Book Review: Viral Acharya’s Quest for Restoring Financial Stability in India

I have written a review (slightly long) of Viral Acharya’s book: Quest for Restoring Financial Stability in India.

Here it goes:

 

When I heard of that we are soon going to get a Viral Acharya book on financial stability I was really excited. However, when I learnt of its contents, I was like oh no not again! In India, it is a practice that former RBI Governors release books which are just a compilation of their speeches which are freely available on RBI’s website! Acharya’s book was an addition to this list and to top it all it also includes his submissions to minutes of RBI’s Monetary Policy Committee. I thought it would be much better if he had broken the tradition and written a book on financial stability without speeches/minutes.

I had a change of heart when I heard the author over the several book talks he was giving in end of July and early August across campuses which are streamed freely in today’s pandemic affected world. We were fortunate to host him at my University as well (recording here).

In these talks, Acharya explained the motivation for writing this book was to start a dialogue/discussion with the public on financial stability in India which was placed on critical crossroads. If we take course the right road of course correction, we could be on the path to sustainable growth. If we take the wrong road of delay and postponement, we could resemble Japan which lost years of growth (3 decades) as it did not pay attention to resolving financial sector problems.

On receiving the book, one gets more insights on the book. In the acknowledgements section, Acharya says these speeches and minutes were “truly my voice, my lifeblood, my raison detre”. He calls them “the result of toiling tirelessly throughout many a night, distilling and pouring every drop, I could find inside me of economic reasoning and persuasion”. As a market and central bank watcher, on does read the minutes and speeches but does realize the effort that goes in writing these minutes and speeches.

Apart from this, what touched me was two things. First, Acharya dedicating his book to his late school teacher –Shailendra Sir- who he credits for igniting the fire in him during school days. We do see authors dedicating books to families, friends but rarely to school teachers. Second, proceeds of the book are going towards Pratham, an NGO which has been trying to improve India’s primary education for a long time. Pratham like all other organisations has been struggling due to the pandemic and Acharya is doing his bit to help the organisation. In his book talks, Acharya said there is not a better way to contribute to society than furthering the cause of education. Talk about hitting two birds with one stone. I am sure Shailendra Sir would be really proud of such a student.

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 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.

Book’s Preface is its heart

Acharya in Preface to the book explains and expands on these ideas further. Unlike Prefaces of other books, this one is more like the main chapter of the book. The title of Preface says it all: “Fiscal Dominance – A Theory of Everything in India”.

The Preface starts like a scene from one of those crime thrillers: “I left New York for Mumbai on the evening of 21 January 2017. As I sat at Newak Airport awaiting to board a United Airlines flight, I couldn’t help reflect on the fact that the Indian banking sector was sitting on one of the highest non-performing loans to assets ratio among the G-20 countries – a marked departure since its standing in 2009.” The author further reflects how Indian banking crises has been going through a silent crisis with udercapitalised public sector banks coupled with lack of significant market discipline, evergreening of loans or zombie lending.

Given his vast experience and research in banking, Acharya wrote two bullet points to fix the crisis. First, fix health of banking sector especially public sector banks through series of reforms such as recapitalization, Prompt Corrective Action, timely recognition of losses and decisive resolution of stressed assets. Second develop financial markets to improve efficiency of capital allocation, reduce dependence of system on banks and allow market based mechanisms to reward and punish the borrowers for their outcomes.

It would have been interesting if Viral had continued to explain how he and RBI went around the task in a thriller format. But unfortunately, it ends with this prognosis and what you get is insights on the fiscal theory of everything.

On these two bullet points, Acharya believes RBI achieved moderate success in fixing banking sector despite some early progress made during Governor Raghuram Rajan’s tenure. In very quick time of 10 months, progress was not just stalled but even decelerated as capital was infused in weak PSBs, PCA and Insolvency and Bankruptcy code were diluted. Despite the deceleration, reforms such as inflation targeting made it difficult to push for a monetary and credit stimulus unlike earlier episodes where it was easier to push for stimulus. However, this led to frictions between the Government and RBI leading to the central bank losing its Governor “on the altar of financial stability”.

On the second point, there was more success as series of regulations have enabled fixed-income and currency markets to become more principles based. In a way this was continuation of efforts taken since 1990s to make Indian financial markets more efficient. However, he laments that market participants continually raise expectations of central bank’s interventions in bond and currency markets and have been unable to walk without these crutches.

The question is what prevented progress in banking? Why does RBI face such an uphill task to manage financial stability when it has been proven that financial stability is an enabler in overall growth? Why do we believe in short term credit stimulus rather than focus on financial markets for allocate of resources?

Fiscal Dominance and Financial Stability

Against all these question Acharya has one answer: fiscal dominance. Fiscal dominance usually means that large government debts and deficits push a central bank into managing the fiscal situation by keeping interest rates low and maintaining easy liquidity conditions. However, Acharya takes the idea forward and says this fiscal dominance also impacts financial system. The dominance ensures that the central bank (and other regulators) adopt sub-optimal financial sector policies and regulations. Acharya points to 6 channels in which fiscal dominance affects financial stability.

First, if one has to timely recognize banking losses then this triggers demand for higher capital. In case of public sector banks the capital has to come from the government’s budget. In case of stretched fiscal position which has been the case for India, raising capital is always a problem. This leads to regulatory forbearances such as relaxed loan loss recognition, delayed adoption of improved accounting standards which recognize expected losses etc.  These forbearances make banks’ capital look right but in reality they are undercapitalized which is recognized by rating agencies as a negative event. As regulation applies to all, the forbearance extends to private banks as well and keeps them weaker than required. In all it is a race to bottom.

Second, related point is weakening of default disclosure norms. This was really an odd connection by Acharya but worth thinking about. He says that in case a listed firm’s financials weaken this should reflect in stock prices in the markets and this is how markets function as well. But not in India as this news will also lead to pressures on the banks who have lent to these firms. If these banks happen to be public sector ones, then again we have a similar cycle as in the first point. It puts pressure on the capital market regulator this time to think about default disclosure norms. SEBI requires companies that default in payment of bonds in 24-hours but same disclosure for default ion loans is 30 days.

Third, monetary policy is under pressure to keep interest rates low. Higher interest rates lead to erosion of treasury profits putting pressure on raising capital. Likewise, liquidity infusions by central banks in repo window are preferable compared to liquidity absorptions under reverse repo window.

Fourth, market regulations are such that whenever there are treasury profits they are recognized immediately. But in case of losses one is allowed to recognize them over several quarters. This is again due to the fact that losses imply raising capital which is an option is not readily available for public sector banks.

Fifth, high deficits and debts lead government to look at short-term measures such as issuing foreign currency denominated bonds (announced in Budget of 2019). The central bank could be pushed in easing capital flow policies to allow such inflows. In case of an external shock the cost of these liabilities rise creating problems for the entire economy

Sixth, the fiscal overbearance leads to constant reliance on other sources of funds such as central bank dividends. This transfers from RBI has been in the news for some years now. In 2018-19 and 2019-20, government not just demanded higher transfers but also interim dividends. The Government also made claims on the reserves RBI had accumulated over the years mainly as a safeguard against financial instability shocks. The constant pressure on RBI led to serious frictions between RBI and the Government which was also seen as a reason for losing the Governor “on altar of financial stability”. The first thing Shaktikanta Das did on being appointed as RBI Governor was to appoint a committee under former Governor Dr. Bimal Jalan whose suggestions generated frenetic discussions and controversies.

There are other indirect channels such as crowding out of private sector, higher external and internal financial fragility as private firms have to resort to borrowing from abroad and borrow at shorter durations and so on.

Thus, in order for RBI and other regulators to focus on financial stability fiscal dominance has to be managed.  This requires a fiscal consolidation path and prudent spending. This does not mean cutting down government expenditure completely but reorientating it towards higher multiplier programs such as infrastructure and education. Acharya also vouches for a bipartisan Fiscal Council which reviews and monitors the government spending. There is also no room for accounting jugglery and hiding deficits via off-balance sheet items.

For financial stability, central bank needs take certain steps to limit being fiscally dominated.

First, RBI should commit itself to financial stability.  Barring listing the usual points Acharya does not really mention how RBI can commit itself. At present, RBI does not discuss financial stability matters on any forum. There was a time when RBI’s monetary policy meetings were open to discussions on financial stability. However, post adoption of inflation targeting RBI keeps itself limited to measures taken around discussing price stability. Either RBI should allow discussions on financial stability or develop a separate committee as in Bank of England to discuss these matters.

Second, central bank must be granted independence and autonomy over regulatory decisions, He highlights that top management appointments must be done in a timely and accountable manner. The term of the top management should be atelas as long as the government and span government terms.

Third, policy should be based on rules and not on discretion. Infact, all the six problems of fiscal dominance over financial stability can be addressed if RBI ties itself to rules.

Fourth, when the government puts a lot of pressure, central bank should draw a line and learn to say rather than chicken to government’s pressures. This is controversial and again there should be well-specified rules which suggest whether the government is applying pressure.

Fifth, independence and autonomy should be backed by public accountability. This is an important point missed by quite a few economists who suggest increased independence but miss accountability. The central bank should back its policy actions with research and reports. There should also be an open acknowledgement of limitations of the central bank which will keep the central bank away from opaque promises.

Sixth, central bank must speak truth to the power and use its voice to safeguard public interest over career growth of personnel! Many a times central bank takes fiscal dominance as given and does not attempt to rectify the situation. We should allow dissent as it promotes diversity of thinking. Without dissent we have a case of a birds of a feather flock together.

With this background, Acharya invites all stakeholders –                 government, the central bank, other financial sector regulators, corporates, investors, analysts and media – to get into an open discussion and join the quest on restoring financial stability.

Book Chapters could have been organised better

The preface is then followed by compilation of Acharya’s speeches given during his tenure. For ease, he divides the speeches in six sections:

  1. Resolving Non-Performing Assets (NPAs) and Recapitalizing Banks
  2. Creating a Public Credit Registry
  3. Incorporating the Financial Cycle in the Monetary Policy Framework
  4. Improving Monetary Policy Transmission
  5. Developing Viable Capital Markets and Ensuring External Sector Resilience
  6. Striking the Right Balance: Enhancing the Autonomy of the Central Bank, the Markets and the Real Economy

I have read most of these speeches and would encourage those who haven’t to read them to get ideas, Acharya could have added a background to each of these sections providing the context behind the speeches and summarizing them. A backgrounder would have connected these speeches to the reader really well.

Final Thoughts

I had mixed feelings reading the book.

First, connecting fiscal dominance to financial stability is really interesting. While much of this is intuitive and not really new but atleast I did not see the linkages as clearly.

Second, connected point is blaming everything on fiscal dominance is a narrative which was dominant before the 2008 crisis. Post-2008, economists have become kinder to rising deficit and debt levels. The world economy had slowed down even before the pandemic and there were calls to initiate fiscal stimulus even in economies with high deficit and debt levels like US and Europe.  The State expenditure is being seen as one of the ways to reduce inequalities and address deficits in infrastructure, education, health and so on. The rise of Modern Monetary Theory which suggests that a sovereign issuing currency need not worry about deficits has captured imagination. It would have been interesting if the author had written a few paras on this change in economic thinking.

Third, the author nearly absolves RBI from the mistakes and blames everything on government. The central bank’s role in supervision and regulation of banks needs to be questioned. While one can blame the government for mismanaging the macroeconomics of banking as suggested by the author, the RBI needs to be blamed for mismanaging the microeconomics of banking. In case of public sector banks there is dual control of government and RBI, hence one cannot blame RBI. But in case of private banks there is no such duality and yet we have cases like Yes Bank slipping from the regulator’s radar. Clearly, there is a case for serious introspection in Yes Bank case even if it was one such case. The failure of Yes Bank has dented the process of privatization of Indian banking where private banks where increasingly getting more share of deposits and loans.

Fourth, while there are always calls for greater central bank autonomy (I don’t like the word independence), this too is being questioned by economists. Paul Tucker in his recent book argued against the growing power of central banks over economies. Tucker pointed how post Great Depression there was a reduction in role of central banks in economies. But post-2008 crisis, central banks have only grown in power despite some economists blaming central banks such as Federal Reserve for sowing the seeds of the crisis. Central banks are also run by technocrats and are not really responsible to the electorate. Whereas governments are elected by the people (in democracies like India) and are accountable directly to the people. So, there are equal calls to limit growing power of central banks which implies lesser autonomy.

Given this, nothing can take away the effort by Viral Acharya to kickstart the debate on restoring financial stability in India. Post-RBI he has been really busy writing several academic papers so putting this book together would have required special effort.

In previous interviews and book talks Acharya mentions how he is a huge fan of Kishore Kumar and old Hindi songs.  Reading the book it almost seems as if Acharya is asking all of us to join and sing the eternal song from the Hindi movie Imtihaan sung by Kishore Kumar: “Ruk jaana nahin tu kahin haar ke, kaaton pe chal kar meilenge saaye bahaar ke, o rahi o rahi.

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One Response to “Book Review: Viral Acharya’s Quest for Restoring Financial Stability in India”

  1. asif445 Says:

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