Historically, economic crises/shocks have provided valuable lessons for fiscal-monetary co-ordination. The global
financial crisis of 2008 evoked expansionary fiscal and monetary policies in cohesion. A post-crisis evaluation suggests
the need to address financial stability as a separate objective besides growth and price stability in the context of fiscal-monetary
co-ordination, while associated risks from the financial sector on the real economy would have to be analysed
endogenously. Other post-crisis challenges include the primary involvement of central banks in financial stability
policy in addition to their core responsibility of price stability, greater proactive interaction between central banks,
governments and other authorities to address financial stability issues, risks of negative feedback from sovereign
debt-related concerns, calibration of fiscal consolidation to avoid a collapse of aggregate demand and greater fiscal-monetary
co-ordination at the international level. In India, while phasing out of automatic monetisation and
discontinuance of Reserve Bank’s participation in the primary government securities market have reduced the
degree of fiscal dominance, the Reserve Bank’s open market purchases, though largely guided by the objective of
liquidity management, at times, result in de facto monetisation of deficit. In the wake of the post-crisis escalation of
fiscal deficits, which has unwound the cushion created during the pre-crisis rule-bound phase in India, returning
to a credible path of fiscal consolidation would require addressing the structural constraints in government finances
in a durable manner. Going forward, greater fiscal-monetary co-ordination in a frame work where central bank
autonomy is not compromised is desirable, particularly in attaining the overarching objectives of growth, price
stability and financial stability.
6.1 The analysis of international and Indian
experiences shows that fiscal and monetary policies
need to co-ordinate at all times to improve
macroeconomic welfare, although the form of coordination
has varied during different episodes of
economic crisis/shock. The global financial meltdown
of 2008 challenged the prevalent view that monetary
policy should be used to stabilise the economy in the
short-run, whereas fiscal policy should be used to
address income distribution concerns and establish
the foundations of long-run growth. The global
financial crisis evoked an unprecedented fiscal
stimulus together with an accommodative monetary
policy. Interest rates were reduced further from their
low levels, and several advanced countries resorted
to unconventional expansionary measures, as
monetary policy operations were constrained by their
low interest rate bounds. After the post-global
financial crisis, financial stability has emerged as
another important policy objective, besides growth
and price stability, of monetary policy. Going forward, the financial stability issue has assumed another
dimension with feedback loops emerging from
concerns relating to fiscal and sovereign debt
sustainability. In India, although the implementation
of the FRBM Act, 2003 has reduced fiscal dominance
of monetary policy, fiscal constraints continue to
occupy a central position on the back of sizeable
market borrowing programmes, necessitating open
market operations to address liquidity concerns.
Against this backdrop, this chapter flags the major
policy lessons and challenges that policymakers may
face in the area of fiscal-monetary co-ordination at
the international level, as well as in the Indian context.
Macroeconomic stability not a sufficient condition
to guard against financial instability
6.2 Prior to the global financial crisis, the broad
consensus, both in academia and among central
banks, was that achieving price and output stability
promotes financial stability. Paradoxically, the stable
macroeconomic environment prevalent up to 2007 turned out to be a harbinger for under-pricing of risks;
it allowed the pursuit of pro-cyclical fiscal and
monetary policies and led to the build-up of financial
imbalances. This indicated flaws in the pre-crisis
policy framework. In particular, monetary and financial
policies failed to incorporate fully the implications of
rapid pro-cyclical growth on financial leveraging and
risk-taking, especially across national borders, while
the fiscal policy failed to create sufficient space for
policy manoeuvre in the event of a crisis. During the
crisis, the explicit pre-crisis assignment of policy
instruments to objectives became blurred. The recent
experience from the global financial crisis has
demonstrated that macroeconomic policymaking is
expected to do a fine balancing act to achieve multiple
and, at times, conflicting objectives of monetary
stability, fiscal stability and financial stability.
6.3 The existing models need to provide for the
integration of financial sector more substantively, so
as to allow the balance sheet channel of financial
intermediaries and risk premia to influence economic
outcomes. The substantive incorporation of financial
intermediaries would enable these models to predict
how asset prices and financial frictions interact with
the real sector and, in that process, generate booms/
busts endogenously. Policy authorities would have
to remain alert to feedback between credit, asset
values and binding financial constraints. They have
to guard against undesirable macroeconomic
outcomes of sustained deviations of asset prices from
their fundamentals, whether resulting from coordination
failures and herding among rational agents
or from irrational pricing of risks that generate self-reinforcing
waves of optimism and pessimism.
6.4 With the ongoing sovereign debt crisis, the
feedback loops between financial and sovereign debt
sustainability need to be properly assessed. It
emerges that an appropriate mix of fiscal, monetary
and macro-prudential policies may have to be used
to achieve macroeconomic objectives without
adversely affecting financial stability. In the near term,
it may be important to support the recovery process,
keep inflation low, and pursue internationally co-ordinated
financial and structural reforms that would help enhance financial market resilience and
strengthen the prospects for macroeconomic stability.
In the medium-term, the policy priority should be to
ensure that the overall policy framework is more
robust than prior to the crisis, which may require
institutional reforms with adequate space for fiscal-monetary
policy co-ordination.
Financial stability, although a primary mandate
for central banks, necessitates greater co-ordination
with fiscal authorities
6.5 After the global financial crisis, it is being held
that the central banks’ involvement in the formulation
and execution of financial stability policy must
increase if such a policy is to be effective. Although
in the post-crisis period central banks are still
grappling with balancing the demands of price stability
and financial stability in an uncertain global
environment, concerns about fiscal and sovereign
debt sustainability seem to have added to their
challenges. In this context, the role of the central bank
in the prevention, management and resolution of
financial crises involves a number of intricate issues.
These issues pertain to governance arrangements
needed for the effective and sustainable conduct of
core monetary policy functions in combination with
an explicit mandate to contribute to financial stability,
taking into account the impact of growing sovereign
debt burdens on the autonomy and governance of
central banks.
6.6 In short, the global financial crisis seems to
have underscored the need to expand the mandate
of central banks from the single objective of price
stability to multiple objectives of price stability,
financial stability and sovereign debt sustainability.
However, achieving these objectives are no less than
a trilemma, as there is vast scope for trade-offs
between these policy objectives. Central banks may
not be able to determine the degree of precision for
inter se priority to be accorded to each of the three
objectives under different sets of circumstances. The
recent massive government budget deficits in
advanced countries and the reluctance to rein in
future entitlements indicate that fiscal dominance may pose greater challenges for central banks to ensure
financial stability. It, therefore, calls for a greater
degree of co-ordination between various decision-making
authorities to avoid conflicts and achieve
optimum macroeconomic outcomes.
Need to lay out a policy co-ordination framework
6.7 Unlike the Great Depression period, the
central banks’ response to the recent global financial
crisis has been multi-dimensional and has proved to
be effective. Nonetheless, central banks have taken
significant credit risks on their balance sheets through
their liquidity management operations and credit
enhancement policies. Further, the use of
unconventional measures undertaken by the central
banks with a fiscal element has diluted the boundaries
between the mandates of public debt management
and that of monetary policy operations. While the
national debt management offices operated more
extensively at the short end of the yield curve, central
banks became active in the long-term segment of the
government bond markets. Many studies (e.g.,
Blommestein and Turner, 2012) argue that these
developments may lead to a situation of fiscal
dominance and, thereby, interfere with the conduct
of monetary policy. Going forward, therefore, the
policy functions and objectives of central banks are
likely to have greater interaction with those of fiscal/
debt management authorities. In this milieu, the policy
decisions of various authorities would increasingly
become inter-dependent, necessitating close
interaction and co-ordination between them, though
it does not necessarily mean the loss of independence
of central banks. Co-ordination structures may vary
across countries and could involve formal advice
being provided to the responsible agency by other
experts. However, whether financial stability should
be an exclusive mandate for central banks or whether
a formal body should look into systemic risks and
financial stability issues is still debatable. Similarly,
there is not yet any consensus on whether ‘arm’s
length’ co-ordination or face-to-face discussion
should be the main co-ordination mechanism.
6.8 The choice of co-ordination mechanism may
also depend on whether fiscal authorities have a proper understanding of the monetary policy reaction
function, and the same applies to the monetary
authorities as far as fiscal policy rules are concerned.
If this is the case, then each authority can tacitly take
account of considerations of the other without going
for face-to-face discussions. Such a co-ordination
mechanism has worked effectively in normal periods.
However, under the current phase of extreme
adversity during the post-crisis, as might be
characterised by Sargent’s “unpleasant monetarist
arithmetic”, policymakers may have to move towards
the extreme situation of joint decision-making. As the
interaction between various policies is expected to
be complex, the need for new functional arrangements
between fiscal authorities/ debt managers and central
banks, either temporarily or permanently, has also
been flagged in policy circles. The current institutional
arrangements for sovereign debt management need
to be examined to determine their efficacy in dealing
with these co-ordination problems in situations of
major shifts in policies and/or policy outcomes (e.g,
unconventional measures, high fiscal deficits, etc.).
6.9 A well co-ordinated policy approach will
ensure that fiscal consolidation being emphasised
and pursued at country-level does not hamper the
overall growth process. A well-specified co-ordination
framework will facilitate policy-makers to rebuild fiscal
and monetary policy space and calibrate domestic
policies to downplay the downside risks to growth,
which continue to exist across the majority of the
economies.
Need to insulate financial sector from negative
feedback from sovereign debt concerns
6.10 The financial crisis giving way to a sovereign
debt crisis in some advanced economies has
highlighted the existence of a feedback loop between
financial stability and sovereign debt sustainability.
In particular, the major challenge emanates from the
lingering weakness of the banking sector in the euro
area. The vulnerability of the banking sector, in turn,
adds to the sovereign risks, as investors perceive
member states as an ultimate backstop for vulnerable
financial institutions. Such concerns have led to high
costs of borrowing for both sovereigns and financial institutions, which may not be sustainable if such a
situation persists for long. Moreover, the public sector
may tend to deleverage, whether out of choice or
under compulsion, affecting growth prospects that
could, in turn, undermine debt sustainability.
6.11 Some of the recent measures in the euro area,
such as, move towards a budgetary union in March
2012, towards banking union in December 2012, and
strengthening of the European Financial Stability
Facility/European Stability Mechanism (EFSF/ESM)
are promising efforts to ensure fiscal sustainability
and break the adverse loops between banks and
sovereigns. Further, ‘Outright Monetary Transaction’
announced by the ECB on September 6, 2012 should
ensure transmission of low policy rates to borrowing
costs for countries under macroeconomic adjustment
or precautionary programme with EFSF/ESM.
6.12 To sever the link between banking, sovereign
and growth problems, policies in the euro area should
support individual countries’ efforts to repair public
and private balance sheets, and implement structural
reforms to restore competitiveness. Further, repair of
banks’ balance sheets through injection of more
capital into domestically systemic banks and
resolution of non-viable banks seems inevitable. At
the same time, it also needs to be ensured that fiscal
consolidation is not fully offset by the worsening of
private sector balance sheets.
Fiscal Consolidation needed for independent
conduct of monetary policy
6.13 Unprecedented escalation of sovereign debt
levels after the global financial crisis has made
government finances vulnerable in many economies.
While fiscal vulnerabilities need to be addressed,
fiscal consolidation has to be structured and calibrated
to avoid the collapse of aggregate demand. Further,
this process needs to be complemented by other
policies, which entails a careful assessment of new
and complex interactions between sovereign debt
management and monetary policies. High sovereign
debt levels reduce fiscal space, which, in turn, could
constrain the use of monetary policy instruments and
also create considerable uncertainty about future
interest rates.
6.14 Amid increased uncertainty, fiscal-monetary
feedbacks are likely to be stronger when public debt/
GDP ratios rise. Further, high debt can adversely
affect growth mainly through (i) the high cost of
capital, (ii) distortionary taxes, (iii) inflation, and
(iv) a lower capital-labour ratio that can lower
productivity. Such infirmities arising out of a high debt
overhang may also pose an additional burden on
other policy options, including monetary policy. In this
context, Jordan (2012) argues “central banks must
guard against finding themselves in a position where
they are forced to take action because of other
institutions’ inactivity”.
6.15 Given the implications of high sovereign
debts, early actions that boost the prospects of a
credible medium-term fiscal consolidation need to be
accelerated across countries afflicted with debt
overhang. An explicit link between sovereign debt
levels and medium-term fiscal policy objectives could
be articulated, which would help anchor fiscal policy
expectations. It is also important to fine-tune the
process of fiscal consolidation with monetary policy
operations. In the initial phase of fiscal consolidation,
monetary policy, due to prevailing low policy rates in
many countries, may not be able to offer much support
for fiscal consolidation. However, as growth recovery
begins and monetary policy becomes less constrained
by zero lower bound, the pace of fiscal consolidation
may be accelerated. Fiscal consolidation should be
driven by policy initiatives that facilitate long-term
growth and minimise the burden on monetary policy.
Fiscal-monetary co-ordination not only at national
level but also at international level
6.16 After the global financial crisis, numerous
weaknesses in the global monetary and financial
systems have come to the fore. These weaknesses,
in turn, lead to faster cross-border transmission of
the crisis. Fiscal-monetary co-ordination is, therefore,
required not only at the national level, but also at the
international level to address these weaknesses.
Accordingly, the world’s largest economies have to
develop a co-ordination mechanism to help guide
fundamental economic policies and find greater
synergy, especially between fiscal and monetary
policies.
6.17 Recognising the high degree of financial interconnectedness
at the global level and the potential
for seamless spread of any economic/ financial shock
across borders almost anywhere and everywhere,
attempts are being made to bring about more effective
international policy co-ordination through various
forums such as the G-20, Financial Stability Board
(FSB), Bank for International Settlements (BIS) and
the International Monetary Fund (IMF). There is a
greater acknowledgement that national policies
cannot be taken on a stand-alone basis and that
international co-operation is necessary to resolve
cross-border financial crises.
6.18 The G-20 framework for strong, sustainable
and balanced growth is making progress on steering
co-ordinated action at the global level under its
mutual assessment plan (MAP) in fiscal, financial,
structural, monetary and exchange rate, trade and
development policies. While there is agreement that
tail risks have diminished, reflecting important policy
actions in the euro area and in the US, there is a
consensus that the global economy continues to
underperform mainly on account of policy uncertainty,
public and private deleveraging, inadequate credit
intermediation and insufficient progress on
rebalancing global demand.
6.19 The G-20’s immediate focus would be on
creating the conditions for a lasting strengthening of
global demand, while at the same time developing
and implementing credible and robust medium-term
fiscal plans in advanced countries where these do
not yet exist. Structural reforms, while in some cases
politically difficult, would also be necessary to ensure
sustainable growth.
6.20 The IMF has strengthened its financial sector
assessment programme, particularly for the 25
systemically important countries. Further, to avoid
new systemic risks, the leaders of the G-20 countries
in the February 2013 meeting held at Moscow
reaffirmed their commitment to full, timely and
consistent implementation of financial sector reform agenda through the Co-ordination Framework for
Implementation Monitoring (CFIM) of the FSB. This
agenda includes Basel III, II.51 and II, the reforms on
over-the-counter (OTC) derivatives markets,
systemically important financial institutions and
shadow banking. Going forward, the activism of these
international bodies is expected to continue, as
spillover from national policies on international
macroeconomic stability need to be minimised
through coherent and consistent adjustment efforts
across major economies.
Indian experience suggests that fiscal rules,
though necessary, are not sufficient in optimising
the outcomes of fiscal-monetary co-ordination
6.21 The assessment of fiscal-monetary co-ordination
practised in India over the years, against
the backdrop of various reform measures undertaken
to align the institutional set-up and practices with the
evolving policy objectives, shows a move towards
reducing the fiscal dominance of monetary policy after
the Fiscal Responsibility and Budget Management
(FRBM) Act, 2003 was implemented. However, at
times, fiscal dominance through high deficits has
taken a new form with deficits and inflation feeding
on one another and debt-deficit dynamics impacting
reserve money creation. Large open market operation
(OMO) have been largely in line with the monetary
programme, but at times large market borrowings of
the government impact liquidity and monetary
conditions and can consequently impact the size and
timing of OMOs. This can lead to attenuation of
monetary policy. Fiscal deficits arising from large
subsidies would suppress inflation in the short-run
but could turn out to be inflationary in the medium-term.
In the Indian context, despite significant
countercyclical stimulus imparted during 2008-09 in
the wake of global financial crisis, government
spending has been found to be pro-cyclical over a
long period. This impacts the availability of fiscal
space for providing stimulus in cyclical downturn. Further, the combined debt of the centre and states
causes changes in reserve money to the extent it is
financed by the Reserve Bank and thus has monetary
implications.
6.22 The Indian experience brings forth several
key lessons. The evolution from an era of pure fiscal
dominance to that of rule-based fiscal discipline
clearly depicts the impact of changes in institutional
arrangements on the nature and degree of fiscal-monetary
co-ordination. Notably, the phasing out of
automatic monetisation of fiscal deficits and
discontinuation of the Reserve Bank’s participation
in the primary government securities market have
somewhat reduced the degree of fiscal dominance
of monetary policy. However, the Reserve Bank has
continued to provide temporary accommodation to
the government through ways and means advances.
Further, the Reserve Bank often purchases
government paper in the secondary market, though
these operations are generally guided by the objective
of providing liquidity support to the financial system.
Fiscal deficits in India have, in general, widened since
2008-09. While the government has returned to the
path of fiscal consolidation since the second half of
2012-13, it is important to reinforce this trend by taking
policy initiatives aimed at addressing the structural
constraints in government finances in a durable
manner so that the rule-based fiscal discipline
becomes effective and credible in the medium-term.
6.23 The persistence of structural imbalances, as
seen after 2008-09, necessitates greater recourse to
debt resources, thereby constraining monetary policy
operations. With fiscal policy having the first-mover
advantage and monetary policy being constrained by
fiscal dominance, the monetary authorities are left
with little option but to react to fiscal policies to avert
macroeconomic outcomes that are inferior to ones
that would be achieved if they do not take fiscal
policies into account. As monetary policy operating
procedures evolve towards greater reliance on
indirect instruments of monetary control, and fiscal
policies become more rule-bound, it is possible to
reduce fiscal dominance of monetary policy, though
the rules may not be sufficient to ensure monetary independence. In essence, weak institutional
arrangements governing co-ordination between the
fiscal and monetary authorities may continue to
impact the efficacy of both fiscal and monetary
policies.
6.24 Structural impediments also constrain the role
of fiscal policy as a counter-cyclical tool. Large fiscal
deficits raise inflation in the economy directly if they
are financed through reserve money expansion.
Otherwise, they impact supply responses through
suppressed prices and constrain the effectiveness of
monetary policy as a demand management tool.
While fiscal policy is intended to be counter-cyclical,
in practice it often turns pro-cyclical, thus losing its
ability to provide stimulus in situations of economic
slowdown and compress aggregate demand in times
of boom. Finally, the Indian experience shows that
government debt has a long-run relationship with
money creation, and debt-financed fiscal expansions,
at times, cause pressures on monetary management.
6.25 These lessons assume significance, because
challenges for fiscal and monetary management are
large in the backdrop of high fiscal deficits and high
inflation in India. Going forward, it is important to
address these challenges through a series of
institutional reforms. On the fiscal side, 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.
6.26 Cross-country experiences underline the
need to frame fiscal rules by taking into account
country-specific circumstances. For example, in
Singapore, budget deficit rules are based on the
principle that the government must have a balanced
budget over the term of its office, meaning that any
deficit in one year must be balanced by surpluses
accumulated in earlier years during the term of its
office. The appropriateness of such hard rules for
Indian conditions is open to debate, especially as they
can also come in the way of counter-cyclical stimulus.
First, in the Indian case, it may be difficult to think of achieving a balanced budget situation in any given
year. Second, in a polity that depends on coalitions,
defining a term of office can become difficult. Third,
there is the problem of how the rule can be
implemented if the government requires an
expansionary response in the first year it comes into
power.
6.27 Against the backdrop of an imminent need to
revert to rule-based fiscal discipline, it is important to
examine what rules can work in India. A notable
lacuna in the FRBM regime has been that there are
often deviations from the fiscal rules. FRBM Act
explicitly provides for breach of targets in the case of
national security need, national calamities and other
exceptional circumstances. This leaves a lot of leeway
in interpretation. The amendment to the FRBM Act
in 2012-13 has re-established the regime of fiscal
rules, and introduced a medium-term expenditure
framework. Going forward, there is a need to remove
a large part of ambiguity about any exceptions to be
made, by adding expenditure rules to deficit rules and
by adopting broader definition of deficit to cover quasi-fiscal activities.
6.28 The issue regarding the impact of large fiscal
deficits on inflation and monetisation of deficits can
only be addressed through enduring fiscal
consolidation that can withstand the cyclicality test.
This would, however, be possible subject to the
implementation of far-reaching fiscal reforms that
cover both revenue-enhancing and expenditure-cutting
measures. On the expenditure side, the move
towards reduction in subsidy expenditure in a phased
manner would help rebalance public expenditure,
from current to capital, to achieve and sustain a higher
rate of growth in the medium-term. An improvement
in the quality of public expenditures can raise the
acceptability of greater tax mobilisation, as is the case
with Scandinavian countries. The government’s non-tax
revenues also need to be stepped up in a more
enduring manner through proper public utility pricing
and reforms in public sector undertakings.
6.29 On the monetary side, institutional reforms
should focus on a better alignment of OMOs with monetary policy objectives. OMOs need to primarily
occur through outright purchase/sales of securities
by the Reserve Bank. Liquidity adjustment facility
(LAF) should generally be used in line with its
intended objective of addressing frictional liquidity
mismatches. Outright OMO purchases have increased
in recent years. While at the present juncture when
capital inflows are moderate, OMOs are not conflicting
with overall monetary management as reserve money
expansion is below the projected levels; episodically,
however, they can impinge upon interest rates and
market functioning. In fact, during 2008-09, the
sizeable additional market borrowing by the
government did create upward pressure on yields at
a time when monetary policy supported softer interest
rate regime. This could have been market disruptive
in the absence of large OMO purchases. With the
possibility that the money creation impact of OMOs,
at times, come in the way of the conduct of monetary
policy operations, the objectives and operational
procedures for OMOs need to be better defined and
constrained by a meaningful central bank reaction
function.
6.30 There is also a need to re-examine the high
held-to-maturity (HTM) provision that support public
debt financing and defacto leads to crowding out of
private credit. Further, financial sector reforms to
reduce dependence on the statutory liquidity ratio
(SLR) need to be carried forward once an improved
rule-based fiscal and monetary regime is put in place.
Overall, the new regime could be supported through
a better co-ordination mechanism for the formulation
and implementation of fiscal and monetary policies.
Need for continuance of effective fiscal-monetary
coordination and strengthening the Reserve Bank
balance sheet in the light of various risks as
witnessed during global financial crisis.
6.31 The Reserve Bank’s balance sheet has
undergone substantial transformation over the years
in line with the shifts in the regimes of monetary policy
operations and different phases of fiscal-monetary co-ordination. Some lessons emanate from the
analysis of the evolution of the Reserve Bank’s
balance sheet, particularly in the post-reforms period.
6.32 First, during the post-reform period, the
move from ad hoc treasury bills to ways and
means advances (WMA) and the adoption of the
FRBM framework has freed monetary policy and
hence, the central bank balance sheet from fiscal
deficit’s straitjacket. The share of net RBI credit to
the Central Government in the overall monetary
base declined progressively from 1980s up until
the crisis, after which it has seen some rise. In the
2000s, while the dominant role of fiscal expansion in
monetary expansion gradually faded, capital flows
took centre-stage, keeping the deviations between
the projected and actual M3 growth significant, albeit
lower than that of the monetary targeting regime of
1980s and 1990s.
6.33 Second, effective fiscal-monetary coordination
in managing sterilisation issues during
the high capital flow regime of early 2000s and
liquidity problems during the crisis period have had
significant impact on the Reserve Bank’s balance
sheet. Capital flows to India increased significantly
from the mid-2000s until 2007-08. The large excess
of capital flows over and above that required to
finance the current account deficit had resulted in the
accumulation of foreign currency assets. The large
build-up of foreign currency assets led to a significant
increase in the size of the Reserve Bank’s balance
sheet between 2001 and 2007. The composition of
the balance sheet also underwent transformation
in favour of larger net foreign assets in relation to
net domestic assets. The introduction of the market
stabilisation scheme (MSS) in April 2004, however,
had some moderating impact on the increase in
the ratio of foreign assets to domestic assets. The
introduction of MSS, under which government
securities were issued for sterilisation purposes,
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
period also, fiscal-monetary co-ordination was at its best to manage the liquidity problems. 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.
6.34 Third, to hedge against variability in prices
of domestic and foreign assets, possible losses on
account of policy intervention, external shocks and
other unforeseen systemic risk, the Reserve Bank,
in line with the suggestion of statutory auditors, has
been pursuing a proactive policy of strengthening the
reserve and revaluation accounts and accordingly
has set an indicative target of 12 per cent of its
total assets to be set aside under contingency
and asset development reserves. 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 which has implications for its
surplus transfers to Government. There is a need
to enhance some of the revaluation accounts like
exchange equalisation account (EEA) keeping in
view the likely impact of forward commitments and
related exchange rate risks on the balance sheet.
This is particularly relevant in the post-crisis scenario
that saw several central banks facing problems on
the capital front. While interest and credit risks have
assumed significance in the central bank balance
sheets of advanced countries, the central banks in
EMDEs, including India, which hold large foreign
currency assets, face the exchange rate risk and the
risk of return on foreign assets falling short of the
cost of short-term sterilisation bonds, if issued by
the central bank or the interest income foregone on
domestic assets.
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
6.35 The previous chapter set out the outlook for
fiscal-monetary co-ordination over the medium-term
in India. The empirical exercise described in the chapter over the post-reforms period indicates that
fiscal deficit tends to put 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 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. Indeed, the
co-ordination of fiscal and monetary policies taken
in the aftermath of the global financial crisis 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 action. 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, of course, depends
on various structural factors as well as interest
rates. Looking ahead, the Twelfth Plan document
highlights the significance of an improvement in
public sector savings for generating the required
resources in order to attain the targeted average
rate of growth of 8.0 per cent. The document has
also estimated total infrastructure investment during
the Plan period at US$ one trillion, with the share of
the public sector placed at over 50 per cent. In this
context, an orderly and qualitative fiscal adjustment
process, as corroborated by the experience and
empirical exercise, would not only facilitate the
attainment of the Twelfth Plan objectives but also
provide more headroom to monetary policy to
address macroeconomic and financial stability, in
general, and the growth objective, in particular.
6.36 As far as institutional arrangements for
government debt management are concerned, the
Paul Fisher Study Group (2011), commissioned
by the Committee on the Global Financial System,
has underscored the need for closer co-ordination
between debt management and monetary
management, with each agency maintaining
independence and accountability for its respective
role. The Group has also cautioned against changes
in the extant arrangements, including those in some
developing economies where the central bank is
responsible for some sovereign debt management
(SDM) functions or involved in SDM oversight.
The views of the Group have been shaped by the
experience from the recent global financial crisis,
which revealed that debt management impacts not
only monetary management but also the maintenance
of 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, though separate, remained housed within
the same organisation. 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.
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