'Our fiscal institutions are not strong enough': Viral Acharya

In a long and candid conversation with Forbes India, ex-deputy governor of Reserve Bank of India, Dr. Viral Acharya speaks about need for restoring financial stability in his new book, 'Quest for Restoring Financial Stability in India'. He discusses the need for reforms, long-term growth targets and much more.

Q. When did you decide to join as the deputy RBI governor and what were the clear ideas that you wanted to implement?  As I state in my book, I was about to start on the January 23, 2017, and when I sat at Newark Airport, two issues stood out for me. The first was that bank non performing assets in India are large; public sector banks in particular, are at fairly low market to book ratios because of legacy debt problems. More importantly, these issues had been festering for a while; we had done Band Aid fixes but the wounds were not really healing without decisive treatment.

So the Reserve Bank of India had already started the asset quality review in 2014-15. But resolution of the distressed assets and recapitalisation of the banks wasn't happening and this had created, on the one hand, risk aversion amongst the lenders. They weren't actually lending to the healthier borrowers, they were more focused on evergreening or doing extend-and-pretend on the old legacy borrowers who had already defaulted on their loans. And on the other hand, it was choking the investment capacity of the economy, because the financing was not there. So the investments were remaining tepid, a lot of indebted sectors such as infra, power, steel, and so on had excess capacity. Even the healthier borrowers in these sectors did not have pricing power and were not able to grow well.

I thought this financial stability aspect was what had to be dealt with first and foremost, perhaps with reconsidering the ownership structure of public sector banks. This could involve recapitalising them decisively, putting weaker banks under prompt corrective action so that they are not haemorrhaging further, resolving the distressed assets in the new Insolvency and Bankruptcy Code, and improving the disclosure and accounting of bad loans.

The second issue is how do we reduce the excessive reliance on the banking system, especially in corporate credit? Corporations should be able to tap into bond markets. Banks are supposed to be lenders more commonly for smaller borrowers, small and medium sized enterprises, retail borrowers and so on. So this required thinking about how to make our bond markets thrive, how to make the regulation of bond markets more principles based.

Of course, corporate bond markets require that investors get timely information about default and credit quality. And so this also required some thinking about whether we need solutions such as a public credit registry.

We made a lot of progress in the first 10 to 12 months after we embarked in the summer of 2017. Things regressed to an extent thereafter; the gains we had made in the beginning to file distressed cases to the Insolvency and Bankruptcy Code. Some of the rule-based approach there was partly undone, prompt corrective action was weakened. Capital was loaded more towards the weaker banks because the desire was not to keep them under prompt corrective action. So clearly, some capital was required to be injected in them as well.

Q. You write, “Yet in about 10 months to follow, not only did progress stall but also, several policies regressed. Capital was injected in weaker rather than healthier public sector banks...” Why did the government change its track?
What happens the world over is that government decision-making horizons can become very short at certain points of the political cycle. What you need in these situations is that the institutional frameworks that are guarding long-term objectives for the economy—and the central bank is one such institution which has several long term objectives.

What governments attempt to do in such times is to turn to the financial sector regulators, asking them to relax the rules so that you get a credit fuelled stimulus in the economy. Now, of course, this is exactly the kind of stimulus that was attempted after the global financial crisis as a way of maintaining very high growth rates in the country. And then the underwriting standards went for a toss. And we are still dealing with the legacy loans problem from there.

This is the real reason why the fiscal deficits actually become large, why the targets are missed, and why the pressures on the central bank rise.

Q. The central government has been missing its fiscal deficit targets, we've seen many off-budgeting measures. How do we clean up this mess?
We are kicking the can down the road as far as fiscal consolidation is concerned, because we are always paying too much attention to short-term growth aspirations. As coaches in chess say that, don't focus on your rating. They say focus on whether your game is structurally right. Are you playing the opening game correctly, the middle game correctly the end game correctly? Once your game is structurally right, the rating will take care of itself. I think this is something that applies also to macro economic management of an economy.

Of course, it's important to have long term targets. But when these growth targets become very short term aspirations, there is a tendency to put aside the structural soundness of the of the economy. This is best manifested in the fact that a large chunk of government expenditure in India is revenue expenditure, subsidy expenditure, not capital expenditures such as infrastructure, health, education. The capex is what crowds in the private sector investment and it creates a long term fiscal multiplier, whereas, the revenue expenditure has been shown to primarily generate short term stabilisation of growth. This leads to then missing of the debt to GDP and the fiscal deficit.

A second important reason besides the incentive problem, is that we do have the targets, but we lack mechanisms to ensure that slippage is are not as large and regular as they have become. These mechanisms that are missing are as follows: Accounting of the fiscal deficits is not terribly transparent. Now, of course, there are institutions that are in charge of this and maybe they could produce more regular and more transparent balance sheets with granular data as to where are the expenditures and the borrowings happening.

Second, we don't have an independent fiscal council to vet if these growth assumptions are reasonable. If they are not reasonable, then certain revisions have to be undertaken. Our fiscal institutions are not as strong and robust as they should be to prevent these short-term objectives from causing repeated slippages on the fiscal dimension.

Q. Fiscal dominance is a key issue you have addressed in the early chapters. Which are the areas where action is most needed?
As I lay out in the introductory chapter, fiscal dominance is rooted ultimately in the excesses on the fiscal side. So those have to be reined in. We need transparent accounting of the government expenditures and borrowings. We need a significant reorientation of the expenditures away from revenue expenses to capital expenditures. We need, in my view also a reaffirmation of the FRBM targets because as you said, they have been missed. And even though the escape clause has been triggered, the debt sustainability concerns for the economy remain in the medium term.

We seem to be focused on disinvestments as a residual category. There isn't a very clear plan or time horizon as to how these disinvestment targets are going to be attained. Usually, the disinvestments done are entirely cosmetic, one public sector enterprise taking over another. This is not genuine economic disinvestment, but a sleight of hand, transferring money from one pocket to the other pocket.

We need to undertake a very, very serious and large disinvestment programme to plug the gap not just of the past years, but past several years. And we are in a situation where we actually most likely need to undertake further expenditures in order to provide relief and repair efforts postponement.

The central bank has to stand up and take its long term financial stability as a stance and resist these pressures. What we need first and foremost is that regulation of banks needs to be ownership-neutral. The Reserve Bank of India has certain rights over private sector banks when they don't perform well. However, the same rights are not available as the banking nationalisation Act overwrites some of these rules in case of public sector banks.

Q. In the book, you have mentioned some of the questions that kept you awake at night...
Yes, I thought of it as laying the foundations of financial stability for the next few decades. These questions were, why is it that even when we take a step forward, we ended up going two steps back? Why are we always looking for short term growth through credit stimulus, rather than actually putting in place structural foundations, transformational reforms that can deliver growth on a sustainable basis? Why is financial stability always been compromised? Why is it that there is pressure on the central bank on almost all dimensions? Is there some common undercurrent that is driving all of these pressures and the resulting tensions and frictions?

Why is it that the central bank is continuously being asked to provide excessive liquidity potentially monetise the deficit, provide interim dividends to the government and so on?

And then I realised that the deep malaise, at the root of all of this is the fact that we have moved from a nationalised to more market based economy. We have moved from everything being in government's control to private sector also contributing to growth and participating in financial markets. And I think this is one reason Dr. Reddy also explains in the foreword of the book, that we can't expect the corporate bond market to thrive if the government is actually borrowing so much from the savers in the economy.

Q. Banks are looking at big NPAs even in the retail segment. Even before we entered the pandemic, the ability to pay off credit card debts has reduced... once the moratorium is over, aren’t we heading towards a situation where retail NPA is waiting to implode?
I think you raised a good point that consumption out of credit has been rising at the retail household level, even leading up to the Covid-19. Savings rates have been going down while the real wages in certain parts of the economy have definitely not kept pace. We do need robust long-term growth. Some of these can happen with the right reforms and creation of more skilled jobs, or enabling the private sector to create more skilled jobs. But I think the financial stability report of the RBI has put out certain NPA numbers in their macro economic stress scenario—these need to be taken very seriously and banks need to be recapitalised proactively. Capital needs to be raised on a war footing in my view. There has been a debt moratorium, and as some of the senior bankers are recommending we don't need to extend it beyond August 31 August because the economy is actually gradually and steadily reopening.

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