The Hindu Business Line : Fiscal management — Why not a financial stability unit?

The Task Force Report on Fiscal Responsibility and Budget Management and the GTB imbroglio have raised issues that the RBI can tackle by setting up a financial stability unit, independent of its supervision and regulatory departments. With support from economists and legal, supervision, and accountancy experts, the unit can evaluate the surveillance reports of the supervision department. To raise people's confidence, the RBI can put out a public information note giving a gist of the main conclusions of the financial stability unit, says A. Vasudevan.

TWO EVENTS in recent weeks, one relating to the publication of the Task Force Report (TFR) on Fiscal Responsibility and Budget Management and the other about the handling of the Global Trust Bank (GTB) imbroglio, have thrown up a number of issues that need further reflection. While the fiscal authorities would take final decisions about the TFR, that on GTB would have to be taken in a concerted way by the Centre and the Reserve Bank of India with the RBI as the focal point.

The TFR is an exquisite technical document that has all the ingredients — the baseline scenarios, the policy proposals and their expected impact — that would be an economist's delight. It could, however, have been made more realistic by statistical exercises that take data only from 1991-92 instead of 1980 so that there would have been a better and an enhanced understanding of the channels through which fiscal policy would transmit its effects to realise the desired outcomes in a market-oriented policy regime. One suspects that data from 1980 were used to let regression and co-integration techniques provide the technical frame.

The TFR is clearly biased towards revenue reforms. Its limited focus on expenditure reforms would act as an incentive to be soft budget constrained insofar as spending is concerned. Its arguments that capital expenditures have to be `well utilised' and revenue expenditure reforms are required are hardly convincing. It is not clear why it did not examine whether there is a link between capital and revenue expenditures and why certain exemptions are given in their tax proposals. Again, there is little discussion on the downside risks in realising some of the impacts of their proposals.

The goods and service tax (GST) proposed by the TFR is an important one. It, however, needs to be judged against the practical experiences of countries that had tried VAT or GST. In Australia, GST seems to have given rise to problems about administrative arrangements, and determination of the threshold level of the tax. That is why the TFR should have made out a case as to why their recommendation for GST is easy to comprehend, and can be effectively implemented. The TFR has given a list of positive impacts of their proposals (on growth, prices, financial sector and so on). An aggregate of all the positive impacts is so impressive that there is no reason why one should wait for nirvana even till 2007-08!

For the sake of argument, let us assume that the TFR projections come out to be true. Still can one be sure that the State governments' expenditures would behave consistent with the idea of reducing overall public sector fiscal deficit? Not long ago, Brazil had the unfortunate experience of getting into fiscal problems because of sub-national governments' errant behaviour. The TFR of course is not required to look at this issue but so long as the States want to exert their independence, it would be risky to assume that their fiscal behaviour would always be compatible with the desired fiscal objective of the Centre.

A tangential issue crops up often in discussions on macroeconomic policies and financial stability. The TFR's emphasis on lowering the fiscal deficit in the medium term is admirable. But look at the argument advanced ever since the 1997 Asian crisis that such problems can arise due to external capital account and not necessarily by external current account deficit. If so, how does one treat fiscal deficit? What is the macroeconomic identity that one views for indications of incipient crisis? The TFR, of course, need not have probed into this question but it needs to be settled.

On the GTB issue, the RBI has been under attack rather unfairly. It is not easy for any central banker to openly announce the vulnerabilities of a bank even when there are no systemic problems. More often than not, most corrective actions would be perceived as delayed and partisan.

The GTB episode, however, offers some major insights. Once it is decided to take corrective actions with respect to a bank under stress, it is necessary to swiftly unveil the strategy. In other words, the strategy has to be worked out even as the processes of determination about the weaknesses of a bank are carried out. In the GTB case, the swift announcement of its merger with Oriental Bank of Commerce and the Finance Minister's assurances to depositors came as great relief. The merger announcement also showed that the RBI has prepared a strategy before undertaking action on GTB. As the main sources of the problem relate to errant auditors and internal control managers, some actions that are perceived to be punitive need to be taken swiftly and transparently. News, however, has trickled down about the RBI writing to the Institute of Chartered Accountants of India on the audit firm's role in the GTB balance-sheet analysis but not much is known about the actions that have been taken or are being contemplated against the managers of the internal control systems of GTB.

To be more credible, the RBI should also put out a public advisory to all the institutions and participants in the markets that the said audit firm may not be considered for audit without due diligence and without appropriate letters of consent or at least `no objection' from the Institute. This could be followed, if necessary by the RBI delisting the firm as it had done after the Harshad Mehta irregularity had come to light. Besides, at every stage of the process of implementing the announced strategy (such as the merger in the present case), the RBI should place in public domain the actions it has taken and the expectations it has of the responses of the other parties associated with the strategy including those now in the employment of GTB.

Let me suggest a long-term strategy that the RBI could pursue to further its reputation as one that fosters financial stability and to give a clear message that it is non-partisan in pursuing this objective. It should set up a distinct financial stability unit independent of the supervision and regulatory departments. The unit could be headed by a person taken on a contract basis from outside the organisation for, say, three years without any renewal possibility.

The head of such a unit with support from economists and legal, supervision, and accountancy experts would evaluate the surveillance reports of the supervision department on each bank and present his views to the Board for Financial Supervision. The unit head would not work under any deputy governor and his evaluation would not be required to be approved by the Governor before they are finalised. This independence would help build public confidence and the unit accountable.

The RBI should put out a public information note giving a gist of the main conclusions of the financial stability unit and of the Board. Besides, the RBI should have a special section on financial stability issues in its Bulletins and publish special studies on them at least once a quarter in order to arouse and kindle academic and international interest in the area.

(The author, a former Executive Director of the Reserve Bank of India, can be accessed at asurivasudevan@hotmail.com)

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