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Interview with Dr. Viral Acharya

Quest for Restoring Financial Stability in India

1. What was your inspiration and intent behind writing the book “Quest for Restoring Financial Stability in India”?

Dr. Acharya: That's a good question and I ask myself that question a lot of times because writing a book and then promoting its ideas takes time. I have explained in the very first two pages of the book (“Quest for Restoring Financial Stability in India”, SAGE India Publishing, July 2020) that the speeches I gave as a Deputy Governor were in a way, my reason for existence there. These speeches were essentially my tool as an advocate for change. They used to follow a certain style in the sense that I like explaining ideas from very simple first principles, so that everyone has a common understanding of the idea, rather than using a lot of jargon. Some speeches are technical but I have made an effort to start from first principles and the reason for that is that it is the only way to convey in a crystal-clear manner what the underlying problems are, and what the solutions might be. I've always tried to bring either international research or India specific research, put facts on the table, understand what has worked and what has not worked, so that we can make the right choices. But that sort of a package was really my tool for advocacy of change.

By the time I ended my term, I had written speeches in several different areas. In the book, there are five or six different sections that are divided into resolving India’s problems- setting up a public registry for transparency of borrower-creditor contracts, there are speeches on improving the transmission of monetary policies so that when the central bank takes actions, how they can reach out to households and corporations. I talk about development of viable capital markets in India, and my most important speeches were on striking the right balance between the government, the central bank, the markets and the private sector.

After I finished, of course, I realized I had contributed to change in a lot of different areas and I wanted to offer a cohesive view as to what it was all about. I reflected upon it and some of the subconscious thoughts were already there as common threads piecing through these various speeches. But I reflected for a while, and felt I needed to say something more and that is really the very extensive preface chapter called “Fiscal Dominance: A Theory of Everything in India”. The basic idea that I was trying to convey is that India was a centralized, nationalized economy in the 70s and 80s. Then, in the 90s, with reforms, we started a movement towards becoming more privatized and decentralized. However, especially over the last decade, we seem to be regressing back towards a more centralized mode of functioning. Along with that, what has happened is that the central bank has come under a lot of pressure as it is being dominated by the demands and the short-term pressures of the government.

The short-term pressures of the government emanate from the fact that it is fiscally trying to do a lot. It's borrowing a lot and it's always stretched, and this has an impact on the financial stability because of a lot of pressures from the fiscal side – through the dominance of the central bank – is transferred over to banks and the financial sector; central bank policies get compromised and that endangers financial stability, the health of the financial sector. So, the key point of the book is that we can no longer separate the fiscal stability and the financial stability of the country. They are heavily and intimately tied with each other, and the dominance of the central bank's policies is actually one powerful mechanism through which this link is getting stronger and stronger. Then, I wanted to offer a roadmap, as I said, explain the concept simply, discuss some evidence, and then explain what would be some ways of reforms, both on the fiscal and the financial stability front.

I would say it's my continuing effort to advocate for change that is required so that we can be on a more sustainable, stable growth path for the next 10, 20, 30 years… so we keep moving faster and faster, away from entrenching our levels of poverty, and we create a better financial ecosystem as a whole.

2. What, according to you, is the first step towards correcting fiscal dominance? What are the measures that the central bank can take to resist this pressure?

Dr. Acharya: I would say that the first step should not be at the central bank. It is actually on the fiscal side, in my view, because what is the primary reason that fiscal dominance takes hold: it is because the government's financing is very stretched. We need to address the root cause because we can't just fix the symptoms, we also have to address the root cause of what is causing this disease in the first place.

In the book, I lay out a clear five-point agenda, which I can quickly summarize. First, we have targets that are set for the government called Fiscal Responsibility and Budget Management targets (FRBM targets) for debt to GDP numbers or the fiscal deficit numbers. But, they have been regularly slipped upon, and the reason is that it is very easy for the government to do a variety of accounting tricks, what I call “Jugaad” in the book, to show that even though the expenditures are rising, the on-paper accounting of the expenditures or the various borrowing programs is not very high. Now, that is not meaningful adherence to the FRBM targets. So, rating agencies are concerned that when the government says we are sticking to these targets, they are saying, what does it actually mean? You don't really mean business when you say this, you mean something else because reality keeps slipping away from targets in a truly effective sense. In fact, Dr. YV Reddy, the former governor of RBI, in the beautiful foreword of the book, says that in India, now we have a notion of an “official” fiscal deficit and a “real” fiscal deficit with a budgetary gap in between.

We need to rebuild fiscal commitment over the medium term with the markets, the rating agencies, with the investors that we actually mean business, that we are going to come back to more prudent fiscal standards over the medium term because that is what will help the government to borrow more in the short run. It is only if people have confidence in your strategy down the line, they will keep lending to you at a reasonable cost in the short run, and we need that right now because of the COVID-19 shock and the required repair and relief measures.

Even though it is sort of motherhood and an apple pie statement that we need to reaffirm our adherence to the FRBM targets, the second point is how do we do that? We need to do that credibly by strengthening our fiscal institutions. What does that mean? We need an independent bipartisan fiscal council to be appointed. It is something that cannot be appointed by the finance ministry and reports to it because then there would be no self-discipline. It has to be an independent bipartisan council that reports to the parliament, and, its function would basically be to hold a mirror to the government's functioning, especially on the borrowing and the expenditures front as to whether it is genuinely on the consolidation path that it has said. It will adhere to in terms of the medium-term FRBM targets; holding that mirror to the government actually means holding it transparently for the people at large as well.

Now, in particular, a lot of budget assumptions are often very rosy. A lot of the programs are actually under-provided for, in the stated expenditures. There is a lot of Jugaad, as I said on balance sheet vs. off-balance-sheet, etc. A lot of divestment expenditures are actually not genuine divestments, they are just musical chairs between one public sector enterprise to the other. So the independent fiscal council should actually assess all of this, assess the government’s budget before it is announced, and it should be granted the authority to require that if the budgets do not adhere to the assumptions that the council believes are reasonable, then, there should be a comply or explain approach, that you have to explain to the people at large as to why the budget is deviating from the assumptions of the fiscal council. That is point number two.

Third, along with this, we need to compute accurately what is called as a public sector borrowing requirement. A lot of the debts of the government are hidden, they are off-balance-sheet, they are on the balance sheets of public sector enterprises, some of them are funded through extra-budgetary borrowings in the form of national small savings funds, etc. Now, if you or I were to try and figure out what is the total borrowing on the consolidated balance sheet of the government, i.e., a national balance sheet, between the center, the states, and the public sector enterprises of the center and the states, we wouldn't be able to find this number. We won't be able to put it together. There are some estimates out there, but they are imperfect. We need an accurately calculated public sector borrowing requirement so that everyone knows what matters in the end, which is how much additional borrowing the government is undertaking to fund its expenditures over and beyond the tax revenues and other revenues that it collects. So, that is point three, that we need a public sector borrowing requirement being calculated accurately and published on an annual basis, and this can be done, by the controller and auditor general of India, the C.A.G.

Fourth, we need to undertake a substantial divestment program. At some point, we have to accept that we cannot be continuously close to an 8 to 10 percent deficit relative to GDP, which during COVID may increase even to 14 to 15 percent. These are extremely high levels of borrowing. The government is borrowing more now than the rest of the economy is saving. It is dis-saving all the savings of the economy, leaving very little space for the private sector. What the government needs to do is to, in fact, embrace economically meaningful divestments. Such a divestment program was undertaken in 1998-2003; it was extremely successful. It improved the functioning, the labor practices, the incentive compensation for the employees, risk management practices, adoption of technology, etc., so privatizing these firms has its own advantages, and, I would say economically meaningful divestment, not as a one-off but actually as a serious strategy or a plan, to reduce the reliance on borrowings, has to be undertaken as well.

Fifth and the last point is that these divestments have to carry over to the financial sector. The government owns a large number of public sector banks. It owns a large number of nonbank financial companies, such as the Power Finance Corporation, which is effectively a bank for all the power sector related stresses that the government has undertaken. These are very large entities. They are costing the public exchequer a lot. It is not at all clear that throwing more taxpayer money after them is actually delivering anything useful at the end, and, so healthier of these entities, the government should reduce its stakes below a majority and perhaps fully privatize some of them. For those that are not healthy enough that the private sector will be interested in buying them, they need to be specialized, their governance, management, and practices improved, and, over a period of time, they could also be reprivatized.

That is my somewhat expansive, five-point agenda, and I call it a fiscal institutional reform agenda. We need to strengthen our fiscal institutions so that the slippages on fiscal marksmanship that have happened in a true economic sense over the last decade don't repeat themselves. And importantly, we rebuild credibility with markets, investors, and rating agencies. That is the first and foremost. The ball is in the government's court, so to speak.

3. You have emphasised on the need to restore public sector bank health. Given the current circumstances, do you think the government is in a position to recapitalise public banks?

Dr. Acharya: I think that's a very important and deep question and would say that all options have to be on the table and considered very seriously. You have to ask the question that if the government does have some fiscal capacity to spend right now, is it better spent in making direct transfers to the states, sectors and citizens who are most affected by the pandemic? Or is it better to continue to throw good money after bad into the public sector banks, many of whom are already at very high non-performing assets ratios? There have been a lot of bad loans and they have not yet been fully covered in terms of recognizing and absorbing their losses. These banks are very risk averse, so they are not necessarily lending to the healthier parts of the economy at the right costs. A lot of them are into what is called the “lazy lending” model, which is just taking deposits and buying government bonds.

I am for an approach that says, “listen, it's time to actually get out of these banks.”

It has to be done as a strategy, as a plan. We have to improve the governance of these institutions by making their boards and management more at arm's length from the government. The government can start diluting its stakes to start with below majority stakes, maybe bringing them down to 25 percent or 30 percent. That's what has been advocated by a large number of reports coming out in the 90s, as well as the P J Nayak committee about five years back. In fact, one of the RBI board members has gone on record saying “why can't the government reduce the stakes below majority down to 25 percent or 30 percent?”

My question is, why should the government rely only on one tool, which is to keep recapitalizing with its own funds? Why don't we adopt an approach of reprivatizing? Perhaps entirely, but as an interim step, divest below a majority stake. There are other gains also in improving the operations of the banks. They will be able to bring in better human capital if they are private because they can actually create more performance-based incentives, for example, for the employees, they could get tech-savvy and do fintech. Maybe they will get the best global practices of some international investors to come in and take a large stake in some of these banks.

And as I said, the weaker ones, there may not be immediate interest to buy them, but I've always asked the question - how do we keep justifying the presence of such public sector banks? We say that they are there because India is a poor country and we need them to perform development and financial inclusion functions. The question we have to ask ourselves is, are they really focused on performing that function? Now, if they are performing that function and not making any intermediation margin, they’re actually loss making, or if they are performing that function well but they're also doing other stuff like corporate lending and making very large losses, then that business model has to be changed. Looking at other small financial banks and some of the microcredit institutions, a few of them have evolved into actually becoming some very large banks now. They are making very healthy margins and yet performing a valuable function of financial inclusion and lending to the last mile. Why can't the less healthier public sector banks over the next year or two be specialized into these kinds of focused microcredit or small financial institutions? Let them have better underwriting, monitoring and collection skills in that segment. Then, they would at least be performing the role we keep thinking they are performing. Maybe if they are specialized, they would actually have better valuation in the market, they would be collecting a healthier margin and maybe they could be reprivatized at that point. Some injection of government capital would be necessary. However, given the tightness of the fiscal situation and the pressing immediate expenditures for COVID-related relief and repair to be directed in the most affected parts of the economy, in my opinion, we must take divestments and re privatisation of public sector banks as a serious option that needs to be considered.

4. What do you think is the main reason that we have not been able to progress with respect to non-performing assets in the last 10 years in the banking sector?

Dr. Acharya: The reasons are many.

I would say the long and short of it is that we moved ahead but regressed. The Insolvency and Bankruptcy Code (IBC) is actually a very, very important structural reform. Enforcing contracts and respecting the property rights of creditors in a timely manner is one of the pillars of the sustainable growth of an economy in the long run. Finance is the lifeblood of an economy. If creditors can't be the bridges that channel savings from onshore savers to the most productive users who are the borrowers at the other end of the bridge, if that function is not working well, if that bridge starts wavering every time there are strong winds, then you can't have an economy that gets this lifeblood regularly.

Now, why is it that despite having put in such an important structural reform, things didn't move that fast? I explain in the Preface chapter on fiscal dominance, which I call a theory of anything in India, that short-term government pressures rose because there are stages in the electoral cycle when the government doesn't want to necessarily incur pain and starts getting focused on making short-term growth to be postured to be high. Very often, that requires that the government does not inject capital into public sector banks; now, if assets get resolved and if they have never been recognized as loss-making in the first place, then when the asset resolves in insolvency and bankruptcy court, suppose the bank earns 50 paise on a rupee, it has to recognise that the other 50 paise is now lost on the low. Now, that will require an erosion of the bank's capital and it will have to be recapitalized because otherwise, it doesn't have growth capital to take any further loans. This creates an aversion to resolve the bad loans.

In my opinion, this T20 approach to the financial sector, where you start adopting policies midway and course correct in the wrong direction because you have short term pressures, is what has caused the decisive forward move towards the resolution of bad assets to be regressed. We have moved forward since 2014. The central bank did put in place an asset quality review to recognize the losses on the loans. By 2017-18, this review was complete, so the marking on the bank's books is a lot better than what it used to be. Of course, some restructuring schemes, unfortunately, in India are always getting prepared. That's what I say, that you are always looking at the central bank to accommodate the short-term pressures of the government. The recognition of losses is never as accelerated or timely as the global standard would require. But to me, this T20 approach is the real problem.

From the central bank, financial stability needs to be played like a test match. So, we have to do what is difficult to do, for the long run. We have to avoid chasing bad balls, as I give the example of playing like Rahul Dravid in the Preface chapter; you just can't chase outside the off-stump balls when you are playing the test match. Like many of these delays have happened in the resolution of bad assets, is basically like kicking the can down the road, saying “we'll see what happens but right now I have to do what is good for me in the short run.” That invariably leads to the wicket going away. That's the sort of approach we need to avoid.

It is no doubt a very complex problem. I don't want to understate the difficulty of resolving it, but in my assessment, for a short while, a period of 10 months, as I say in the Preface chapter, we were on the right track. In fact, there is an improvement that has happened in the discipline in the corporate sector because they are worried they would end up in the insolvency and bankruptcy court, so they are making their payments to banks in a more timely manner. The question is about the legacy stock. Can we deal with it swiftly and decisively and that requires a certain focus. That focus should not get distracted by short term pressures and compulsions that arise with electoral cycles. The only way to make it happen is to make financial stability regulations of the central bank at arm's length from the government.

We have to have operational autonomy and independence in the supervision and regulation functions of the central bank so that short term pressures on the fiscal side are not ultimately transmitting and distracting the central bank from what really matters for financial stability.

5. Your book has been well acclaimed for the solutions you have provided to the issues in terms of financial conditions and how to attain that stability, so in brief would you like to share some of them for our listeners who are yet to read your book?

Dr. Acharya: The Preface chapter is like a thread that pieces through all the speeches. In the speeches, there are more detailed proposals on each individual problem. I already spoke about the first-pronged problem proposal plan which was on the fiscal side. So let me touch upon a little bit on the second prong, which is on the financial stability side. Again, I'll break it up into five points.

First and foremost, let me reiterate the point that the central bank needs to have operational autonomy or independence over some of its key functions. As Dr. Y.V. Reddy, former Governor of RBI notes in the foreword of the book, that in the letter of the law, the RBI Act is one of the weakest in granting this autonomy to the central bank. Nevertheless, at certain points of time, it didn't matter that the central bank didn't have this autonomy. In the 70s and 80s, India was a centralized country and he very wittingly remarks that the government, the central bank and the public sector banks were like a “Hindu undivided family”, where no one kept anyone’s proper accounts.

But we are not that kind of an economy any more, we are a more decentralized economy. We have a thriving private sector both in the real side and the financial side, and we need to grow far higher than the three percent growth rate that we used to deliver in the 70s and 80s. One of the key pillars of this has to be that the government distances itself from public sector banks. One way to do this is that, of course, it reprivatizes them and when it divests stakes below majority, it gives up the control rights that come with it, like rights to appoint board members, rights to appoint management, etc. It means that the government would still play a role as a shareholder, but not the dominant one, others would also have a say.

Right now, the RBI and the Banking Regulation Acts are essentially overridden by the Banking Nationalization Act. The central bank's powers over the management of public sector banks are limited, e.g., in a prompt corrective action of an undercapitalized bank. The central bank cannot get capital into the bank because it cannot right now force the government’s stake to be diluted by requiring that the public sector bank raise enough capital. These powers have to be given to the central bank so that there is operational autonomy and the regulation of banks is ownership neutral. Private banks and public sector banks should face exactly the same kind of regulatory discipline.

The second point is that the central bank needs to do a lot more rule-based decision-making. One of the reasons why fiscal dominance compromises financial stability in India very easily is because there is a lot of discretion attached to the central bank policy, especially in bank supervision and regulation. This discretion is exercised without putting out very transparent and timely reports on - Why exceptions are being made? What are their intended and unintended consequences? Is there a sunset clause after which these exceptions would be removed? And because the exceptions and discretionary decisions are so easy to take, that has actually become the norm. The norm should actually be rule-based decision-making.

A good example of this is our inflation targeting framework, which gives the central bank a very clear mandate, to maintain inflation at four percent and a band of two percent around it. It gives it a very specific policy too, which is the policy repo rate, the rate at which the central bank lends to the banks against the government bonds as collateral. Then, there is democratic accountability. The Monetary Policy Committee members have to explain every two months after every meeting why they voted the way they did. And if they did not succeed in meeting the mandate, then there has to be a representation made to the parliament to explain what factors led to inflation. Now this is a rule-based decision-making process. There is an exception that says you have to maintain the inflation at four percent while paying attention to growth. There is also an exceptional clause built in as a secondary mandate of the central bank. This kind of approach needs to be adopted more in bank supervision and regulation.

In my view, the RBI needs to move to a system where it requires that banks recognize losses ahead of time. There has to be some steady, smooth, accelerated provisioning. The Stress Test that the Financial Stability Report of the RBI conducts can be used more as a tool in supervision and for setting regulatory capital requirements. Also, a lot of accounting treatment of both losses on loans, as well as on Treasury books, which is the positions of the government bonds, is just changed mid-way of the year. Accounting rules can't be changed in this manner. They have to be changed in truly exceptional situations, rather than as an ordinary course of action.

So, we need more rule-based decision-making. The analogy I always give is that Odysseus, in Homer’s writing, had to tie himself to the mast so that he doesn't give in to the call of the siren. And rule-based decision-making is the way that allowing for some exceptions with democratic accountability, would be similar to tying to the mast of the central bank.

The third point, I would say, is that the central bank does need to lean against the winds of fiscal dominance, the central bank has to say no at times. It has to play what I call the game of chicken. You can't just agree to compromises the first time they come up, because a compromise today is going to be a starting point for compromise tomorrow. And then finally, when you try to draw the line, there could be a complete dominance of the central bank, either by altering the letter from the law or by changing the appointments, or things like that. It's better to draw the lines up front and reiterate what the long-run mandates of the central bank are, that it is playing a test match. It is protecting the interests of depositors, it is guarding the external sector and preventing the rapid depreciation of the rupee, and that it is maintaining price stability or inflation stability. All of these can only be attained over a period of time. They cannot be played if you play economic management like a T20. This needs to be reiterated again and again.

The example I like to give is of the late Governor Paul Volcker, of the Federal Reserve System in the United States. When Ronald Reagan came to power in the 80s, he had a very expansionary manifesto. He wanted to give massive tax cuts and to undertake a lot of spending, and he wanted the central bank to ease interest rates to facilitate tax benefits. Now Paul Volcker had just fought double digit inflation in the United States. He said - listen if you want to go and borrow, if you want to engage in fiscal excesses, I can't really give up on my inflation targets. I've just made these long-term gains. I need to retain this credibility over a period of time. In the end, he won the day. He didn't give in to the pressures of the government and the Reagan manifesto was not implemented in its full grandeur, the fiscal situation remained more benign, and the borrowing costs of the United States government came down. So, the central bank does need to lean against the wind and speak truth to power, when needed.

The fourth point, I would say is that the central bank is in a unique position because it takes what I call in the book, as a 35,000 feet view of the macroeconomy. It's studying all aspects of the economy collectively across its different groups. It does a lot of interesting data collection and research. A lot of this research never really reaches the common man. It never reaches the analyst, media, the investors and the markets. It is my view that on the one hand, central bank research needs to be scrutinized by outsiders and at the same time it needs to be negated so that everyone can actually benefit from it. And the central bank is also getting the discipline of its research better.

This is very crucial in my view, because the modern central bank has to rely on data-based analysis. It has to employ certain kinds of economic models in order to figure out the right path. What is the most common question one asks in Economics? This is the problem that I'm trying to solve. If I adopt a particular policy, what will be its consequences? For that you need to know if the policy is in place or when it is not in place, what are the counterfactual outcomes? Sometimes these things are not easy to do without looking at data or without looking at some models. No model is perfect. No data analysis always gives you the final answer. But what data and models do is that they reduce the large errors that you may end up making by relying on just thought processes that are in your mind. Your first intuition need not always be the right one. And very often your first intuition is heavily shaped by what others are saying around you, which may very often be conflicted because they want the central bank to undertake a particular policy action.

The final point I would make on restoring financial stability in India, especially in the present juncture of COVID-19, is that when you buy a property, the real estate agents tell you that your focus should be on location, location, and location. I say, when it comes to financial stability, the central bank's focus has to be on capital, capital, and capital.

The Central Bank has announced restructuring schemes to provide a soft lending to certain COVID-19 affected sectors. There's some process that has been announced, but it has not yet announced a very definitive plan of getting the banks to recapitalize. Large private sector banks are capitalizing on their own. But the smaller banks, and especially the public sector banks, need capital to come in. The losses are going to mount. The Reserve Bank's own financial stability report has already highlighted that these losses in a stress scenario are likely to hit twelve and a half to fourteen and a half gross non-performing assets ratio. As I have been repeatedly saying, in the case of public sector banks, it just can’t be a matter of the government putting in money. We now have to entertain divestments below majority stake and reprivatisation in some cases.

So, I encourage the readers to look at the book for further details. There is a wealth of sound economics in there, if I may say. Most of it is written from first principles so you can understand the concepts in an easy manner. And then at some point I have to take off because then I have to get into being the advocate for change.


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