The Fiscal Responsibility and Budget Management Act is currently under review by government. It must not be diluted. It is essential to our financial system.
Economic policy is in the news these days. Everyone’s talking about Demonetisation and GST, but while those big policies get all the headlines, there are a slew of small ones that are also critical for our economy. For example, the Fiscal Responsibility and Budget Management Act (FRBM) is currently being reviewed by policymakers and bureaucrats. It may sound mundane, but it is vital for our economic growth that the FRBM not be diluted.
Since independence, the penetration of financial markets has improved in India. Bank deposits and bank credit have been increasing continuously over the past few decades. The FRBM, which delinks monetary policies from fiscal ones, is key to managing our financial system. To understand why it is important, let’s look at its history.
Profligate Expenditures Incorporated
Before the liberalization of the Indian economy in 1991, the government maintained the prices of commodities, and used subsidies to keep those prices steady. These subsidies were often financed from the coffers of the state, and, with revenues less than expenditures, chronic budget deficits were faced by the government.
To continue profligate expenditure, the government borrowed money from nationalised banks in the form of loans and ad-hoc treasury bills. The issuance of these bills led to an almost automatic monetization reign, and the net RBI credit was used for reserve money expansion. The money supply got affected by this in an unconditional and instinctual manner, reducing the faculty of the RBI to manage the economy. Other monetary tools were also impacted by such fiscal policies – the interest was kept artificially low, and the Cash Reserve Ratio (CRR) was increased to stabilise the economy. As is evident, until the 1990s, RBI operations were subservient to the credit needs of the government. The maintenance of the interest-rate regime was a major impediment to performing open-market operations. Yet, to finance the needs of the government, controlling the interest rate was crucial.
In 1985, the Report of the Committee to Review the Working of the Monetary System, popularly known as the Chakravarty Committee Report, was released. Its goal was to develop frameworks to reduce the inflationary pressures on the economy while allowing government expenditure to continue. Among other things, the committee suggested revealing the fiscal deficit figure, which the government didn’t disclose explicitly until then. Instead, one had to go through a series of calculations to reach the deficit number. It took six long years to incorporate this suggestion, and in 1991, under then Finance Minister Manmohan Singh, the figures were released for the first time.
Breathing Room for the RBI
The measures of the Chakravarty Committee were helpful in increasing the autonomy of the RBI. Notwithstanding this, the RBI was still constrained with the fiscal stance of the government. Due to liberalization, this period saw an increase in capital flows and a change in interest-rate regimes. The rate of financial innovation was also unprecedented, and the RBI undertook the task of creating a corridor for the short-term money-market rate in a phased manner. This enabled them to carry out open-market operations and repo/reverse repo operations with more options to intervene, thus increasing its autonomy over the economy. Yet, despite this and many other reforms to the tax system and expenditure strategy of the government, the external liabilities of the centre and state combined climbed to 81.09% of GDP by 2002-03. Something had to be done to bring in more discipline to run the economy without overheating it.
In 2003, under Article 268 of the Constitution, the FRBM Act was passed. It asked the government to set targets for fiscal deficits, and become more committed and transparent in its dealings with the RBI. It formally set a target of 3% fiscal deficit to be met by 2009. Moreover, FRBM required the government to publish annual reports with economic assessments, taxation, expenditure strategy and three-year rolling targets for revenue and fiscal balance. Further, it also allowed the parliament to review these changes quarterly.
FRBM: Pros and Cons
Owing to FRBM, the pressure was put on the government, and they couldn’t coerce the RBI to meet their spending needs and demands. As a result, the fiscal deficit, which was at 7.61% at the start of the 1990s and at 5.72% when the FRBM Act was implemented, dropped steadily by 0.5% each financial year to a low of 2.54% in 2007-08. Thereafter, the global financial crisis hit, and liquidity and solvency issues propped up all over the world. The government then rolled out expansionary schemes like the rural farm waiver grant scheme, MNREGA, and the revised salaries of public servants under the 6th pay commission to absorb the effects of the crisis. With this, the fiscal pressures were back on and the fiscal deficit target was suspended.
There are many criticisms to the FRBM. Some say it keeps in check the various states’ fiscal deficits but not the centre’s. The 14th finance commission stated that there should be a 3% target for the centre and a separate 3% target for states. Several even question whether the fiscal deficit targets should be a range or a fixed number. The biggest criticism, however, is that FRBM has no teeth. Ministers can always ‘pause and play’ the recommendations to suit their own needs and motivations – either political or personal.
While some of these criticisms are reevaluated by the N.K. Singh Committee Report, many still remain a concern. The Committee has recommended a medium term target of 2.5% by 2023. Arvind Subramanian, however, disagreed with this target, and said in his dissent note that the calculations don’t justify this number. The Committee has also recommended the establishment of a three-member Fiscal Council that will provide the state and central governments with fiscal forecasts to inform spending and collection. The Committee further recommends repealing the Act entirely, and enacting a ‘Debt and Fiscal Responsibility Act’ instead.
The Modi government is in a unique position to accept and enforce changes that it wants. FRBM, like any other policy has its merits and demerits, but the Act reminds us that democratic mechanisms that bring about transparency are indispensable to keep government institutions under check. That core tenet needs to be protected.