Eternal quest for financial stability: Dr Rupa Rege Nitsure reviews former RBI Deputy Governor Viral Acharya's new book

Viral Acharya’s latest book – Quest for Restoring Financial Stability in India – is essentially a compilation of his thought-provoking speeches delivered as a deputy governor of the Reserve Bank of India (RBI) and his analytical commentary as a member of the Monetary Policy Committee (MPC). The book is enriched with a preface: Fiscal Dominance – A Theory of Everything in India, and an epilogue that defines a few preconditions to create a stable financial sector. If these are met, a system will not require extraordinary measures on a frequent basis, asserts Acharya.

Acharya’s propositions strongly reflect the tumultuous period (2017 to 2019) for the Indian financial sector when he served as a deputy governor. This phase was marked by an acute economic slowdown following demonetisation, the seemingly irreparable crisis of NPAs, a persistent liquidity squeeze for NBFCs, hot debates on the autonomy of the Central bank because of profit transfer from the RBI and the controversial exit of an RBI governor.

According to Acharya, during the early part of his tenure, the RBI was moderately successful in terms of fixing the banking sector’s health due to the introduction of the asset quality review in 2014-15, the imposition of a PCA framework on weak public sector banks (PSBs), the government’s revealed intention to support healthier PSBs with “growth” capital and the functioning of the IBC for NPA resolution. However, in about ten months to follow, many components of these policies got diluted and the RBI came under severe governmental pressure to open the liquidity and credit taps to prop up the economy.

Acharya says the efforts of the RBI at restoring financial stability were seen by the government as contradictory to pursuing growth. He further asserts that the government’s fiscal profligacy is generally driven by short-term populist pressures while the Central bank is more focused on the long-term objectives of stable and sustainable growth. Fiscal dominance impacts not just monetary policy-making but also financial sector policies and regulation, leading to suboptimal policy outcomes. Acharya admits that fiscal dominance was not unique to the period that he served at the RBI. But India had made definite progress since the 2000s, to reduce “financial repression” by lowering the resource pre-emption (CRR/SLR) and by institutionalising the FRBM Act to prevent automatic monetisation of the government deficit. These progressive steps were facilitated by the conducive environment of high economic growth and savings during 2000 to 2010. Unfortunately, fiscal dominance returned in India with a vengeance, once these favourable economic factors got reversed.

No one will disagree with Acharya that the return of fiscal dominance in the past few years has reduced the effectiveness of monetary as well as financial sector policies in India in many ways. In the section on “Advance Praise” to his book, the former and most effective governors and deputy governors of the RBI, like C Rangarajan, Y V Reddy, Raghuram Rajan, Rakesh Mohan, Usha Thorat and Shyamala Gopinath, have openly endorsed Acharya’s thesis and accepted the constraints created by India’s political economy. It is interesting to note that during the tenures of these governors/deputy governors, the Indian economy grew healthily, some tough reforms were successfully implemented and institutions carrying public deposits were saved without creating a huge disruption. And they achieved all of this within the sticky political economy framework.

Acharya’s solution is that the RBI should never compromise with financial stability, especially when government pressures are driven by its short-term objectives or quick fixes. The RBI should always stick to well-designed rules for decision-making (e.g, the inflation-targeting mandate, PCA framework for under-capitalised entities, Basel standards for bank capital, liquidity requirements, etc). But this is also not enough, he feels. Hence, Acharya hopes that more and better gatekeepers of financial stability (like him) will spring up tomorrow at the RBI, the government and other parts of the financial system, helping to complete this unfinished agenda. Besides arguing for Central bank independence and the much-needed improvement in the health of the PSBs, he has recommended big-ticket disinvestments (including privatising PSBs), setting up an independent fiscal council to vet government accounts and boost spending on health and infrastructure by curtailing revenue expenditure, to set India’s public finances in order. He also adds that the inflation-targeting mechanism has worked well for India and nobody should indulge in any “adventurism” by refining the target especially, given the fog of uncertainty.

There is no doubt that the book is written with a strong sense of conviction and scholarly rigour. It depicts Acharya’s urge to ignite public debate over growing fiscal dominance that has created formidable challenges for the RBI. However, the book also reflects Acharya’s systematic biases in many aspects. In particular, the book does not answer the following pressing questions.

1. Empirical studies indicate that the performance of PSBs and new private banks converged over a long period between 1994 and 2011. Actually, their performance started diverging from the global financial crisis of 2008 and the divergence became marked after 2011. The NPA pain in large corporate exposures was equally felt by private banks but unlike PSBs, they were allowed to exit their corporate exposures much earlier. Also, they had used various other avenues to hide these NPAs. When most of the large corporate exposures were syndicated, how can one blame the PSBs alone for serious dilution of underwriting standards?

2. While it is a legitimate demand of the RBI to have more power and control over PSBs, why did it apparently delay action against the erring officials in the large and systemically important private sector banks, despite claiming to have enough powers to deal with private sector lenders?

3. When so many irregularities were getting reported from the large private banks, why were they referred to as idiosyncratic issues and not as a systemic problem?

4. When it comes to equalisation of the net regulatory burden to different ownership groups (public, private and foreign), why was no thought given to bringing entities other than PSBs under the purview of the Central Vigilance Commission, as they too are raising public deposits?

5. If fiscal dominance has weakened the role of RBI as a financial regulator, why is the privatisation of PSBs being advocated so strongly? Empirical studies clearly show that privatised banks play an efficient role in financial development only under a strong and independent regulatory agency.

6. All structural reforms entail adjustment costs on the economy. It is easier to cope with the adjustment costs of reform when the economy is strong. While steps like asset quality review, launching of the IBC or public credit registry project were extremely laudable, the PCA on under-capitalised banks or the lack of a “lender of last resort” kind of mechanism for NBFCs tended to increase the intensity of the economic slowdown, when the economy was at the lowest point of growth in the past decade. How has that helped in promoting financial stability?

7. If not PSBs, then which entities would support large-scale financial inclusion steps like the Jan Dhan Yojana and a plethora of other flagship schemes?

8. Finally, Covid-19 has created extraordinary uncertainty about the future course of the economy. How will a Central bank be able to stick to well-designed rules for decision-making? Forecasts made today about future output and inflation risk could be completely off the mark tomorrow. Based on the behavioural macro-economic model, some economists are suggesting that the Central bank should not be forward-looking in times of crisis. It makes sense to adopt policies based on current conditions, rather than forecasts.

Acharya’s book is certainly timely and relevant given the growing signs of fiscal dominance. Unfortunately, the response to coronavirus will take the country backward rather than forward, in its path to achieving financial stability. It looks like the quest will go on and on.

(Dr. Rupa Rege Nitsure is the Group Chief Economist, L&T Financial Services) (Syndicate: The Billion Press) (email:

(To download our E-paper please click here. The publishers permit sharing of the paper's PDF on WhatsApp and other social media platforms.)

Free Press Journal