Don’t Be Seduced by Sirens

GoI raiding the central bank’s reserves is no solution for the fiscal deficit

The controversy over the Reserve Bank of India’s (RBI) independence cloaks a bigger issue: the government’s chronic inability to control overspending and the fiscal deficit. RBI deputy governor Viral Acharya recently pleaded in a passionate speech, replete with global examples, for an independent central bank, free from government pressures.

He opposed the government’s proposal to get a large one-off transfer of what it feels are ‘excess reserves’ in RBI’s balance sheet. These should not be confused with foreign exchange reserves. Acharya called this “raiding the RBI’s reserves” to reduce the fiscal deficit.

Self Goal in Argentina

He related the dramatic tale of the resignation of Argentina’s central bank governor Martín Redrado when his government pushed him to transfer $6.6 billion of “excess reserves” to reduce Argentina’s fiscal deficit. This, said Acharya, incurred the “wrath of markets”. Within a month, Argentina’s sovereign bond yield and credit default swap spread skyrocketed a disastrous 250 basis points, hitting currency and stock markets too.

To be fair, Acharya did not predict immediate disaster if the finance ministry raided RBI reserves. Rather, he said that markets valued independent central banks that could stand up to populist government demands, and that the erosion of such independence could at some point lead to disaster. Economic affairs secretary Saurabh Garg responded with an acid tweet, ‘Rupee trading at less than 73 to a dollar, Brent crude below $73 a barrel, markets up by over 4% during the week and bond yields below 7.8%. Wrath of the markets?’ Very witty. But this did not address Acharya’s long-term worry.

Actually, a storm in a teacup is being blown out of proportion. The government accepts formally that RBI should be independent. Even so, the finance ministry surely has the right to discuss whether RBI’s reserves are excessive. Experts can disagree on this technical issue. Large one-time transfers have occurred in the past without disturbing the markets.

The government owns RBI. It grants autonomy to RBI to enable it to focus on the long-run public interest, checking the short-term temptations of finance ministers. For the government to give RBI autonomy is like Ulysses in Homer’s Odyssey tying himself to the mast to avoid seduction by the songs of sirens.

Yet, RBI independence cannot mean absence of accountability to anybody, including its owner. RBI, like any central bank, is capable of grievous errors, and the government is entitled to ask it searching questions. The two need to work out a formula governing ‘excess reserves’ and stick to that.

The Argentina crisis was only marginally impacted by the government attempt to raid the central bank reserves. The problem was not this single act, but the government’s inability to check its fiscal deficit for years. The proposed ‘raid’ was just one of a large bundle of straws that broke the camel’s back. India’s finances are in reasonable shape. So, a one-time ‘raid’ of RBI reserves will not spark panic.

The deeper, worrying fact remains that finance minister Arun Jaitley has failed repeatedly to meet his original fiscal deficit target, which was to come down to 3% of GDP by 2016-17. Meanwhile, the fiscal deficit of the states has risen from 2.5% to around 3.5% of GDP. India has the second-highest consolidated fiscal deficit among major economies. Only Brazil is worse.

Fiscal Bridge on Deficit Valley

For decades, all finance ministers have used smoke and mirrors to hide the ugly truth about overspending. The fiscal deficit is the difference between spending and revenue. This can be bridged by borrowing (officially ‘fiscal deficit’). It can also be bridged by selling government assets (like shares in public sector utilities). Jaitley now seeks to bridge it by raiding RBI’s reserves.

The government has assets (like public sector shares) and liabilities (like borrowings). Its net worth remains exactly the same whether it borrows from markets, sells shares or raids RBI’s reserves to bridge the fiscal deficit. To claim that privatisation or raiding RBI reserves reduces the deficit — while claiming that borrowing increases it — is smoke and mirrors.

This is not the only budgetary game played by finance ministers. By simply not paying some bills by March 31, they can transfer this year’s deficit to the next one, something all parties have done for decades. Again, borrowing by PSUs is not considered part of the fiscal deficit, but borrowing by the government is.

So, a gap in government finances can be plugged without showing up in the Budget by borrowing through government financial corporations or PSUs. Raiding RBI reserves is simply one more such game.

In truth, such ploys are ways of funding the deficit in that year, not of actually reducing it. Reducing the deficit requires either increasing revenue or cutting spending. Right now, this requires some bitter medicine.

Jaitley must avoid any farm loan waiver or similar goodies despite this being an election year. After the election, the next finance minister should abandon ultra-high minimum support prices (MSP) for several crops, and rescind the recent cut in excise duty on petrol and diesel. That’s politically tough, but economically wise.

What do you think?