dynamics tend to take over.

2. Merely having the FRBM targets in place did not suffice to ensure adherence and lack of fiscal slippage, even in the pre-COVID era. Hence, objective monitoring of consolidated debt and deficit numbers is the need of the hour. This can be achieved by setting up an independent, bi-partisan, fiscal council, which can hold a mirror to the government’s annual progress on FRBM targets. The Thirteenth Finance Commission and the FRBM Review Committee have recommended the appointment of Fiscal Council by the Finance Ministry. However, such a Council ceases to be independent and is bound to fail when most needed, no matter how well intentioned. In contrast, the Report of the Fourteenth Finance Commission chaired by former RBI Governor Dr YV Reddy has recommended amendment of the FRBM Act, which would enable the Parliament to appoint the Fiscal Council, whose assessment should be tabled in both the Houses of Parliament. This will have a greater chance of remaining independent when it matters and it should be granted authority to enforce a “comply or explain” discipline on budgetary assumptions. 

3. Regardless of if and when an independent fiscal council is set up, India needs improved disclosure standards for government expenditure and deficit that preclude obfuscation of numbers by accounting jugaad (tricks). Such jugaad includes moving expenditures from ‘before’ to ‘immediately after’ the accounting date, from ‘above the line’ to ‘below the line’, from on-balance sheet to off-balance sheet, and from one public sector enterprise’s (PSE) borrowing to ‘dividend’ payout for the government via acquisition of another PSE. What matters in the end is the government’s accurately calculated public sector borrowing requirement (PSBR), on a consolidated basis between the Centre, the states, and their respectively owned enterprises. The office of the Comptroller and Auditor General (CAG) of India seems the best positioned to provide this all-important aggregate statistic on an annual basis. Alternatively, the CAG could make all pieces of individual data available for analysts to compute the PSBR. Such transparency would pave way for a focus away from accounting sleight of hand towards fiscal management in a true economic sense.

4. More than 90% of the Central government’s annual Budget is allocated year after year to revenue expenditures, notably subsidies that have not been found to have much long-run fiscal multiplier on growth. State budgets feature a somewhat higher allocation to capital expenditures (such as on infrastructure), but revenue expenditures typically account for over 70% of their budgets, too. A substantial quantum of merit-based subsidies can be phased out and rolled into a single universal basic income that is transferred directly via India’s impressive investment in providing unique identifiers and bank accounts to most citizens. This would lead to a compression in the revenue expenditure and allow citizens to spend the transfer on items their specific situations demand (hire a private tutor for children, start a micro-enterprise, pay off debt). Equally importantly, this will free up space for a reorientation of expenditure towards health, education, and especially, infrastructure, which has substantial multiplier effects on long-term growth. Such expenditure will also have the potential to crowd in private sector investment by enhancing its productivity and improving the ease of doing business on ground.

5. Last, but not the least, there is an urgent need to recreate a substantial divestment programme to shed government presence in sectors where private firms have the ability and the willingness to take control. India can take inspiration from its golden era of divestments during the 1998-2003 period, when they were not just cosmetic “musical chairs” from one PSE to another. Economically meaningful divestments will improve their efficiency by allowing them to raise market financing, subjecting them to higher governance and performance standards, and unleashing the repressed potential of their human capital. Such divestments will also reduce the pressure on the government-borrowing programme.

India can no longer rely simply on attempts to boost tax revenues as a way to address the fiscal woes. This strategy isn’t working despite multiple and varied attempts. Put simply, the government’s focus should also be on expanding the pie rather than on getting a larger share of a shrinking pie that will only shrink further if it does not course-correct. 

Secure financial stability for the next decade (if not longer): As I explain in my book’s Preface chapter titled “Fiscal dominance: A Theory of Everything in India”, improving the fiscal condition in itself will help restore financial stability in part, as it will reduce the pressure on the government to dominate the financial sector rules and regulations. In particular, there would be less leaning on the central bank to accommodate short-run growth concerns at the cost of its long-run objectives such as protecting depositor interests, maintaining price stability, and keeping external sector fragility at bay. In parallel, direct reforms in the financial sector can aid economic recovery. Let me elaborate. 

When it comes to buying a property, they say the criterion should be “Location, location, location”; when it comes to securing financial stability, the criterion should be “Capital, capital, capital”. As I have demonstrated at length in my research, under-capitalized banks and financial institutions do not lend well to healthier productive parts of the economy; instead they throw good money after the bad, extending and pretending as though bad loans are okay ("evergreening"), and vitiating credit culture in the economy. As and when we recover from the pandemic, growth will need support from well-capitalized credit intermediaries. To this end,

1. Basel capital and liquidity norms should be upheld in their full spirit, rather than softened through regular forbearances for the financial sector; forbearances must be exceptional and subject to a “sunset clause” of no longer than six months and not become permanent dilutions of the norms. Debt moratoria and corporate restructuring schemes may be warranted as relief for the borrowers to deal with the shock of the pandemic (but whither the Insolvency and Bankruptcy Code for large borrowers?). However, this should not mean lack of adequate upfront provisioning for losses. The current 10% provisioning standard for restructured assets is simply too low compared to the realized losses on defaulted bank debt in India. Instead, the expected losses resulting from restructuring should be recognized more aggressively upfront, capital required to absorb the losses should be raised on a war footing by all banks (as already done of their own volition by large private banks), and the current benign equity market conditions should be tapped with immediacy for such capital-raising.

2. Annual asset quality reviews and macro-prudential stress tests for banks as well as non-bank financial companies (NBFCs) need to be conducted. Such methods are implicit in some of the internal workings of the RBI, as reflected in its Financial Stability Report (FSR). This should pave way for their natural role as the standard for capital requirements going forward. The FSR (June 2020) has estimated gross non-performing assets (NPA) ratio for the financial sector to be between 12.5% and 15% under macroeconomic stress that is less extreme than what some analysts fear is likely to materialize. Hence, the FSR estimates must set the floor on the extent of capital that is required on bank and non-bank balance sheets. It is not good enough that the financial sector survives stress; it must continue to function and intermediate well to support growth when green shoots reappear. 

3. Such capital requirements for PSU banks and NBFCs will be difficult to meet in the form of government fund infusion given the continuing fiscal stretch of the past several years. Hence, the government must divest stakes to below majority to 25% at least in PSU banks and NBFCs (even insurance companies). This has been recommended several times over the past three decades, notably by the Narasimham Committee and the PJ Nayak Committee. I would in fact favour a re-privatization of the healthier PSU banks to help them attract growth capital in time, improve management and human capital practices, embrace technology including fintech innovations, and adopt better risk-management standards. Simultaneously, a re-prioritization of the business model of the weaker PSU banks towards micro-finance style intermediation can be undertaken. This way, they can specialize in the function of financial inclusion while making decent profit margins, following which they can be considered for re-privatization at better market valuations.

4. To the extent that government presence in the financial sector remains large for now, regulation of banks and NBFCs should be made ownership-neutral. The central bank must be allowed to exercise the same powers over all regulated entities, whether they are state-owned or private. These powers should involve the ability of the central bank to enforce critical aspects of prompt corrective action on under-capitalized entities, viz., replacing errant management and requiring automatic dilution of equity stakes (including those of the government) to potential capital providers when existing shareowners do not inject the required loss-absorption buffers. Such ownership-neutral regulation would limit the scope for fiscal dominance that is prevalent under the present dual control of these entities between the central bank and the finance ministry. 

5. Finally, inflation impulses in India are getting stronger since three quarters, including in the pre-COVID months. Supply-side pressures and induced cost-push inflation have led to a further upward revision in inflation expectations of households, and in turn, of analysts, both at home and abroad. An increase in fiscal deficit in a time of rising inflation, negative real interest rates and ultra-loose liquidity conditions, raises the prospect of runaway inflation down the line. This could occur if the central bank chooses not to normalize monetary accommodation (when the credit growth picks up) because it seeks to maintain short-term growth and/or to keep government borrowing costs low (the classic form of fiscal dominance of monetary policy). Anticipation of such an outcome can cause external investors to vote with their feet resulting in a “sudden stop” of foreign financing and the associated depreciation spiral.

Flexible inflation targeting framework adopted in 2016 is aimed precisely to avoid the central bank’s interest-rate decisions from being fiscally dominated. The flexible inflation targeting framework has had a promising run in its first four years and needs to be persevered with. The gains from the framework will amplify over time once adequate central bank credibility to maintain long-run price stability has been established. Already, the volatility of the Indian rupee has converged since 2014 to lower levels than for currencies of other emerging markets. Barring recent quarters, household inflationary expectations have been relatively well-anchored or been on a downward trajectory; and concomitantly, financialization of savings away from real estate holdings is under way.

There was a time when India kept rationalizing that manufacturing a faster and smoother Ambassador car would have been inappropriate for the then dire quality of its roads. With all its current imperfections, the Indian road network has come a long way since. Unsurprisingly, the country is replete now with better cars, domestic and international. It is time to recognize that a similar modernizing transformation is needed in India’s financial sector and its regulations as we migrate from the centralized and nationalized era of low growth to a decentralized and privatized era of high potential.

Every crisis presents an opportunity. The unprecedented COVID-19 shock should be used to — acknowledge where the true states of our fiscal and financial stability stand, commit to bringing them where they need to be over the medium term, delineate a blueprint of the required economic and financial bridges, and rebuild them pebble by pebble with transformational reforms. These bridges should be robust enough to withstand the hurricanes of future and yet continue to channel savings from one shore to the most productive users awaiting their arrival at the other.

I cannot resist the temptation to end with a cricket analogy… It is on treacherous wickets that a sound batting technique is most necessary. The right time to restore the institutional foundations of India’s fiscal and financial stability is right now.