There is a renewed focus on fiscal-monetary co-ordination in the wake of activist fiscal response to the global
financial crisis of 2008. These developments have raised apprehensions of greater fiscal dominance at the global
level particularly when the central banks have resorted to unconventional monetary policy measures to restore
orderly conditions in financial markets and to stimulate aggregate demand in the economies affected by the global
crisis. The Indian experience shows that the rule-based fiscal legislation may have reduced, but not eliminated
fiscal dominance. The changing dynamics of fiscal-monetary interface has imparted flexibility in the Reserve
Bank’s balance sheet management amid greater challenges from the openness of the economy and the increase in
government market borrowings. Keeping in view the international experience gained from the recent financial
crisis that would impinge on debt management, monetary management and maintenance of financial stability,
as well as the specific circumstances in India, a broad guidance on the implications of the evolving path of fiscal
deficit, output gap and inflation gap for monetary policy over the medium term is provided.
1.1 Fiscal-monetary co-ordination continues to engage attention in macroeconomic theory and policy practice, and more so with the return to fiscal dominance after the impact of the global financial crisis. As both fiscal and monetary policies can influence aggregate demand and potentially complement/substitute for modulating economic activity, co-ordination between these twin arms of macroeconomic policymaking becomes essential. Expansionary fiscal policies could raise inflationary
concerns for a central bank by fuelling aggregate
demand pressures or by requiring the monetisation
of deficits. Market financing of deficits may, at times,
come in the way of keeping long-term interest rates
low and conducive for investment and economic
growth. On the other hand, a tighter monetary
policy could raise market interest rates and interest
payments on government borrowings, leading, in
turn, to larger fiscal deficits. The monetary policy
could also impact seigniorage and the inflation tax
revenue for the government. More recently, issues of sovereign debt sustainability in the euro area
are impinging on the financial stability concerns of
central banks, either through the adverse impact of
sovereign debt burden on the health of the banking
system or through traditional concerns of fiscal
dominance on monetary management.
1.2 The fiscal-monetary interface has remained
one of the central tenets for the conduct of
policymaking in the Reserve Bank over the years,
and some policy-relevant analytical issues on
this subject have been highlighted in the Bank’s
publications in the past including in earlier issues
of the Report on Currency and Finance (RCF).1 The motivation for choosing fiscal-monetary coordination
as the theme for this issue of RCF is
based on several considerations.
1.3 First, after the activist fiscal response to
the global financial crisis of 2008, central banks in
the advanced economies confronted the additional
challenge of managing sovereign debt sustainability.
There is apprehension that the conduct of liquidity management operations by central banks could
potentially monetise public debts indirectly at a
scale much beyond the extent of traditional direct
monetisation that was prevalent during the fiscal
dominance era after the Great Depression up to
the 1970s. Second, turning to India, there is a
need to assess whether phasing out automatic
monetisation of fiscal deficit and abandoning the
practice of direct subscriptions by the Reserve Bank
in the primary government securities market as
well as introducing a rule-based fiscal policy have
actually reduced fiscal dominance in the conduct
of monetary policy. Third, the evolving phases
of fiscal-monetary co-ordination in India have
posed new challenges to the Reserve Bank in its
balance sheet management. As monetary policy
switched its operating procedure from monetary
targeting to a multiple indicator approach, it had to
manage capital flows in a more open economy and
seamlessly fine-tune its liquidity adjustment facility.
Fourth, over the last couple of years, while the fiscal
deficit and inflation have remained high, investment
has slackened on account of both structural factors
and interest rates. In this context, the reform
measures announced by the government since
September 2012 and the imperatives of stepping
up the growth rate as envisaged in the Twelfth Plan
document2, while maintaining macroeconomic and
financial stability, may require careful calibration of
fiscal and monetary policies. Finally, in the light of
the strengthening interactions between sovereign
debt management, monetary policy and financial
stability in the aftermath of the global financial crisis,
a need exists to revisit the nature of institutional
arrangements for debt management over the
medium-term in India.
1.4 Accordingly, the present Report seeks
to examine various facets of fiscal-monetary coordination
in India as it has evolved, particularly
in the recent past and keeping in view the likely
developments over the medium-term, especially
the macroeconomic outlook and policy priorities. The following chapter traces the evolution of fiscal-monetary
co-ordination across a few advanced
and emerging market and developing economies
(EMDEs) and assesses the implications of the
recent global financial crisis for the fiscal-monetary
interface. Chapter 3 presents the Indian experience
in this regard, noting that fiscal dominance of
monetary policy has moderated over last two
decades, though large fiscal deficits, suppressed
inflation and debt dynamics continue to feed into
reserve money. Chapter 4 traces the substantial
transformation in the Reserve Bank’s balance
sheet over the years in line with the shifts in the
regimes of monetary policy operations and different
phases of fiscal-monetary co-ordination. Chapter
5 examines the outlook for fiscal-monetary-debt
management co-ordination in India, particularly in
the context of the post-crisis return to the prescribed
fiscal roadmap and the renewed thinking on the
institutional arrangements for debt management,
against the backdrop of the global financial crisis.
The concluding chapter identifies a few key lessons
and future challenges for fiscal-monetary coordination
internationally as well as in India in the
light of recent experience. The coverage of various
chapters along with key questions analysed therein
are set out below.
How has fiscal-monetary co-ordination evolved
in theory and practice? What have been the
implications of the recent global financial crisis
for the fiscal-monetary interface?
1.5 Addressing these questions, Chapter 2,
‘Fiscal-Monetary Co-ordination: Theory and
International Experience’, begins by setting out the
macroeconomic orthodoxy which favoured a lead
role for fiscal policy to address aggregate demand
deficiency in economies during the Great Depression
of the 1930s and to support the post-World War
II reconstruction process. With monetary policy
becoming ineffective at high unemployment levels,
direct monetisation of fiscal deficits and keeping interest rates low were the prescribed channels
whereby central banks had to acquiesce to fiscal
dominance. With the failure of Keynesian policy
prescriptions during the period of co-existence of high
inflation and high unemployment in the 1970s amid oil
price shocks and the breakdown of the multilateral fixed
exchange rate system, monetary policy independence
was sought to be achieved by adopting a monetary
targeting approach. Nonetheless, monetary policy
had to be co-ordinated with fiscal policy, particularly
in cases where independently pre-set inter-temporal
paths of fiscal deficits, uncertainties and objectives
outnumbered the available independent instruments.
Fiscal policy’s potential for directly impacting price
levels was brought forth by the ‘Fiscal Theory
of Price Level’ developed in the 1990s, thereby
identifying another channel of fiscal constraint on
monetary policy’s pursuit of price stability. Open
economy extensions, particularly after the formation
of European Monetary Union (EMU), and the need
to address the financial stability objective, brought in
more explicitly during the post-2008 global financial
crisis, have also favoured the co-ordination of fiscal
and monetary policies in recent years.
1.6 The experience of select advanced
economies in the context of fiscal-monetary
co-ordination shows that following the high
inflation of the 1970s, the issue of central bank
independence in the conduct of monetary policy
gained importance during the next two decades.
During the 1990s, many countries adopted inflation
targeting, while fiscal policy increasingly became
rule-based. These developments were reflected
in commensurate changes in monetary policy
operating procedures, while government borrowings
reduced as fiscal rules came into play. The policy
co-ordination mechanism between the central
banks and the governments improved further during
the 1990s amidst an emphasis on price stability in
the UK and some other advanced countries3. By
the early 1990s, many OECD countries had set
up committees for consultation and co-ordination between fiscal authorities and central banks on
public debt policy. At the same time, the operational
responsibility for managing government debt was
largely assigned to independent debt management
offices with their own clear-cut objectives. This
realignment of the operational framework often
went together with the independence of central
banks with explicit inflation mandates. Nonetheless,
it is difficult to conclude whether the degree of fiscal
dominance actually diminished significantly with
central banks becoming more independent since
the 1990s. As far as EMDEs are concerned, fiscal
policy dominance was often the outcome of the
importance assigned to socio-economic objectives
that they had set for their respective economies.
However, major economies like South Africa, India,
Brazil and Russia eventually recognised that fiscal
consolidation was essential to pursue and achieve
the monetary policy objectives. An analytical
assessment for the period up to the crisis shows
that with the improving co-ordination mechanism
between fiscal and monetary authorities, advanced
as well as EMDEs have used both fiscal and
monetary policies to deal with cyclical fluctuations.
1.7 Favourable economic and financial
conditions during the pre-crisis period masked debt
build-up in certain advanced economies, which got
accentuated during the crisis. The recent financial
crisis reinforced some of the traditional questions
about the co-ordination between monetary policy
and fiscal/debt management policies. A build-up
of fiscal imbalances and sovereign debt during the
crisis was observed as both advanced economies
as well as EMDEs had to respond in terms of tax
cuts and higher public spending. This situation
has continued in the post-crisis period, particularly
in the advanced economies. During the crisis,
major central banks used their balance sheets to
pursue accommodative monetary policies. The
post-crisis debate that has emerged in respect
of fiscal-monetary co-ordination is whether fiscal
dominance or monetary dominance will prevail. It is quite likely that if fiscal dominance prevails, near-term
interest rates would need to be kept lower than
under monetary dominance. However, fiscal policy
can be accommodated by monetary policy only till
inflation expectations remain contained. Therefore,
it is necessary that countries, particularly the
advanced economies, work out credible medium-term
fiscal consolidation plans, which could ensure
a balance between short-run needs for supporting
recovery in growth with medium-term fiscal
sustainability. Central banks’ interaction with fiscal
authorities is likely to be critical not only from the
viewpoint of the smooth conduct of monetary policy
to anchor inflation expectations but also from the
perspective of sovereign debt sustainability and
financial stability. The chapter also highlights current
concerns relating to the sovereign debt crisis in the
euro area and the efforts being made to strengthen
the economic pillar of the EMU by adopting a set
of rules envisaged to foster budgetary discipline
through a ‘fiscal compact’, strengthen the coordination
of economic policies and improve the
governance in the euro area.
Has fiscal dominance of monetary policy in
India reduced post-FRBM? Did the legislation
cease monetisation of deficits? Have the large
fiscal deficits in India been inflationary? Is
government spending pro-cyclical or countercyclical?
Do debt-deficit dynamics impact
monetary policy?
1.8 Chapter 3, ‘Fiscal-Monetary Co-ordination:
An Assessment in India’, which makes an
assessment of the fiscal-monetary co-ordination
through shifts in institutional arrangements for
monetary and fiscal policies in India, addresses
these questions. The regime shifts that first
curbed automatic monetisation by phasing out
ad hoc treasury bills and later prohibited the
Reserve Bank from subscribing to the primary
issuances by the Government under the Fiscal
Responsibility and Budget Management (FRBM)
Act has reduced, but not eliminated, the fiscal
dominance of monetary policy. Newer forms of
dominance have emerged, particularly, due to suppressed inflation, deficits and inflation feeding
on one another. The debt-deficit dynamics of large
fiscal deficits can potentially cause monetisation
in a broad sense. This is because open market
operations (OMOs) create reserve money in case
of net purchase of government securities by the
Reserve Bank. Whether such monetisation reduces
the efficacy of monetary policy depends on whether
OMOs conflict with monetary policy objectives.
In practice, it is not always easy to determine
what part of OMOs affects liquidity or monetary
conditions and what part of OMOs facilitates debt
auctions. The size of government market borrowings
has increased nearly ten-fold in the past eight
years (2004-05 to 2012-13). The Reserve Bank
conducted large OMO purchases during this period.
As long as fiscal deficits remain large, fiscal policy
dominance is likely to remain. To the degree that
OMOs do not affect the monetary expansion targets
of the Reserve Bank, fiscal dominance is muted.
However, when additional liquidity injected into
the system through the OMOs is in excess of the
limit that is commensurate with inflation objectives,
fiscal dominance becomes detrimental to monetary
stability. It can impinge upon monetary policy
operations, as it provides a game-theoretic setting
for a game of chicken.
1.9 Large fiscal deficits have impacted inflation
in India in several ways. First, to the degree that
these deficits reflect price rigidities in the economy
on account of prices being administratively
determined – such as energy prices, viz., price of
diesel, electricity, coal or fertilisers – they remain
potentially inflationary, although they result in
suppressed inflation in the short-run. Such prices
often need large sudden revisions when subsidy-induced
expenditures lead to an unsustainable
fiscal position. These discrete changes not only
lead to a surge in inflation, but also impact inflation
expectations. Second, large fiscal deficits, when
used to finance current rather than capital spending
affect investment and delay supply responses that
are necessary to curb medium-term inflation. They
also lower potential output, making monetary policy
easing more difficult. Third, financing of large fiscal deficit by market borrowings crowds out private
investment through its impact on interest rates and
availability of credit in the economy. This further
slows necessary supply responses. Fourth, the
liquidity position at time tightens in response to
large fiscal deficits with a build-up of government’s
cash balances with the Reserve Bank. If this
is accompanied by OMO purchases, there is a
monetary impact that can be inflationary. Empirical
work presented in this chapter, using a Vector Error
Correction Model (VECM), shows that the long-term
impact of inflation is much larger on government
expenditure than on government revenues. High
inflation can lead to higher government expenditure,
which, in turn, could lead to higher inflation, leading
to a self-perpetuating cycle.
1.10 Fiscal policy has an important counter-cyclical role that has been envisioned and practised
ever since Keynes recommended the same in the
face of the Great Depression. However, government
spending is often found to be pro-cyclical in the
case of EMDEs. Pro-cyclical fiscal policy implies
that fiscal policy is expansionary in times of boom
and contractionary in times of recession. Fiscal
policy should ideally aim to borrow more during
cyclical slowdown when revenues shrink and ‘social’
spending rises, and reduce debt in upswings.
Fiscal policy should try to dampen business cycle
fluctuations, especially when shocks to the tax base
or spending are transitory and not permanent. This
often does not happen. All this raises macroeconomic
volatility, depresses investments, reduces growth,
redistributes income and wealth away from the
poor and reduces the general level of welfare in the
economy. It also produces a large deficit bias and
poses the risk of debt unsustainability and defaults.
Empirical evidence presented in this chapter for
a long period (1950-51 to 2011-12) suggests that
fiscal spending in India is pro-cyclical, both in the
long-run and the short-run. Given that government
final consumption has been largely expansionary, it
has a limitation in addressing cyclical fluctuations in
aggregate demand. This exerts added pressure on
the monetary policy. However, counter-cyclical fiscal
expansion was undertaken during 2008-09 amidst
global financial crisis.
1.11 The debt-deficit dynamics interacts with
monetary policy in several ways. The government
can finance its spending either through tax or
non-tax revenues or by running deficits that are
financed through debt. The way the debt is raised
also has a bearing on the monetary policy. Further,
debt financing may also impact future fiscal and
monetary policies. Its impact may depend on
whether or not the Barro-Ricardo equivalence, that
requires debt to be financed by future tax and non-tax
revenues, holds. If debt does not add sufficiently
to the future revenue stream, it may be difficult to
meet future obligations. Empirically analysing the
dynamics of the relationship between deficit, debt
and money, using an auto-regressive distributed
lag (ARDL) model, the chapter finds a long-run
co-integrating relationship between the combined
government debt of the centre and states and the
change in reserve money.
How has fiscal dominance impacted the
Reserve Bank’s balance sheet over the years?
Have phasing out of direct fiscal constraints
and the increased external openness of the
Indian economy influenced the Reserve Bank’s
autonomy in balance sheet management? What
was the impact of policy response to the crisis
on the Reserve Bank’s balance sheet?
1.12 Chapter 4, ‘Fiscal Operations and the
Reserve Bank’s Balance sheet’, addresses these
issues by seeking to detect inflexion points in the
balance sheet of the Reserve Bank in the context
of changing fiscal-monetary dynamics. Historically,
fiscal dominance was evident in India during the
period of social control (1968–1990). As a banker
to the government, a crucial development goal for
the Reserve Bank during the pre-reforms era was
to bridge the resource gap of the government in
the Plan process. The size of the Reserve Bank’s
balance sheet increased significantly during this
phase, reflecting its growing accommodation to
the Government and its use of monetary policy
instruments to curb attendant inflation. Fiscal
conditions deteriorated significantly during the
1980s, leading to monetisation of fiscal deficit, which eventuated in a balance of payments crisis in
1990-91.
1.13 The size of the Reserve Bank’s balance
sheet continued to expand during the first half
of the 1990s due to an increase in the reserve
requirements of the banks to neutralise the monetary
impact of foreign exchange reserve accretion
following the opening up of the economy. The post-reforms
period has been characterised by a gradual
move towards dilution of fiscal dominance, resulting
in greater flexibility for the Reserve Bank in the
conduct of monetary policy as manifested through
a shift towards more market-oriented monetary
policy operating procedures. The discontinuation
of automatic monetisation of government deficit
through the phasing out of ad hoc treasury bills by
April 1997 and the simultaneous development of the
government securities market allowed the Reserve
Bank to progressively bring down the cash reseve
ratio (CRR), which, in turn, resulted in contraction of
the balance sheet size during the second half of the
1990s.
1.14 The emergence of a market-based
government borrowing programme, the cessation
of the Reserve Bank’s involvement in primary
government securities issuances as well as the
substantial reduction in its contribution to various
long-term funds ushered in a new era in the
interface between the central bank’s balance sheet
and fiscal policies. The size of the Reserve Bank’s
balance sheet increased between 2001 and 2007,
reflecting the Reserve Bank’s efforts to contain the
destabilising effects of large capital flows on the
domestic economy through interventions in the
foreign exchange market. Surges in capital inflows
added a new dimension to the balance sheet of
the Reserve Bank, as net foreign assets were
accumulated alongside a reduction in net domestic
assets on the Reserve Bank’s balance sheet. The
introduction of the market stabilisation scheme
(MSS) under which government securities were
issued for sterilisation purposes was an important
milestone in the interface between the fiscal and
monetary authorities, with the fisc also sharing the cost of sterilisation. The situation changed after the
onset of the global financial crisis in 2008, which
led to a reversal of capital flows. It is important to
note that in contrast to the expansion of the balance
sheets of several central banks as a result of their
unconventional monetary policies and quantitative
easing measures during the global financial crisis,
the balance sheet of the Reserve Bank contracted in
2008-09 despite extensive use of both conventional
and unconventional measures. On the asset side,
the expansion of domestic assets through OMOs
and liquidity accommodation was more than offset
by the reduction in foreign assets to stabilise the
exchange rates. On the liability side, the decline in
bank reserves and government balances due to
CRR reductions and unwinding of MSS balances,
respectively, led to the contraction of the balance
sheet. The Reserve Bank’s balance sheet has
expanded significantly since then reflecting
its liquidity management operations, aimed at
strengthening the recovery process while supporting
the government market borrowing programme and
simultaneously containing inflation.
How do we visualise the outlook of fiscal-monetary-
debt management co-ordination
in India given the global uncertainties, the
imperative of attaining the growth target
envisaged in the Twelfth Five-Year Plan
document, the fiscal roadmap laid out by the
Government of India in October 2012 and the
proposed change in institutional arrangements
in the conduct of cash and debt management?
1.15 The Central Government would need to
return to the path of rule-based fiscal consolidation
as its fiscal deficit-GDP ratio has been generally
ruling high since 2008-09. The Twelfth Plan (2012-13
to 2016-17) document has set an average targeted
rate of growth of 8.0 per cent and has, inter-alia,
estimated the public sector savings rate to improve
by around 3.5 percentage points by 2016-17 over
that in 2011-12. Beginning mid-September 2012,
the Government of India has announced a series of
measures to restrain the fiscal deficit and improve
the investment climate. In late October 2012, the Finance Minister announced the government’s
decision to adopt a fiscal consolidation plan during
the Twelfth Five Year Plan that would progressively
bring down the fiscal deficit from 5.3 per cent of
GDP in 2012-13 to 3.0 per cent of GDP in 2016-
17. Further, with the government’s move towards
setting up a Debt Management Office under its
ambit, there could be an institutional change in
cash and public debt management in India, which
used to come under the purview of the Reserve
Bank. Accordingly, Chapter 5, ‘Fiscal-Monetary
Policy Co-ordination and Institutional Arrangements
for Government Debt and Cash Management – A
Medium-Term Outlook’ assesses the relationship
between fiscal and monetary policies in the post-reforms
period. In this context, the empirical exercise
estimates a linear function with the call rate – which
is the operating target of monetary policy and can
be generally used as a proxy for the monetary
policy rate – as the dependent variable and the
inflation gap (i.e., the difference between the WPI
inflation rate and its trend component), output gap
(i.e., the de-trended or cyclical component of GDP),
the ratio of the Centre’s fiscal deficit to GDP (with a one-period lag) and the one-period lagged call rate
as explanatory variables. The estimated equation
provides broad guidance on the implications of
the evolving path of fiscal deficit, output gap and
inflation gap for monetary policy over the medium-term.
1.16 The chapter also summarises the debate, or
rather the rethink, on the institutional arrangements
for debt management that has been triggered by
the global financial crisis. In India, a Middle Office
has already been set up in the Ministry of Finance,
Government of India and a proposal to introduce
a Bill on the Public Debt Management Agency of
India has been in the offing to complete the transit
of the debt and cash management function from the
Reserve Bank to the Government of India. Even so,
keeping in view the international experience gained
from the recent financial crisis that would impinge
on debt management, monetary management
and maintenance of financial stability, as well as
the specific circumstances in India, this chapter
highlights some issues that may call for a nuanced
approach in this regard.
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