Financial Stability: Viral Acharya

 The blog ‘Mostly Economics’ has a good review of the book on financial stability by Viral Acharya, Former Deputy Governor of RBI. I have reproduced some portions here as I see them to be very relevant today.

YV Reddy’s Foreword is a useful addition.

Coming to the book, one of its highlights is the Foreword by Dr. Y.V. Reddy who starts with a quote from Dr. B.R Ambedkar. Ambedkar in the Constituent Assembly (1949) had warned that if the Parliament does not make a law to limit the borrowing of the executive now, it is highly unlikely that any future Parliament will make any such law! Ambedkar had foresight on many political and economic matters and one could add fiscal accountability to the list as well.

Ambedkar’s words also preempted another economics principle of time inconsistency. Time inconsistency implies that if the government promises something in future, there are chances that it reneges on the promise when that future comes. For e.g. the central bank might promise that it will achieve lower inflation in future but enact policies which lead to higher inflation. Thus, central banks have to be bound by a rule-based policy such as monetary targeting, inflation targeting and so on. This is similar to what Ambedkar said years ago that if policymakers do not make a law to control their borrowing they are unlikely to make such a law in future.

The sagacity of Ambedkar seventy years ago shows him to be a visionary in terms of governance and economic matters. Very few leaders of the time could think so far into the future.

Today, the Union Government as well as all state governments are borrowing far beyond what the FRBM allows. This extra borrowing is on the books of the PSUs of the government and do not show up on the accounts of the State Governments. The issue is compounded by the fact that the purpose for which the PSUs borrow is in most cases not met and States arrogate money to themselves and use it for different purposes. Any Private sector entity indulging in such diversion would immediately be liable under various laws of the country.

YV Reddy believes that lack of Fiscal prudence is leading to financial instability.

The question is why YV Reddy quotes Ambedkar to bring home the point of fiscal stability when the book is on financial stability? Well, the answer is Acharya’s premise is that our fiscal imbalances are weighing on everything including financial stability. Reddy points how post bank-nationalisation, public sector banks were forced to buy government bonds at pre-fixed interest rates to support high government borrowing. Post 1991 reforms, the practice continued even when government bonds were auctioned on account of high SLR. The story is not very different for State Governments whose bonds were also pushed on public sector banks.