Fiscal deficit, a black hole

Newspapers are carrying reports on the ‘progress’ made in cutting down fiscal and revenue deficits from their previous levels. They do not tell the whole story.

Certain conceptual issues are glossed over in the attempt to create a favourable public opinion on the Government’s fiscal management.

One of the reasons for the so-called stringency of liquidity in the banking system in the last quarter of 2012-13 was the accumulation of Government’s cash balances in the Reserve Bank of India (RBI) to bring down fiscal deficit by restraining planned expenditure.

The Government says that such constraints amounted to only around Rs 15,000 crore. However, there was also a further restriction like delaying tax refunds, settlements of government bills, and so on.

Pernicious practice

This pernicious practice is an annual feature that is facilitated by the cash flow accounting in Government under which only actual inflows and outflows are recognised.

The ideal is the accrual system under which transactions are recorded at the time when economic value is created, exchanged, transferred or impaired, irrespective of whether cash is actually exchanged or not.

Following the recommendation by the Twelfth and Thirteenth Finance Commissions for a gradual shift to accrual-based accounting, operational guidelines were issued more than two years ago for the transition to the new system in the interests of greater transparency and accountability of departments.

The real extent of fiscal deficit can be known only if the liabilities due to be discharged during the year but not done are revealed along with the revenue receipts (not under litigation) expected but not realised. There is no information available on the progress of the transition to the new system in the Budget papers.

There is another aspect of fiscal deficit about which I wrote in this daily (‘The Fiscal Deficit Conundrum’, February 7, 2002).

While the central bank lending to Government is considered as deficit financing, the interest paid by the latter and returned to it by the RBI at the end of the year as part of a transfer of the surplus of income over expenditure is treated as revenue receipt.

No doubt, the interest paid and the corresponding annual transfer together have a neutral effect in their consolidated balance sheet. However, the impact on the economy is substantial because while the payment of interest is mere book entry, the year-end transfer is a real transaction generating funds for the Government.

Substantial underwriting

In the past, before the central bank was prohibited from entering the primary market for Government securities, there was a substantial underwriting by the former although there evolved a practice of unloading them later on the market when conditions were favourable.

Still, the interest paid by Government when the securities were held by the RBI should have been substantial.

When I wrote my article in 2002, at one point of time, the RBI was holding Rs 1.4 trillion worth of securities. As on May 24, 2013, the holdings of rupee securities (including treasury bills) add up to Rs 6.3 trillion.

The Fiscal Responsibility and Budget Management Act prohibiting the central bank from purchases in primary market has made little difference to the monetisation of fiscal deficit. Substantial volumes of the securities have been added to the portfolio through the debt buyback operations in the secondary market.

The Government does not get the money to finance the current year’s deficit as there is only a change in the ownership of the gilt-edged paper from the seller to the RBI.

This led to a former Finance Secretary claiming that buybacks were not monetising fiscal deficit.

However, it does imply a retroactive monetisation of fiscal deficit, since the net RBI credit to Government goes up as a consequence.

One may even take the view that the current year’s deficit is also financed by RBI credit through the medium of banks and other institutions participating in the buyback scheme – a case of backdoor financing.

Time to come clean

Elsewhere I have called the so-called Open Market Operations (OMO) as Debt Management Operations (DMO).

It is important for the Government and the RBI to come clean and become transparent on the matter and reveal the total interest paid by the former to the latter, including the amount paid on Ways and Means Advances, which is now treated as revenue receipt. In reality the RBI is financing the interest payment and it should be included in fiscal deficit.

Monetary experts may argue that what I say may be true of all OMOs, in which case the rationale for its being an instrument for the implementation of monetary policy is compromised.

But the distinction between OMOs and DMOs is clear. The former has a monetary objective of regulating money supply; the latter has the fiscal objective of helping the Government in its borrowing programme.

Interestingly, whether outright monetary transaction, i.e., open market purchases of sovereign debt, is compatible with the Treaty on the European Central Bank, which prohibits its lending to governments but allows open market operations, has been a subject of intense debate in academic circles in the US and Europe.

I came to know of this during an interaction with Martin Hellwig, Director of the Max Planck Institute for Research on Collective Goods, Bonn, consequent to my review of his book entitled The Bankers’ New Clothes co-authored jointly with Anat Admati of Stanford.

(The author is a Mumbai-based economic consultant.)

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