The Reserve Bank of India released today its Report on Currency and Finance, 2009-12 on Fiscal-Monetary Co-ordination. The Report on Currency and Finance, a staff research report, has focused on select themes since 1998-99.
The theme for this Report assumes importance in the light of renewed focus on fiscal-monetary co-ordination across advanced economies and emerging market and developing economies (EMDEs) in the aftermath of global financial crisis. While the onset of the crisis saw close co-ordination between fiscal and monetary policies, both at the national and international levels, in the exit mode, individual countries have adopted different strategies to deal with their respective concerns of economic growth, inflation and financial stability.
Regime shifts, culminating in the Fiscal Responsibility and Budget Management (FRBM) Act, have considerably enhanced the degrees of freedom for monetary policy setting in India. However, fiscal dominance of monetary policy still remains as a result of large fiscal deficits, suppressed inflation and debt dynamics that feed into reserve money. At times, de facto monetisation of deficit occurs, as large open market operations are needed to preserve liquidity and monetary conditions as well as orderly conditions in the debt markets. This has inflationary consequences. The Indian experience suggests that fiscal rules, although necessary, are not sufficient in optimising the outcomes of fiscal-monetary co-ordination. The regime of fiscal rules could be improved by (i) focusing on structural deficits; (ii) removing ambiguity about any exceptions to be made by including expenditure rules to deficit rules; and (iii) adopting broader definitions of both deficit and debt to cover quasi-fiscal activities. On the issue of institutional arrangements for government cash and debt management, the post crisis international experience underscores the need for closer co-ordination between monetary and debt managers and fiscal authorities. Given that government borrowing continues to be large in India and the general economic environment warrants a close monitoring of the evolving fiscal situation, persisting with the central bank™s engagement with government debt management coupled with more intensive co-ordination with the government appears to be the appropriate approach for the medium term.
Highlights
Until the early 1980s, monetary policy was generally subservient to fiscal policy, with the central banks™ financing of government deficits often introducing an inflationary bias.
During the 1990s, with the spread of rule-based fiscal policies and the adoption of inflation targeting by central banks across many countries including those in the emerging markets, fiscal-monetary coordination showed signs of progressive improvement with a gradual shift towards market-based monetary and debt management practices.
The global financial crisis of 2007-09 and the euro zone crisis of 2010 to the present, marks a new phase in fiscal-monetary co-ordination. On the one hand, the adoption of unconventional measures and expansion of balance sheets through purchases of long-term dated securities and unimpaired loans by central banks blurred the distinction between fiscal and monetary policies. On the other hand, bailouts by governments and the nationalisation of troubled financial institutions blurred the boundaries between fiscal and financial policies.
In India, fiscal dominance of monetary policy has moderated over the past two decades, but not waned. The two supplemental agreements between the Reserve Bank and the government during the 1990s first curbed and then removed automatic monetisation through phasing out the system of ad hoc treasury bills. The FRBM Act, 2003 ushered in a regime of fiscal rules with the objective of lowering the size of the fiscal deficits and restraining debt. The Act also prohibited the Reserve Bank from subscribing to primary issuances of the government securities, thus putting an end to direct monetisation.
Notwithstanding these gains, newer challenges have emerged that include (i) pressures on monetary policy arising from large market borrowings to fund high fiscal deficits that, at times, lead to de facto monetisation of deficit, (ii) inflationary potential of large fiscal deficits, (iii) pro-cyclicality of government spending and (iv) deficit-debt dynamics that poses the risk of crowding out private investment.
The size and composition of the Reserve Bank™s balance sheet has evolved in line with the changing institutional arrangements of fiscal-monetary co-ordination in India. In the post-fiscal reforms period, monetary policy and hence, the central bank balance sheet has been generally freed from straitjacket of fiscal deficit. The introduction of the market stabilisation scheme, under which government securities were issued to sterilise the large capital flows witnessed in the 2000s, was an important milestone in the interface between the fiscal and monetary authorities, with the fisc also sharing the cost of sterilisation.
During the crisis year 2008-09, the Reserve Bank’s balance sheet shrank in size, unlike the expansion witnessed by the central banks of several advanced economies. The Reserve Bank™s balance sheet has expanded significantly since then reflecting its liquidity management operations, aimed at strengthening the recovery process while containing inflation.
The fiscal-monetary coordination during 2008-09 and 2009-10 met with considerable success in reviving growth and maintaining financial market stability. Developments in the more recent period, when both fiscal deficit and inflation remained high and investment and growth slackened, also reflected the imperative of co-ordinated policy actions.
An empirical exercise indicates that fiscal deficit tends to exert upward pressure on the call rate (which is used as a proxy for the monetary policy rate) after a lag, even after controlling for the output gap and the inflation gap. This underscores the need for greater co-ordination of fiscal and monetary policies in order to attain the overarching objectives of growth, price stability and financial stability.
In India, even as the long record of debt management conducted by the central bank has been impressive, the successful staving off of the indirect adverse effects of the global financial crisis in the recent period, has been attributed to the close co-ordination between debt, liquidity/ monetary and exchange rate management. The processes in this regard were greatly facilitated because these functions, although separate, remained housed within the same organisation.
In the aftermath of the global financial and the euro zone sovereign debt crises, a substantial body of opinion has favoured widening of the mandate of central banking beyond price stability to encompass financial stability and sovereign debt sustainability, keeping in view the close inter-linkages between the three objectives. This has caused a rethink on the institutional arrangements for debt management in India, going forward.
Lessons and Future Challenges
Some valuable lessons for fiscal-monetary co-ordination have emerged from the recent crisis. The crisis highlighted the inadequacy of macroeconomic stability in ensuring financial stability. Financial stability has, therefore, emerged as a separate policy objective besides growth and price stability for central banks.
Among the prominent post-crisis challenges is the need to insulate the financial sector from negative feedback from sovereign debt related concerns as also to minimise the fiscal burden on monetary policy. With the inability of governments to stabilise debt levels or even finance deficits at reasonable interest rates, monetary policy is confronting a new phase of fiscal dominance. Therefore, credible fiscal consolidation plans and co-ordination strategies need to be designed to ensure an appropriate fiscal-monetary mix that is consistent with growth, inflation and financial stability.
The Indian experience suggests that fiscal rules, although necessary, are not sufficient in optimising the outcomes of fiscal-monetary co-ordination. There is a need for an improved regime of fiscal rules with a focus on structural deficits. The rules could be made flexible to allow adjustment for cyclical factors while ensuring that the embedded flexibility in fiscal rules does not lead to fiscal imprudence in the name of cyclical considerations. Going forward, there is a need to remove ambiguity about any exceptions to be made, by adding expenditure rules to deficit rules and by adopting broader definitions of both deficit and debt to cover quasi-fiscal activities.
Effective fiscal-monetary coordination in managing sterilisation issues during the high capital flow regime of early the 2000s and liquidity problems during the crisis period have had a significant impact on the Reserve Bank™s balance sheet. Going forward, such fiscal-monetary co-operation in a framework where central bank autonomy is not compromised is desirable, particularly in increasing the strength and credibility of the central bank balance sheet.
In light of the increasing valuation and systemic risks in today™s market oriented and globalised environment, there is a need to further strengthen the balance sheet of the Reserve Bank.
With inflation now showing signs of moderation and the output gap remaining negative, the need to stimulate investment as a means to revert to the trend rate of growth of the economy, is indeed pressing. The revival of investment activity depends on various structural factors as well as interest rates. In this context, an orderly and qualitative fiscal adjustment process would not only facilitate the attainment of the Twelfth Plan growth objective but also provide more headroom to monetary policy to address macroeconomic and financial stability objectives, in general, and the growth objective, in particular.
Keeping in view the emerging economic situation and the lessons of the global financial crisis, the institutional arrangements for government debt management in India over the medium term would require the continued involvement of the central bank coupled with more intensive co-ordination with the government.
Careful calibration towards reverting to fiscal consolidation and proper assessment of any likely institutional changes in public debt management constitute key imperatives for the outlook of fiscal-monetary debt management co-ordination in India.
The persistence of very large borrowings by the government has significant macroeconomic, monetary and financial stability implications areas where the central bank has an undeniably important, if not unique, role to play. The debt management of all the state governments casts an added and distinct dimension to the issue. Against this backdrop, there is a need to review the content and pace of the proposed shift of the debt management function from the central bank to the government.
Chapter Scheme
The Report is organised in six chapters. After setting forth the rationale for the theme of the Report in Chapter 1, Chapter 2 Fiscal-Monetary Co-ordination: Theory and International Experience deals with theoretical underpinnings and cross-country experience with regard to fiscal-monetary coordination. Chapter 3 Fiscal-Monetary Co-ordination in India: An Assessment presents the Indian experience in this regard, noting that fiscal dominance of monetary policy has moderated over the past two decades, though large fiscal deficits, suppressed inflation and debt dynamics continue to feed into reserve money. Chapter 4 Fiscal Operations and the Reserve Bank™s Balance Sheet traces the substantial transformation in the Reserve Bank™s balance sheet over the years in line with the shifts in the regimes of monetary policy operations and different phases of fiscal-monetary co-ordination. Chapter 5 Fiscal-Monetary Policy Co-ordination and Institutional Arrangements for Government Debt and Cash Management: A Medium-term Outlook examines the outlook for fiscal-monetary-debt management co-ordination in India, particularly in the context of the post-crisis return to the prescribed fiscal roadmap and the renewed thinking on the institutional arrangements for debt management, against the backdrop of the global financial crisis. The concluding Chapter Lessons and Future Challenges identifies a few key lessons and future challenges for fiscal-monetary coordination internationally as well as in India in the light of recent experience.
DISCLAIMER
The findings, views, and conclusions expressed in this Report are entirely those of the contributing staff of the Department of Economic and Policy Research (DEPR) and should not necessarily be interpreted as the official views of the Reserve Bank of India.”
R. R. Sinha
Deputy General Manager
Press Release : 2012-2013/1476
