The Hindu Business Line : The flip side of quasi-fiscal activity

The government often resorts to the use of off-Budget activities for public policy purposes that can be duplicated by specific fiscal measures. But such quasi-fiscal measures have a flip side. Not only do they defeat the signalling mechanism of prices, they tend to promote opacity by disguising the real fiscal position.

The Finance Ministry's recent communication to public sector banks to refer interest rate changes to their respective boards has spawned a debate in the media on issues such as central bank independence, governance of public sector banks, operational efficiency, market structure of the banking industry, and level-playing field between the public and private banks.

While all this will certainly settle down, what has not received adequate attention is the flip side of this issue, that is, quasi-fiscal activities (QFA).

What is quasi-fiscal activity? It is the use of off-Budget activities for public policy purposes that can be duplicated by specific fiscal measures, such as taxes, subsidies or other direct expenditures.

Public enterprises, for instance, are used to promote or subsidise certain groups through below-market pricing.

Oil bonds

More recently, oil companies were asked to absorb the higher costs of international price of crude oil rather than pass them on to the users. When the losses of the oil companies mounted and started eating into their net worth, they were partly compensated by means of oil bonds.

One would think that any compensation should increase the Budget deficit, but in fact this move has only a limited impact on the Budget, by way of interest payments. How come?

What the Government has done is a variant of "recapitalising" the oil companies by increasing their assets — by providing bonds. Thus, its only cash outflow is the servicing of the bonds.

Yet another classic vehicle used by governments engaging in quasi-fiscal activities is the banking system. In the erstwhile centrally planned systems, banks were actually a means for fiscal resource transfers. To varying degrees in developing countries, public sector banks have also been used to direct subsidised credit to specific sectors or activities.

A recent example is the Government capping the interest rate on loans to farmers at 7 per cent. Banks will receive two percentage points as compensation.

However, the modalities have not yet been worked out and it is not clear whether this transfer will be made from the Union Budget or, once again, through some creative accounting.

The flip side

What is wrong with quasi-fiscal activities? First, they defeat the signalling mechanism of prices. Let prices rise and provide the incentives to reduce consumption of petroleum products, conserve energy and adopt energy-saving technologies. At the same time, directly subsidise those who are poor. Similarly, for monetary policy transmission to be effective, the banking system should not be part of the grants economy.

Second, such activities are opaque. There are many reasons why transparency is important. But the one directly relevant here is not to disguise the real fiscal position in terms of overall magnitude and allocation of expenditure. Obfuscating the true picture can be risky, as it can lead to complacency and delays in taking corrective action while problems may accumulate. These quasi-fiscal costs can become quite large and since they are not fully collated, the extent of damage becomes evident when, for example as in the case of the oil sector, the net worth of companies is eroded. Based on estimates by the IMF, the quasi-fiscal costs of oil price subsidies in India exceeded 1 per cent of GDP in 2005-06, rising from 0.75 per cent of GDP in 2004-05. Adding the quasi-fiscal deficit to the conventional budget deficit measure could change the picture of the fiscal deficit.

Gross fiscal deficit

By conventional measures, the combined gross fiscal deficit (GFD) of the Centre and States fell significantly, from 9.6 per cent of GDP in 2002-03 to 7.5 per cent in 2004-05. It is estimated to have remained at 7.5 per cent in 2005-06 and is budgeted to come down further to 6.5 per cent of GDP in 2006-07. However, if the quasi-fiscal costs of oil are added, the fiscal deficit apparently worsened in 2005-06. If other quasi-fiscal costs are included, then the underlying fiscal stance would become more apparent. Under the aegis of the RBI-constituted Standing Committee on International Financial Standards and Codes (May 2002), the Advisory Group on Fiscal Transparency chaired by Dr Montek Ahluwalia recommended that, "... increased reporting on contingent liabilities, major tax expenditures, quasi fiscal activities, fuller discussion of the consolidated position of Central and State Governments and availability of information on the overall public sector balance... "

IMF code

Recognising the pragmatic difficulties in estimating QFA, the international benchmark of the IMF's Code of Good Practices on Fiscal Transparency stated that a basic requirement should be to include a statement on quasi-fiscal activities in the Budget, which indicates the public policy purpose of each QFA, its duration and the intended beneficiaries.

The Ahluwalia Advisory Group accordingly recommended that a start be made towards this objective by listing the major QFAs in the system. Initially, these estimates could be attempted in the Economic Survey. Taxes and subsidies are legitimate fiscal activities. The issue is not the subsidies per se but the transparency of fiscal transactions.

(The author is a Deputy Managing Director of State Bank of India. These are personal views and do not reflect the views of the institution she is associated with.)