Module 1

1. ‘Fiscal Federalism’ in India since 1991: Infirmities of Sound

Finance Paradigm
~Chirashree Das Gupta, Surajit Mazumdar

● The 1991 reforms reshaped Indian federalism by separating political and fiscal federalism.
● Fiscal federalism was prioritised, allowing the Centre to control states through financial
mechanisms.
● The sound finance paradigm (low deficits, spending discipline), despite its weaknesses, guided
fiscal policy after 1991.
● This led to a systematic erosion of states’ autonomy, reducing them to facilitators of national growth
policies.
● The post-reform growth process increasingly favoured capital over labour, widening wage–profit
inequality.
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● Regional inequality in India is not new. Differences between richer and poorer regions have existed
since the 1960s.
● Economic reforms after 1991 worsened these disparities. Inequality increased: Between states (rich
vs poor states); Within states; Across sectors (especially agriculture vs non-agriculture); Across
social groups; Between rural and urban areas
● Despite decades of policy changes, the ranking of states by per capita income has barely changed
over the last 30 years. Poor states largely remain poor, Rich states remain rich, only minor shifts
have occurred among middle- and high-income states
● This shows a long-term continuity of inequality, which has persisted across different governments
and policy regimes since independence.
● Importantly, natural resources are not the main reason for these differences. Prosperity across
states shows little connection to natural endowments.
● Around 2005–2010, a few low-income states grew faster than the national average, which was
unusual.
○ Bihar received most attention and was called a “growth miracle”
○ However, this growth started before the new government came to power, so it was not purely
policy-driven
● Even during this growth phase:
○ States like Bihar became more dependent on central government funds
○ Their per capita development spending fell behind the national average
○ Tax collection relative to GSDP remained very low, showing weak fiscal capacity
● Most importantly, economic growth in poor states did not reduce social inequality.
○ Improvements in education, health, and human development were minimal
○ This reflects a broader Indian pattern where growth does not automatically lead to social
development

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The Sound Finance Paradigm

 ● It is ironic that even 25 years after the 1991 economic reforms, debates on federalism—which
were central to the making of the India Constitution and Centre–state relations—have become
largely silent.
● After independence, federalism involved active political conflicts over many issues such as:
○ State boundaries and constitutional asymmetries
○ Land reforms and freight equalisation
○ Unequal industrial credit and development spending
○ Industrial policy and location of industries
○ Disputes over subjects in the Concurrent List
● The 1991 reforms ended most of these political struggles and reshaped federalism into two
separate spheres:
○ Political federalism, which was sidelined
○ Fiscal federalism, which became the main focus
● After 1991, academic and policy discussions shifted from political negotiation and conflict to
technical and managerial concerns, focusing on efficiency rather than power-sharing.
● The neo-liberal framework reduced the role of the state to that of a facilitator of private
investment, abandoning the earlier, broader understanding of fiscal constraints.
● Fiscal problems were simplified into the idea that states overspend, and the solution offered was
fiscal compression(cutting expenditure), based on the “sound finance” paradigm.
● Under sound finance, states were treated like individual market actors with “bounded rationality,”
rather than political institutions with developmental responsibilities.
○ This approach did not require a proper theory of the state.
● As neo-liberalism deepened inequalities, fiscal federalism was redefined as an institutional
framework for efficient public service delivery, still rooted in sound finance.
● This perspective confused decentralisation with devolution and promoted competition among
states, assuming competition would automatically improve efficiency.
● The sound finance paradigm relied on weak economic logic, arguing that:
○ Monetised fiscal deficits cause inflation
○ Non-monetised deficits raise interest rates and crowd out private investment
These claims hold only at full employment, which is rarely the case in developing
economies.
● In a growing, demand-constrained economy, deficit financing can raise output without causing
inflation, since money may chase a larger volume of goods.
● Despite these flaws, fiscal austerity was institutionalised through Fiscal Responsibility and
Budget Management (FRBM) laws after 2004, enforced via incentives and penalties by Finance
Commissions.
● These rules used arbitrary numerical targets, copied from the Maastricht Treaty, without a strong
economic justification.
● Fiscal reforms pressured states to compress expenditure, regardless of their specific economic
conditions.
● As a result, fiscal federalism became a tool for centralised control, effectively undermining even
the narrowest meaning of federalism in India.

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Expenditure Compression
 ● With the opening of the economy after 1991, India adopted the sound finance paradigm, which
focused on:
○ Keeping taxes low
○ Controlling the fiscal deficit
● This created continuous pressure to cut government spending (expenditure compression).
● As a result, India followed a growth path with rising inequality, where growth occurred but its
benefits were unevenly distributed.

Growth and inequality after 1991

● After 1991, there was rapid growth of the private corporate sector in India, dominated by a
small number of large business groups.
● This sector grew much faster than the rest of the economy, but income within the sector was
redistributed in favour of profits (surplus).
● The share of wages (employee compensation) in the sector’s income:
○ Fell from about 55% in the early 1990s
○ To about one-third or less by 2007–08
○ This happened despite higher salaries for some white-collar workers
● The main reason was wage compression:
○ Real wages in the organised factory sector stagnated
○ The share of wages in value added declined sharply

Role of the agrarian crisis

● A deep agrarian crisis since the mid-1990s pushed workers out of agriculture.
● This increased the reserve labour force, especially in non-agricultural sectors.
● The large supply of labour:
○ Reduced workers’ bargaining power
○ Kept wages low across the economy
● This made polarised growth inevitable:
○ Corporate profits rose sharply
○ Workers’ share of income declined

Weak tax mobilisation despite growth

● Despite higher growth and inequality, tax collection did not improve significantly after 1991.
● Historically, the tax–GDP ratio:
○ Rose steadily from 1950s to the 1980s
○ This upward trend stopped in the 1990s
● Only during the high-growth period before the global financial crisis (2002–03 to 2007–08) did
tax collection improve slightly.
● After the crisis, the tax–GDP ratio fell again and has not recovered to pre-2008 levels.

Centre vs states and tax structure

● State governments’ own taxes performed better than central taxes in supporting the tax–GDP
ratio, especially after 2007–08.
● There was a shift in tax composition:
○ Direct taxes increased
○ Indirect taxes declined due to liberalisation
● However, the rise in direct taxes did not fully compensate for the fall in indirect taxes.
● Even though inequality increased (which should have raised taxable income), tax growth was
limited.
 ● The temporary rise in tax–GDP ratio before 2008 was driven mainly by a boom in corporate
profits, not higher tax rates.

Impact on public expenditure

● Because revenue growth remained weak, there was little room to expand public spending.
● Government expenditure as a share of GDP:
○ Remained below the 1991 level
○ Was often cut to control fiscal deficits
● When revenues improved, spending was restrained to reduce deficits.
● When revenues worsened, expenditure cuts were again used to manage deficits.

Overall conclusion

● Expenditure compression became the central adjustment mechanism after 1991.

● This:
○ Worsened the agrarian crisis
○ Constrained social sector spending
○ Limited public investment
● As a result, expenditure compression has been a key cause of economic polarisation and rising
inequality in India over the last 25 years.

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Trends in Taxes

● Since 1991, expenditure compression has become the core purpose of fiscal federalism in India.
● Cutting public spending has helped sustain India’s integration into the global economy by keeping
labour cheap.
● At the same time, post-1991 fiscal federalism has shown a notable silence on effective direct tax
rates, especially on the wealthy and corporations.

Distribution, taxation, and the role of the state

● After liberalisation, the market-based distribution of income has been heavily biased against
labour.
● Growth increasingly depends on:
○ Low wages
○ Various forms of unpaid or underpaid labour
● In classical capitalism, such inequality is usually addressed through:
○ Progressive direct taxation
○ Using tax revenue to fund basic needs like health, education, housing, sanitation, and social
security
○ Reducing reliance on unpaid labour by supporting social reproduction

Post-1991 tax reforms

● In India, tax reforms were designed in line with the state’s new role as a facilitator of private
investment, not as a redistributor.
● The problem of weak tax mobilisation was blamed on:
○ High tax rates
○ Administrative inefficiencies
○ Multiple taxes
 ● This view was promoted by the Tax Reforms Committee headed by Raja Chelliah (1991).
● As a result, tax reforms focused on:
○ “Rationalising” (lowering) tax rates
○ Simplifying tax structures
● Alongside this, the post-liberalisation period saw:
○ Large tax exemptions and subsidies for corporates
○ Use of tax concessions as an incentive for investment

Lack of transparency in tax data

● There is limited empirical evidence on how these reforms affected effective tax rates.
● A key reason is reduced data availability:
○ The Central Board of Direct Taxes (CBDT) stopped releasing:
■ State-level direct tax data after 1989–90
■ Detailed national-level data on income assessed and tax collected after 1999–2000
○ Only limited data was released again for 2012–14 after a long gap
● This makes it difficult to fully analyse:
○ Who actually bears the tax burden
○ Whether direct taxes have become more progressive

Implications for analysis

● Ironically, the period when tax debates intensified and direct taxes marginally gained
importance over indirect taxes is also the period with poor data transparency.
● Due to these constraints, researchers rely on:
○ Data from the Statistical Abstract of India
○ Estimates of effective income tax rates for different types of taxpayers

Corporate structure and taxation

● Income tax data in India treats five categories of taxpayers as separate and unrelated.
● However, India’s family-owned business groups operate through:
○ Complex networks of ownership and control
○ Interlinked entities across all taxpayer categories
● This disconnect between tax reporting and actual corporate governance hides the true
concentration of income and tax privileges.

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● Tax reform reports over the last 20 years show a major disconnect between how corporate
taxation is officially analysed and how it actually operates.
● Policy discussions assume firms are independent entities, but in reality, many firms are part of
interlocking business groups that internally shift income to reduce taxes.
● This self-rationalisation within corporate groups is largely ignored in official tax reform thinking.

Evidence from firm-level data

● Studies using databases like PROWESS database show that:

○ About 60%–71% of firms reporting profits paid effective tax rates (ETRs) below 25% in
recent years.
○ Larger firms face lower effective tax rates than smaller firms.
● These findings support the argument that corporate taxation has become less progressive.
● However, PROWESS has serious limitations:
 ○ It does not distinguish between types of firms (companies, partnerships, HUF-linked
entities, trusts, etc.).
○ It ignores interlocking ownership structures between firms.
○ It does not capture links between firms and Hindu Undivided Family (HUF) accounts.
○ It cannot show how tax policy changes affect different tax entities differently.

Long-term trends in effective tax rates (ETRs)

Three major historical patterns emerge:

1. 1954–1965: Nehru–Mahalanobis phase

● During the Nehru–Mahalanobis model:

○ ETRs were largely stable across most tax categories.
○ Registered firms (sole proprietorships and partnerships) were an exception, showing a
gradual rise in tax rates.

2. Early–mid 1970s: Regulation phase

● From 1972–73 to 1975, ETRs rose for all categories.

● This coincided with strong monopoly regulation under the Monopolies and Restrictive Trade
Practices Act(MRTP Act).
● The period reflects a policy environment less favourable to large corporate capital.

3. Post-1975 divergence and post-1991 shift

● From 1974–75 onwards, tax trends diverged sharply across entities.

HUFs (1970s–1980s):

● ETRs for HUFs increased steadily between 1972 and 1985 due to:
○ Equalisation of tax rates between individuals and HUFs
○ Removal of special HUF privileges in Kerala and Andhra Pradesh

After 1991:

● ETRs for individuals and HUFs declined.

● The steepest decline was for limited liability companies:
○ Their ETR fell continuously after the mid-1970s
○ By 1999–2000, it dropped to below 10%

Reversal in tax burden across firm types

● At independence:
○ Registered firms (partnerships) had the lowest ETRs
○ Limited liability companies had the highest ETRs
● Over time, this pattern reversed:
○ Registered firms experienced a steady rise in ETRs across all policy regimes
○ Limited liability companies saw a sharp and sustained fall, especially after 1991
● By 2000:
○ Registered firms were paying higher effective tax rates than companies
○ ETRs of HUFs converged with those of individuals

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Methodological Implications

● First proposition: Limited policy impact after 1991

○ Trends in effective tax rates (ETRs) show little direct response to post-1991 tax
reforms.
○ These trends began much earlier, at least 15 years before the formal tax reform agenda.
○ Therefore, trying to explain ETR changes using the post-1991 macro policy paradigm is
methodologically weak.
○ It is difficult to establish causality or even correlation within this framework.

Institutional Structure and Taxation

● India’s structure of asset, wealth, and property ownership consists of:

○ Interlocking family-owned and business entities
○ Networks spanning all five categories of tax assessees
● This entire network should be treated as the real unit of taxation, not isolated firms or individuals.
● The only law that recognised this comprehensive unit was the Monopolies and Restrictive Trade
Practices Act(MRTP Act).
● Ironically, this Act was:
○ Strategically diluted from the late 1970s
○ Among the first regulations repealed in 1991
● The Indian state does not systematically collect data on:
○ Interlocking tax entities
○ Direct and indirect ownership of assets
○ Property holdings of family-owned business groups

Regressivity of the Tax System

● Evidence shows that India’s income tax system is strongly regressive, even after decades of tax
reforms.
● Effective tax rates decline sharply as income levels rise, especially for corporate entities.
● Higher-income and larger corporate entities pay lower effective tax rates than smaller ones.

Implications for Competition and Data

● If market-led competition is to be the foundation of the macroeconomy:

○ The state must develop information systems to measure:
■ Monopoly and oligopoly structures
■ Effective tax rates of large corporate entities

Property and Wealth Taxation

● The decline in effective taxation is not limited to income tax.

● Similar regressive trends exist in:
○ Property taxation
○ Wealth taxation
● These trends date back to 1975–76 and intensified after 1991.

Fiscal Consequences and Labour

 ● Declining effective taxation is a key reason for the “resource crunch”, even during high-growth
periods like the 2000s.
● The state increasingly supports growth by:
○ Lowering effective taxes for large corporates
○ Reducing public support for employment-generating production
● This shifts the burden of social reproduction onto households through:
○ More unpaid labour
○ Greater labour cheapening

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From VAT to GST

1. GST and the Erosion of State Fiscal Powers

● After 1991, one major change in India’s fiscal federalism has been the gradual erosion of
state-level taxing powers.
● This has been justified using an “efficiency” argument: that a single tax at a rationalised rate is
superior to multiple state and central taxes.
● GST subsumes almost all indirect taxes levied by both the Centre and states into one unified tax
system, introduced through the 122nd Constitutional Amendment Bill (2014).
● Although GST is formally described as being under the “aegis of the states,” in practice it
centralises tax authority, prompting renewed debate on whether India’s fiscal federalism is
becoming excessively centralised.

2. The “Common National Market” Claim

● GST is promoted as a tool to create a “common national market” and a more harmonious tax
structure.
● However, the passage challenges this claim by pointing to the United States, the world’s largest
economy:
○ The US does not have a VAT/GST system.
○ Instead, it has state-level sales taxes, with rates and structures decided independently by
states.
● This raises a critical question: Why has the US not felt the need for a single national tax to
create an integrated market?
○ The implication is that a common market does not necessarily require uniform taxation.

3. Importing the European Model: A Conceptual Mismatch

● India’s pursuit of a “common market” is traced back to the Maastricht Treaty, which laid the
foundation for the European common market.
● In Europe, the common market made sense because:
○ It involved multiple sovereign nation states.
○ Markets were separated by national borders.
○ Consumption patterns were relatively homogeneous across countries.
● India, however, is already a single sovereign nation, not a collection of independent countries.
● Blindly applying the European logic to India ignores:
 ○ The federal nature of the Indian state.
○ The extreme heterogeneity in consumption patterns across Indian states.

4. Questioning “Home-Grown Reforms”

● The claim that GST represents “home-grown reforms” (Ahluwalia, 2016) is questioned.
● The passage argues that India has uncritically imported a formulaic tax model designed for very
different political and economic conditions.
● This reflects a deeper issue:
○ The absence of a theory of the state and nation-state within the framework of so-called
“sound finance architecture.”

5. Lessons from Europe’s Transition Economies

● Even within Europe, VAT/GST was not uniformly suitable:

○ Transition economies (with more heterogeneous consumption bases) adopted VAT largely
as a condition for joining the European Union, not because it was organically optimal.
● This strengthens the argument that GST is often imposed through institutional conditionalities,
rather than emerging from domestic economic realities.

1. The “Efficiency” Argument Is Not Universal

● The passage begins by noting that only developing economies in Asia and Africa justify
VAT/GST primarily on efficiency grounds.
● In contrast, developed countries did not adopt VAT/GST based on universal efficiency logic.
● This directly challenges the dominant claim that GST is an economically neutral, globally optimal
tax.

2. Efficiency Assumptions Do Not Hold in India

● Economic efficiency arguments for VAT/GST assume:

○ Full employment
○ Homogeneous and divisible goods
● These assumptions do not hold in India, given:
○ High informality
○ Unemployment and underemployment
○ Structural inequality
● In India, “efficiency” has been downgraded to “ease of doing business”, which serves corporate
interests rather than macroeconomic welfare.
● Hence, the passage argues that:
○ The GST shift reflects a change in the class basis of the state, not the triumph of superior
economic theory.

3. Ignoring India’s Own VAT Experience

 ● GST was preceded by VAT, introduced with similar promises:
○ Removal of cascading taxes
○ Higher tax buoyancy
○ Increased indirect tax–GDP ratio
● However, more than a decade later, no study has found:
○ A clear, nationwide structural break in tax buoyancy after VAT.
● Empirical evidence from Bihar shows:
○ Almost all tax circles experienced a decline in tax buoyancy post-VAT.
● This empirical failure has been ignored (“collective blinker”) in pushing GST.

4. Problems with Revenue Neutral Rate (RNR) Calculations

● GST debates focus heavily on calculating the Revenue Neutral Rate (RNR) to compensate states.
● These RNR studies:
○ Use imputed data (mainly from corporate databases)
○ Assume shares of “sin goods” instead of observing real tax bases
● The lack of rigour and transparency in these calculations is highlighted as deeply problematic.

5. Missing Micro-Level Tax Data

● A rigorous GST assessment requires:

○ Circle-wise and commodity-wise tax data
● Such data exists with state tax departments after computerisation.
● Yet, no serious attempt has been made to use it by GST “technical experts.”

6. Evidence from Bihar: Narrow and Exempt Tax Base

● Detailed study of Bihar (2007–2011) shows:

○ 45–50% of VAT growth came from:
■ Petroleum products
■ Coal
■ Country liquor
■ Electricity duties
● These commodities are outside the GST ambit.
● Therefore:
○ Half of Bihar’s consumption base lies outside GST.

7. Systematic Under-Projection of Exemptions

● Most RNR studies assume only 30–35% exemptions.

● This grossly underestimates the exempt base for low-income states.
● As a result:
○ RNR calculations systematically overstate GST revenue potential for poorer states.

8. Ignoring Intra-State Inequality

● GST projections assume uniform tax spread within states.

● In reality, tax collections are highly concentrated:
○ Patna accounts for 86% of Bihar’s VAT
 ○ Similar concentration exists in:
■ Hyderabad in Andhra Pradesh
■ Mumbai in Maharashtra
● GST completely abstracts from these structural spatial inequalities.

9. False Analogy with Developed Countries

● In developed countries:
○ GST works because basic consumption needs are universally met
○ Consumption structures are relatively homogeneous, after decades of welfare provisioning
● India lacks this foundation.
● Hence, adopting GST is described as a “leap of blind faith.”

10. The False Production–Consumption Binary

● GST discourse wrongly assumes:

○ Rich states = producers
○ Poor states = consumers
● In reality:
○ Low-income states are both low-production and low-consumption, with agrarian
dominance.
● Only commodity-wise tax analysis can reveal this—but it has not been done.

11. Broader Political Economy Critique

● Post-1991 fiscal federal reforms:

○ Ignore informality
○ Ignore monopoly and oligopoly dominance (≈40% of assets/investments)
● The outcome:
○ Erosion of federal autonomy
○ Transformation of the state into a facilitator of capital-led growth
○ A wage–surplus distribution increasingly favourable to capital
 2. How Much Public Debt Is Too Little?
~Pronab Sen

1. Policy Dissonance within Government

● The passage opens with the idea that different arms of government often work in silos.
● Decisions taken by one ministry may ignore their spillover effects on other ministries.
● This lack of coordination produces policy dissonance, which can:
○ Dilute policy effectiveness (loss of synergy), or
○ In extreme cases, trigger systemic crises.
● The author argues that public debt policy represents such a case—ironically within the same
ministry, the Ministry of Finance, suggesting deep internal incoherence.

2. The FRBM Debate and Its Hidden Consensus

● The author revisits a 2017 discussion on the Fiscal Responsibility and Budget Management Act.
● This debate involved:
○ A dissenting note by Arvind Subramanian, and
○ The official response of the FRBM Review Committee.
● Despite disagreements on several issues, both sides shared a crucial assumption:
○ A continuously declining public debt–GDP ratio is inherently desirable.
● Accordingly, both supported strict fiscal rules aimed at enforcing debt reduction.

3. Why This Consensus Is Problematic

● The author challenges this intuition as deeply flawed, even though it aligns with mainstream
economics.
● Standard economic theory treats public debt as:
○ An unavoidable evil, or at best,
○ A “necessary evil”.
● Most analyses focus narrowly on:
○ How much debt is “too much”
○ At what point debt becomes a systemic risk
● This framing is seen as one-sided and incomplete.

4. The Overlooked Role of Public Debt

● The author highlights a critical omission:

○ Government debt is the only risk-free, interest-bearing asset in an economy.
● Because of this, public debt plays a central role in:
○ Financial stability
○ Portfolio choices
○ Liquidity management
○ Monetary and financial architecture
● Ignoring these functions while defining an “optimal” debt level leads to:
○ Analytically flawed
○ Potentially dangerous policy conclusions
5. Recent Reconsiderations of Low Debt

● After the global financial crisis, some economists began asking:

○ Are public debt levels too low, not too high?
● This question emerged because:
○ Private balance sheets were damaged
○ Interest rates were near zero or negative
○ Recovery remained sluggish
● In such contexts, higher public debt may have a therapeutic role, by supporting demand when
the private sector cannot.

6. From Therapeutic to Prophylactic Public Debt

● The author distinguishes between two roles of public debt:

○ Therapeutic: used after a crisis to repair private-sector damage
○ Prophylactic: preventing instability before a crisis occurs
● The paper focuses on the latter:
○ Can public debt stabilise the economic system structurally?
○ Is public debt inherently safer and more stabilising than private debt?
● The implicit claim is that public debt should not be treated as inferior to private debt in
macroeconomic management.

7. Objective of the Paper

● The paper aims to:

○ Reframe how we think about the desirable stock of public debt
○ Examine its flow counterpart—the fiscal deficit
● While the empirical focus is India, the conceptual arguments are widely applicable across
economies.

Monetary Conditions

1. Currency Is Ultimately Backed by Sovereign Debt

● In modern economies, national currencies are not backed by commodities, but by the
sovereign capacity of the state.
● Central banks issue currency against assets on their balance sheet, mainly:
○ Sovereign government bonds
○ Sometimes gold
● Thus, public debt is not an aberration—it is a structural foundation of the monetary system.

2. Minimum Public Debt in a Closed (Autarchic) Economy

● In a closed economy (autarchy):

○ Currency issued by the central bank must be backed by domestic sovereign debt and
gold.
● Therefore:
 ○ Minimum public debt held by the central bank
= Currency in circulation − Gold holdings
● In India’s case, this minimum works out to about 14% of GDP.
● This establishes that some level of public debt is unavoidable, even in principle.

3. Open Economy Changes the Backing of Currency

● In an open economy, this tight link between:

○ Currency issuance and
○ Domestic public debt
can be relaxed.
● This happens because the central bank can hold:
○ Foreign sovereign assets (foreign exchange reserves).
● Hence, domestic currency can be backed by foreign assets instead of domestic debt.

4. India’s Current Situation: Rupee Backed by Foreign Assets

● At present, the rupee is backed almost entirely by foreign assets, as seen in the balance sheet of
the Reserve Bank of India.
● This is not inherently problematic because:
○ India has had persistent balance-of-payments surpluses
○ These surpluses arise mainly from the capital account, not trade
● For a country with a non-convertible currency like India:
○ Accumulating foreign exchange reserves is desirable to:
■ Guard against external shocks
■ Prevent excessive appreciation of the currency

5. Why RBI Still Needs Government Securities

● Despite holding large foreign reserves, the RBI must hold domestic government debt to:
○ Conduct open market operations
○ Manage liquidity
○ Maintain credibility of monetary policy
● There is no fixed rule on how much government debt a central bank should hold.
● Rule of thumb offered:
○ If the currency is non-convertible and
○ The economy is open to foreign portfolio flows
→ The RBI should hold more, not less, government debt.

6. Is RBI’s Current Holding Excessive?

● Presently:
○ RBI holds 15% of central government securities
○ This equals about 10% of total government securities
● The author argues:
○ This level is not excessive
○ It is appropriate given the RBI’s monetary and financial-stability responsibilities

7. The Risk of Depending on Foreign Exchange

 ● Prudence requires preparing for scenarios where:
○ Balance of payments is not in surplus
○ Capital inflows dry up
● Domestic liquidity cannot depend on foreign exchange availability.
● Otherwise:
○ Growth becomes hostage to volatile global capital flows.

8. Role of Fiscal Deficit in Providing Liquidity

● One solution:
○ Ensure that domestic sovereign debt creation keeps pace with the economy’s liquidity
needs.
● The flow of sovereign debt = central government fiscal deficit.
● This flow should be at least as large as:
○ The additional currency required for economic growth.

9. Deriving a Minimum Fiscal Deficit for India

● Assume:
○ Desired nominal GDP growth ≈ 11.5% per year
○ Stable ratio of currency held by the public to total currency
● Using Fisher’s equation (linking money supply, prices, and output):
○ The economy needs a minimum expansion of currency supply.
● This implies:
○ A minimum central government fiscal deficit of about 1.6% of GDP per year.

Core Insight

The passage shows that public debt and fiscal deficits are not pathologies to be eliminated, but
structural necessities for:

● Currency issuance
● Liquidity provision
● Macroeconomic stability

Trying to compress fiscal deficits below this minimum risks strangling growth and making domestic
liquidity dependent on unstable foreign capital inflows.

Fiduciary Considerations

1. Why Households Need Safe Assets

● In all economies, a large share of household wealth is held:

○ For precautionary reasons (uncertainty, emergencies)
○ To finance post-retirement consumption
● For these purposes:
○ Safety of principal matters more than returns
● In countries like India, where:
○ Risk tolerance is low
 ○ Social security systems are weak or absent
households therefore demand a large volume of low-risk financial assets.

2. Fiduciary Assets and the State’s Role

● To protect household savings, governments impose fiduciary obligations on institutions offering

certain assets.
● Typical fiduciary asset classes include:
○ Life insurance
○ Pension and provident funds
○ Certain mutual funds and asset management products
● In India, there is an additional category:
○ Small savings instruments, where the government itself is the fiduciary, bearing 100%
liability.

3. Fiduciary Assets Create Structural Demand for Public Debt

● In India:
○ Small savings instruments account for 11.5% of GDP
○ Other fiduciary assets (insurance, PFs, etc.) account for ~25% of GDP
● Laws governing these institutions require:
○ At least 50% of their assets to be invested in public debt
● Hence, purely to meet legal requirements, public debt must be at least:
○ 12.5% of GDP (from insurance, pensions, etc.)
● This establishes that public debt is not discretionary, but institutionally required.

4. Banks, Deposits, and Moral Fiduciary Responsibility

● Commercial banks are not legally fiduciaries, but:

○ Depositors perceive bank deposits as safe, quasi-guaranteed assets
● This creates a moral fiduciary responsibility for banks.
● Governments respond via prudential regulations, which require banks to:
○ Hold a share of assets in safe or highest-rated securities

5. Lessons from the Global Financial Crisis

● In the United States, banks were allowed to treat:

○ Private AAA-rated securities as “safe”
● The global financial crisis showed:
○ The danger of confusing “almost risk-free” with truly risk-free
● The passage implies that public debt is uniquely risk-free, unlike private instruments.

6. India’s Statutory Liquidity Ratio (SLR)

● In India, prudential regulation mandates:

 ○ 20% of banks’ net liabilities be held in government securities
● This is known as the Statutory Liquidity Ratio (SLR).
● In GDP terms, this equals:
○ 18% of GDP
● Although the SLR has varied historically (up to 25%), banks:
○ Voluntarily hold more government bonds than required

7. Minimum Public Debt Required by Law

Adding together the legally mandated demand for public debt:

Source % of GDP

Small savings instruments 11.5%

Insurance, pensions, PFs 12.5%

Banks (SLR) 18%

Total minimum required 42% of GDP

Thus, 42% of GDP worth of public debt is structurally required to support India’s financial system.

8. What Is “Excess” Public Debt?

● India’s total public debt is about 68% of GDP

● After accounting for the required 42%, this leaves:
○ 26% of GDP as “excess” public debt

This “excess” is not wasteful—it is absorbed by different institutions:

● External debt (central government): 3%

● Reserve funds (centre & states): 6%
● Holdings by the Reserve Bank of India: 5%
● Excess SLR holdings of banks: 3.5%
● Excess insurance/PF holdings: 2.5%
● Corporate holdings: 6%

9. Why This Matters for Interest Rates

● The last four categories (RBI, banks, insurance funds, corporates):

 ○ Determine the demand for government bonds
○ Therefore, they are central to interest rate formation in the economy
● This means:
○ Public debt levels directly shape financial stability and borrowing costs

Interest Rate Considerations

1. Why the Interest Rate Matters

● The interest rate is a central variable in any economy because it affects:

○ Saving and investment decisions
○ Choice of technology by firms (capital-intensive vs labour-intensive)
○ The production structure of the economy
● Because so many decisions hinge on it, distortions in the interest rate can have system-wide
consequences.

2. Sovereign Debt as the Anchor of the Interest Rate System

● Government bonds are the only truly risk-free financial assets.

● Therefore, they provide the benchmark (anchor) for all other interest rates.
● In theory:
○ Interest rate on private debt
= Interest rate on government bonds (same maturity)
■ Risk premium for default
● For this anchoring role to work:
○ Government bonds must be actively and freely traded
○ Their yields must accurately reflect liquidity and market conditions
● Hence, a well-functioning government bond market is essential.

3. Structure of the Government Bond Market in India

● India’s government bond market is:

○ Wholesale, with no retail participation
○ Participants include:
■ Banks
■ Financial institutions
■ Foreign Portfolio Investors (FPIs)
■ Some non-financial corporates
● Although total government bonds ≈ 48% of GDP:
○ Only 17% of GDP is actually “in float”
● Why?
○ Large portions are statutorily locked with banks and fiduciary institutions and cannot be
traded.

Composition of the tradable float:

● Excess holdings of banks & fiduciary institutions: 6%

● Non-fiduciary bodies: 6%
 ● Holdings of the Reserve Bank of India: 5%

This is sufficient to ensure a reasonably efficient bond market.

4. RBI as the Market Maker

● The RBI effectively acts as the market maker in government bonds.

● Unlike private market makers:
○ RBI’s goal is not profit
○ Its objective is to achieve a desired interest rate level
● To do this, a central bank normally operates around a target real interest rate.

5. The Missing Target Real Interest Rate in India

● Most central banks clearly articulate a base real interest rate, adjusting it cyclically.
● In India:
○ Neither the RBI nor the government has stated a “desirable” real interest rate for over a
decade.
● This creates ambiguity in monetary management.

6. Social Rate of Time Preference: The Theoretical Benchmark

● The minimum risk-free long-term real interest rate should reflect the:
○ Social rate of time preference
○ That is, how much society values present consumption relative to future consumption
● Poorer countries typically have:
○ Higher time preference, hence higher real interest rates

7. India’s Earlier Practice: Planning Commission

● Earlier, the Planning Commission fixed the social discount rate:

○ 12.5% (nominal) from the 5th to 9th Five-Year Plans
○ Reduced to 9.5% from the 10th Plan onwards
● This reflected:
○ Higher incomes
○ Rising savings
○ Lower expected inflation
● Today, NITI Aayog has provided no guidance on this benchmark.

8. Inferring the Implied Time Preference from Market Data

● One workaround:
○ Assume the 10-year government bond yield reflects the finance ministry’s implicit view
● Current figures:
○ 10-year yield ≈ 7%
 ○ Target inflation ≈ 4%
● Implied real interest rate ≈ 3%
● The author argues this is too low for a developing economy like India.

9. Are Voluntary Holdings of Government Bonds Excessive?

● To judge this:
○ Compare actual market yields with the desired real interest rate
● If yields are:
○ Higher → Excess supply of government bonds
○ Lower → Excess demand for government bonds
● Excess demand is dangerous because:
○ Reducing bond supply would push interest rates even lower
○ This would distort savings, investment, and technology choices

10. Final Assessment

● Currently:
○ Market yields ≈ Coupon rates on government bonds
● Therefore:
○ The voluntary holdings of public debt (≈12% of GDP) are not excessive
○ They may in fact be insufficient, given the economy’s structural needs

Minimum Public Debt

1. Minimum Public Debt: A Moving Benchmark

● When voluntary holdings of public debt are added to:

○ Mandated holdings (banks, fiduciary institutions), and
○ Holdings of the Reserve Bank of India,
● The minimum public debt stock required for India comes to about 58% of GDP (as of 2016–17).
● This figure is not fixed:
○ It will evolve with changes in the economy, financial deepening, and institutional structure.
● Therefore, fiscal rules cannot be designed mechanically; they must be forward-looking.

2. Financial Inclusion Implies Higher Minimum Debt

● Government policies promoting financial inclusion (bank deposits, insurance coverage, pensions)
will:
○ Increase the demand for safe assets
○ Raise the structural requirement for public debt
● Hence, a buffer or cushion is needed to absorb contingencies.
● In this context, the FRBM Committee recommendation of a 60% public debt ratio is defended:
○ Not as a ceiling, but as a floor below which debt should not fall.

3. Why Insufficient Public Debt Is Dangerous

The passage stresses that too little public debt can be as harmful as too much.

(a) Impact on the Financial Sector

● Low public debt → low yields on government securities

● This reduces earnings of:
○ Banks
○ Insurance companies
○ Pension and provident funds
● Since these institutions must hold government bonds by law:
○ Their financial viability is threatened
○ They are pushed toward riskier assets
● Result: Higher systemic financial risk

(b) External Vulnerability via the Current Account

● Persistently low interest rates would:

○ Reduce domestic savings
○ Increase investment
● This leads to a widening current account deficit (CAD).
● The exchange rate may not correct the imbalance because:
○ Foreign portfolio inflows (FPI) can temporarily finance the CAD.
● However:
○ A sudden FPI reversal could trigger a balance-of-payments crisis.

(c) Employment and Technology Bias

● Lower interest rates:

○ Encourage capital-intensive technologies
○ Favour capital-intensive sectors over labour-intensive ones
● This:
○ Suppresses employment growth
○ Undermines India’s much-touted demographic dividend

4. The Optimal Debt Range

● Excessive public debt:

○ Undermines credibility
○ Reduces private investment
● Insufficient public debt:
○ Weakens financial institutions
○ Shrinks savings supply
● Therefore, sound fiscal rules should aim for a middle range, avoiding both extremes.

5. Why the Composition of Public Debt Matters

 ● Most economic literature focuses only on the size of public debt.
● It assumes the composition does not matter.
● This assumption is valid only if debt is viewed purely as a financing tool.
● Once we recognise that public debt also:
○ Anchors interest rates
○ Supports financial stability
○ Enables monetary policy
→ Composition becomes crucial.

6. Tradable vs Non-Tradable Public Debt

A key distinction is drawn between:

(a) Tradable Debt

● Government securities
● Actively traded
● Held by fiduciary institutions
● Determine market yields and interest rates

(b) Non-Tradable Debt

● Small savings
● Postal deposits
● Provident funds
● External borrowings
● No direct role in interest-rate formation

This creates a serious risk:

● A country may have high total public debt

● Yet too little tradable debt to manage macroeconomic policy.

7. Why This Is a Developing-Country Problem

● Developed economies:
○ Mostly issue tradable government securities
● Developing economies:
○ Large share of non-tradable debt
○ Heavy reliance on:
■ Aid
■ Negotiated loans
■ Postal savings (especially where banking reach is weak)
● This makes fiscal and monetary management far more complex.

8. India’s Current Debt Composition: A Warning Sign

● Total public debt: 68% of GDP

○ Tradable: 47.5%
 ○ Non-tradable: 20.5%
→ Non-tradable share ≈ 30%
● But for a minimum desirable debt of 60%:
○ Tradable should be 48%
○ Non-tradable 12%
→ Non-tradable share ≈ 20%
● This implies:
○ India may already be short of tradable government securities
○ Even though total debt looks adequate

9. Implications for Future Debt Reduction

● If debt reduction towards FRBM targets is achieved mainly by:

○ Slowing the growth of government securities
● Then:
○ The RBI could run out of instruments to manage liquidity and interest rates
● At present:
○ The gap is small (~0.5% of GDP)
● But if it widens to 5% of GDP:
○ Monetary management would become severely constrained

Fiscal Deficits and the Flow of Debt

1. Why the Flow of Debt Matters as Much as the Stock

● Public debt has two dimensions:

○ Stock: total public debt outstanding
○ Flow: the fiscal deficit, which adds to the stock each year
● A desired debt–GDP ratio is meaningless unless the fiscal deficit is consistent with maintaining
that ratio over time.
● This is the central flaw identified in the recommendations of the FRBM Committee.

2. The Internal Inconsistency in the FRBM Recommendation

● The committee:
○ Set a target public debt ratio of 60% of GDP
○ Recommended a consolidated fiscal deficit cap of 4.5%
● Arvind Subramanian, in his dissent, correctly pointed out:
○ To stabilise a 60% debt ratio with nominal GDP growth of 11.5%, the fiscal deficit must be
6.2%, not 4.5%.
● A 4.5% cap would cause the debt ratio to fall continuously, contradicting the stated target.

3. Ceiling vs Floor: The Conceptual Confusion

● The committee defended itself by claiming that 60% is a ceiling, not a floor.
● This “solves” the inconsistency only by:
 ○ Allowing the debt ratio to fall without any lower bound
● However, if—as argued earlier—60% is the minimum required (a floor), then:
○ Any deficit below 6.2% risks breaching the minimum
● Under sustained 11.5% nominal GDP growth:
○ A 6.2% deficit would converge smoothly to 60% in about 15 years
● There is no clear justification for forcing a faster reduction.

4. No Need for Further Fiscal Correction

● Current fiscal positions:

○ Centre: 3.5%
○ States: 2.7%
○ Consolidated: ~6.2%
● Therefore:
○ A 6.2% target requires no fiscal tightening
○ It broadly aligns with the Fiscal Responsibility and Budget Management Act already in
force
● Calls for sharper deficit cuts rely mainly on “global norms”, a weak argument:
○ There is no proof that global averages are optimal
○ Especially when India has performed better than peers

5. The Compositional Constraint Returns

● Beyond size, the composition of debt matters.

● To avoid a growing mismatch between:
○ Required stock of government securities, and
○ Actual availability
● At least 5% of GDP of the annual fiscal deficit must be financed via:
○ Tradable government securities
● If total deficit is capped at 4.5%, this becomes arithmetically impossible.
● Even a 6% deficit demands a rethink of deficit financing strategy.

6. The Required Shift in Fiscal Thinking

● Current practice:
○ Government securities issuance is a residual
○ After accounting for:
■ Non-tradable debt receipts
■ Fiscal deficit target
● Given the compositional problem:
○ Issuance of government securities must become a policy target in itself

7. The New Fiscal Dilemma

By definition:
Fiscal Deficit = Non-tradable debt receipts + Securities issuance

● Meeting both:
○ A fiscal deficit ceiling, and
○ A minimum securities issuance target
● Depends on how much control the government has over non-tradable debt

8. Limits to Controlling Non-Tradable Debt

Non-tradable debt comprises:

1. External debt (~3%)

2. Reserve funds & deposits (~6%)
3. Government employees’ provident funds (~5%)
4. Small savings (~6.5%)

What can the government control?

● Provident funds & small savings:

○ Determined largely by household portfolio choices
○ Government influence only via interest rates
○ Rates already cut by ~400 basis points over 20 years
○ Politically very sensitive to reduce further
● External debt:
○ Now negligible and declining
● Reserves & deposits:
○ Compositionally complex
○ Limited policy control

Conclusion: Control over non-tradable debt is highly uncertain.

9. An Unavoidable Policy Choice

● Given these constraints, the government may face a forced choice between:
○ Meeting the fiscal deficit target, or
○ Ensuring adequate government securities issuance
● Currently, neither the Ministry of Finance nor the Reserve Bank of India systematically tracks this
problem.

10. The “Hard but Simple” Exit Option

● If the government is determined to reduce debt and deficits without compositional stress:
○ It could:
■ Discontinue small savings schemes, and/or
■ Shift government provident funds to an independent institution
● This would:
○ Reduce the minimum required debt stock
○ Shrink the non-tradable component
● However:
 ○ These options are politically explosive, even if administratively simple

Pressures and Policy Choices

1. Core Thesis of the Paper

● The paper’s central claim is that public debt and fiscal deficits are not merely financing tools for
government expenditure.
● They perform crucial macroeconomic, financial, and institutional functions, including:
○ Providing safe assets
○ Anchoring interest rates
○ Supporting financial stability
● However, contemporary fiscal discourse—shaped largely by international finance capital and
credit rating agencies—treats:
○ Public debt
○ Fiscal deficits
○ Interest rates
as ends in themselves, rather than policy instruments.
● This shift has caused policymakers, including technocrats within governments, to ignore the
broader roles of fiscal variables.

2. Fiscal Rules as a Global Phenomenon

● This problem is not unique to India.

● According to the International Monetary Fund, by 2014:
○ 80 countries had adopted fiscal rules.
● Many developing countries likely adopted these rules:
○ Without careful analysis of long-term consequences
○ By mechanically importing rules designed for very different economic contexts
● Fiscal policymaking has thus become rule-bound rather than reasoning-based.

3. The Dominant Narrative on Growth and Investment

● The prevailing orthodoxy claims:

1. High growth requires high private investment
2. Public debt, fiscal deficits, and higher interest rates:
■ Crowd out private investment
■ Slow growth
● The paper challenges this on two grounds:
1. Context matters: The claim may hold under specific conditions, not universally.
2. Empirical evidence increasingly shows:
■ The growth–private investment relationship is non-linear
■ Growth tends to decline once private credit reaches 80–100% of GDP
● India is already close to this danger zone, suggesting an inflection point where conventional
prescriptions may backfire.
4. Rethinking the Fiscal Deficit and “Crowding Out”

● The fiscal deficit ratio is commonly used to assess:

○ Government profligacy
○ Crowding out of private investment
● This has contributed to India receiving lower sovereign ratings than warranted by its overall
performance.
● The paper argues this metric is conceptually wrong for assessing crowding out.
● The correct metric is:
○ Fiscal deficit as a percentage of non-government savings
● On this measure, India is no longer an outlier.
● Therefore:
○ Decisions on reducing the fiscal deficit should be based on:
■ Debt sustainability
■ Structural demand for government bonds
○ Not on abstract global norms.

5. The Public Debt Stock: A More Complex Trade-off

● India currently has some slack in its public debt position.

● But:
○ Rapid debt reduction runs into the composition problem discussed earlier:
■ Insufficient supply of tradable government securities
● Technically, this problem could be resolved easily:
○ By reducing the Statutory Liquidity Ratio (SLR), or
○ By allowing private debt instruments under SLR norms
● These steps:
○ Require no legislation
○ Can be taken directly by the Reserve Bank of India
● However, this would:
○ Shift risk from the state to households
○ Replace truly risk-free assets with “almost risk-free” private assets
● The paper frames this as a political–economic conflict:
○ International finance capital vs low-risk domestic savers
○ High-risk rapid growth vs stable, sustainable growth

6. The Politics of Interest Rates

● Pressure to keep interest rates low will be even stronger:

○ Large domestic corporates and finance capital benefit directly
● The costs of low interest rates:
○ Lower savings
○ Financial instability
○ Employment distortion
are diffuse and macroeconomic, so political resistance is weak.
● The paper makes a crucial normative claim:
○ The social discount rate (and hence sovereign bond yields) is a political choice, not a
technical one.
● Policymakers must ask:
 ○ Is India truly a capital-surplus, low-poverty developed economy?
● If not:
○ Interest rates cannot be left entirely to market forces.

7. Implications for Fiscal Frameworks

● The argument does not end with critique.

● The paper calls for:
○ Incorporating these insights into a new version of the FRBM framework
(see Fiscal Responsibility and Budget Management Act)
○ Embedding them in:
■ Public debt sustainability models
■ Fiscal policy models
■ Monetary policy models
● Without this integration:
○ Fiscal rules will remain mechanical
○ And macroeconomic policy will remain structurally blind.
 3. The New Thrust of Fiscal Conservatism
~C P Chandrasekhar

1. What the IMF Is Arguing (April 2022 GFSR)

In its Global Financial Stability Report (April 2022), International Monetary Fund argues that:

● During the COVID-19 pandemic, a sovereign–bank nexus intensified:

○ Banks increased lending to governments
○ Governments relied heavily on domestic banks to finance deficits
● This close linkage, according to the IMF, poses risks to banking stability, because:
○ Banks become excessively exposed to sovereign debt
○ Any stress in public finances could destabilise banks

IMF’s Proposed Solutions

The IMF recommends that emerging market governments:

1. Discourage banks from holding “excessive” sovereign bonds through prudential regulations
2. Impose capital surcharges on banks whose sovereign bond holdings exceed specified thresholds
3. Consider revisiting global banking rules:
○ The Basel Committee on Banking Supervision should potentially:
■ Reclassify sovereign debt as risky
■ Assign higher risk weights to banks’ holdings of government bonds

If adopted, these measures would reduce banks’ ability and incentive to lend to governments, thereby
narrowing an important channel of government financing.

2. Why This Matters for Government Finance

● In many countries—especially developing and emerging economies—banks are a primary source

of deficit financing.
● Curtailing bank lending to governments would:
○ Make deficit financing harder and more expensive
○ Force governments to either:
■ Cut spending, or
■ Depend more on volatile foreign capital markets
● Hence, the IMF’s proposal has direct fiscal consequences, not just financial-stability implications.

3. The Broader Neo-Liberal Fiscal Agenda

The passage situates the IMF’s proposal within a long-standing neo-liberal project aimed at restricting
the role of the state.

Core Elements of This Agenda

● Promote:
○ Business-friendly, low-tax regimes
○ High private investment
● Simultaneously enforce:
 ○ Caps on fiscal deficit-to-GDP ratios
○ Caps on public debt-to-GDP ratios

Institutions such as the World Bank and the IMF have historically championed this framework.

4. The Ideological Justifications (and Their Critique)

Fiscal conservatism is typically justified using two arguments:

1. Debt-financed spending is inflationary

2. Government borrowing crowds out private investment

The passage critiques these as misplaced or overgeneralised:

● These outcomes may occur under certain conditions

● They are not universal economic laws
● Yet they are treated as such to justify strict limits on government borrowing

5. Crisis Moments and the Return of Austerity

● During the Great Recession and COVID-19 pandemic:

○ Demand collapsed
○ Large fiscal stimulus was clearly necessary
● Even then:
○ Neo-liberal orthodoxy only temporarily relaxed
○ Austerity returned quickly, especially in:
■ Developing
■ Emerging
■ Frontier economies
● This reveals that fiscal conservatism is ideological, not purely pragmatic.

6. Why Governments Resist Fiscal Conservatism

Governments are expected to:

● Build physical infrastructure

● Provide social services
● Undertake redistributive spending to counter inequality

Rigid fiscal conservatism makes this extremely difficult. Hence:

● Many governments violated fiscal rules when not forced by IMF/World Bank conditionalities
● Simple numerical rules (deficit caps, debt ceilings) proved insufficient to enforce compliance

7. Shifting Strategy: Targeting Financing Channels

Since persuasion failed, the strategy shifted:

 Instead of telling governments not to spend, cut off how they finance spending.

Step-by-Step Evolution

1. First target: Central bank financing (“monetised deficits”)

○ Incorrectly labelled as uniquely inflationary
2. Preferred alternative:
○ Borrowing from domestic banks
○ Seen as non-inflationary because it supposedly:
■ Redirects existing private savings
■ Does not add to aggregate demand
3. Current target:
○ Bank lending to governments itself
○ Now portrayed as a threat to financial stability

8. The Flaw in the IMF’s Assumption about Bank Lending

The passage challenges a key implicit assumption:

● That banks can lend more to governments only by reducing lending to the private sector

In reality:

● Banks do not operate under a fixed pool of savings

● They can usually:
○ Expand balance sheets
○ Create additional credit
● Lending to government does not automatically crowd out private credit

Thus, restricting bank lending to sovereigns is not neutral:

● It actively constrains fiscal policy

● Without necessarily improving private investment or stability

1. Why Monetised Deficits Were Targeted First

● Monetised deficits (government borrowing directly from the central bank) were opposed on two
main grounds:
○ They could encourage fiscal profligacy by giving governments “on-demand” access to
finance.
○ They were seen as undermining central bank independence, limiting the ability of central
banks to conduct monetary policy autonomously.
● Neo-liberal policy advocates therefore pushed to:
○ Severely restrict or eliminate government borrowing from central banks.
● This privileging of central bank independence became a core element of modern macroeconomic
orthodoxy.

2. Fiscal Rules as the Next Line of Defence

● Even after banning central bank financing, governments could still:

○ Borrow from the open market
 ○ Run what were considered excessive fiscal deficits
● To prevent this, institutions such as the International Monetary Fund and the World Bank, backed
by international finance capital, promoted:
○ Legislated ceilings on:
■ Fiscal deficit–GDP ratios
■ Public debt–GDP ratios
○ Mandatory declining paths for these ratios over time
● Achieving these targets typically required:
○ Cuts in government expenditure
○ Adoption of austerity policies, even where fiscal space was already limited

3. Why Governments Could Not Stick to Austerity

● Expenditure cuts had:

○ Severe economic and social consequences
● As a result:
○ Many governments failed to meet fiscal targets
○ They continued debt-financed spending by borrowing from the domestic banking system
● This borrowing was seen as “unacceptable” by fiscal conservatives, despite being one of the most
stable forms of deficit financing.

4. Why Bank Lending to Governments Is Now Being Targeted

● This helps explain the IMF’s recent shift:

○ From opposing central bank financing
○ To now opposing bank lending to sovereigns
● The IMF justifies this shift by arguing that:
○ COVID-19 led to a sharp rise in bank lending to governments
○ This strengthened the sovereign–bank nexus in emerging markets
○ The result is heightened macro-financial instability risk

5. The IMF’s Empirical Claims

Drawing on its Global Financial Stability Report, the IMF argues:

● Public debt in emerging markets is already elevated

● Bank lending financed a large share of pandemic response:
○ Discretionary fiscal stimulus averaged ~10% of GDP in 2020–21
● As foreign participation in domestic bond markets declined:
○ Domestic banks became the main financiers
● By 2021:
○ Banks’ exposure to sovereign debt reached 17% of total banking sector assets

6. Why the IMF Sees This as Dangerous

The IMF outlines several interconnected risks:

(a) Debt Sustainability Risk

● Further sovereign borrowing could:

○ Push debt to unsustainable levels
○ Raise concerns about governments’ ability to service debt

(b) Corporate Dependence on State Support

● Nearly half of the stimulus took the form of:

○ Loans
○ Guarantees
○ Equity support
● This has made the corporate sector dependent on continued policy support
● If support is withdrawn prematurely, defaults may rise

7. Macroeconomic Headwinds Intensifying the Risk

According to the IMF’s World Economic Outlook:

1. Weaker Growth Prospects

○ Emerging market growth is projected to be lower than pre-pandemic
○ This constrains governments’ ability to spend or cut taxes
○ Public debt ratios may rise further
2. Monetary Policy Normalisation
○ Higher global interest rates can:
■ Raise borrowing costs
■ Make debt rollover harder
○ This may trigger:
■ Capital outflows
■ Sharp currency depreciation or currency crises

8. Feedback Loops Between Banks and Sovereigns

The IMF identifies a dangerous spiral:

● High sovereign exposure weakens banks

● Bank stress forces governments to bail out banks
● Bailouts weaken sovereign balance sheets
● Weak sovereigns further undermine banks

This sovereign–bank doom loop is seen as a major threat to stability.

9. Final Link: Real Economy and Financial Fragility

● Reduced fiscal capacity limits governments’ ability to:

○ Support growth
○ Stabilise the real economy
● Low growth:
○ Raises corporate vulnerability
 ○ Increases bank losses
● This amplifies:
○ Banking stress
○ Sovereign stress
○ System-wide instability

1. IMF’s Core Claim: How Sovereign Stress Creates Bank Fragility

The passage begins by summarising the International Monetary Fund (IMF) position:

Bank vulnerability increases when three things occur together:

1. A fall in the value of government debt, weakening banks’ balance sheets

2. Reduced access to a government safety net, due to fiscal stress or enforced fiscal conservatism
3. Fiscal consolidation, which suppresses growth and lowers bank profitability

These dynamics can operate in both directions:

● Sovereign stress can destabilise banks

● Bank fragility can worsen sovereign stress

This is the familiar sovereign–bank doom loop.

2. The Two-Part IMF Argument

The IMF’s discussion has two distinct components:

(a) Contextual Diagnosis

It correctly describes how:

● The weak post–Global Financial Crisis recovery

● The COVID-19 shock
● The Ukraine war
have together heightened financial fragility in both advanced and emerging economies.

(b) Policy Prescription

It then claims that:

● Bank fragility has been intensified by excessive bank exposure to sovereign debt
● Therefore, banks’ holdings of government debt must be reduced through regulatory and
prudential measures

3. The Central Contradiction

The passage argues that these two components contradict each other.

● If the problem is weak growth, fragile recovery, and heightened vulnerability,

● then the logical response should be:
○ Expanded state spending
 ○ Stronger social safety nets
○ Counter-cyclical fiscal stimulus

Since:

● Tax revenues cannot be raised significantly during a recession,

● This spending must be financed by borrowing in domestic currency.

Domestic banks are a crucial source of such borrowing.

To cut off bank lending to governments in this context:

● Deepens the recession

● Weakens growth
● Ultimately increases bank fragility, not reduces it

Ironically, the IMF’s own analysis implicitly recognises this.

4. A Category Error: Treating Sovereign Debt Like Private Debt

To justify its stance, the IMF:

● Treats banks’ holdings of sovereign debt as equivalent to holdings of private sector debt

The passage argues this is fundamentally wrong.

Key distinction:

● Domestic-currency sovereign debt has a very low probability of default

○ The state can tax in the future
○ It can refinance obligations
● Private debt lacks this backing

Therefore:

● Sovereign borrowing to finance recovery is not the problem

● The real constraint is inflation management, not debt levels per se

5. Crisis Dynamics: Cause vs Consequence

The passage stresses that:

● Increased bank exposure to sovereign debt is a consequence of crisis, not its cause
● In stressed conditions:
○ Banks move away from risky private borrowers
○ They engage in a flight to safety toward government securities
● Some sovereign holding is mandated via liquidity regulations
● Much of the increase is voluntary and defensive

By ignoring this, the IMF misreads risk aversion as risk creation.

6. Misreading Credit Rating Correlations

The IMF argues that:

● Sovereign and bank credit risks are closely linked

● Evidence: positive correlation between sovereign and bank credit ratings

The passage dismantles this claim:

● The relationship is one-way, not symmetric

● Sovereign rating downgrades:
○ Automatically trigger corporate and bank downgrades
○ Due to rating-agency ceiling rules
● Corporate or bank downgrades:
○ Do not affect sovereign ratings

Thus:

● Similar ratings do not show that sovereign borrowing causes banking stress
● They show that:
○ The entire economy is under stress
○ Sovereigns are vulnerable because recovery has failed, not because debt is excessive

7. What the IMF Avoids Confronting

The passage’s sharpest critique is that:

● The IMF offers no serious strategy for:

○ Reviving growth
○ Ending prolonged stagnation
○ Repairing real economic capacity
● Instead, it focuses on:
○ Further weakening governments
○ Restricting access to bank credit
○ Enforcing fiscal consolidation

This:

● Worsens recessionary conditions

● Shrinks state capacity
● Amplifies, rather than mitigates, financial fragility