Zones of scepticism

Indian Express, 8 December 2011

On December 9th Eurozone will attempt to find a solution to the deepening banking and fiscal crisis in Europe. Many believe that liquidity provision may provide a short term solution, but the deeper problem of solvency of many governments will remain. Borrowing by governments and lending by banks often has a strong overlap. This relationship has a long history in India. In the light of the problems of Europe, it is important to look at this intimate connection with fresh skepticism, and worry about distancing bank assets from government bonds. Holding risk free government bonds, a practice Basle norms encouraged for banks, has, as it has turned out, encouraged governments to borrow imprudently.

The simplest lending by bank to governments is through `financial repression'. Financial repression is when government usurps powers of financial regulation. The government, or the regulator, then classifies its own bonds as risk-free and then forces banks and other financial firms to buy these bonds. In India, 24 per cent of all bank assets are required to be held statutorily in liquid assets, that is government bonds under the SLR (Statutory Liquidity Ratio) requirement. In the case of employees provident funds this can go upto 100 per cent of all assets. The financial system is able to collect household savings from all across the country, and deliver them as cheap lending to the government.

This makes it easy for the government to run large deficits and to build up debt, without the disciplining constraint of facing a bond market. In India, we are constantly up against a government that borrows too much. We have tried disciplining the government by enacting the FRBM Act. This did not deliver results. On an international scale, fiscal responsibility legislation is not the main roadmap of how any country achieved fiscal prudence.

Effective fiscal prudence comes from ending financial repression. It requires modifying financial regulation so that financial firms are not forced to buy government bonds. When a government wants to borrow, it should run an auction, and nobody should be forced to lend to the government.

Once investors are voluntary participants in the market for government bonds, they exert market discipline upon the government. When the government is profligate, investors get nervous about whether the government will be able to repay in the future. A government may cheat in the future in two ways. It might either explicitly default. Alternatively, it can ignite inflation, debase the currency, and thus defraud the bondholders who are repaid Rs.100 in full but the rupee is worth less.

People who lend to the government voluntarily would constantly look at the government, and make a call for what interest rate they require in return for taking the risk of lending to the government. When a government is in a fiscal danger zone -- as India has done from the early 1980s onwards -- the bond market would witness higher interest rate, and thus exert pressure upon the government.

This first element of the story is well understood. The world over, fiscal - financial - monetary reforms have been undertaking focused on two subjects: cutting off monetisation (the purchase of government bonds by printing money) and cutting off financial repression (the forced purchase of government bonds by financial firms). India is a laggard by world standards in continuing to run a system rooted in financial repression. Looking forward, putting an end to financial repression is a major pending item in Indian economic policy reform.

The second element of the story is new: this is the soft version of financial repression that was built by the Basel Committee on Banking Supervision (BCBS) at the Bank of International Settlements (BIS) from 1988 onwards. The BCBS sets international standards for how bank regulation is done. With the benefit of hindsight, we now know that there were major mistakes in what BCBS/BIS did.

The international standards which were established by BCBS/BIS claimed that bank investment in bonds issued by government bonds of OECD countries were riskless. While some economists strongly criticised these propositions, by and large, they were not seen as a big issue. Now, with the benefit of hindsight, we realise that this has been a mistake.

When banks were told that they did not need to hold any equity capital for investing in bonds issued by OECD governments, they piled up such debt. This gave abnormally cheap financing to OECD governments. Most OECD countries responded to this cheap financing by ramping up fiscal imprudence. Governments exuberantly built welfare programs in the so-called `European-style welfare state'. Deficits and debt steadily crept up. The cost of financing was very low, and the equations seemed to square.

Some European governments are now in deep fiscal trouble. But most European banks are heavily invested in their government bonds. The most toxic asset in the Euro crisis is government bonds issued by weak OECD countries. If a country like Italy or France should default on its government bonds, it would trigger off a major crisis in the European banking system.

What lessons can we draw? First, that we should be more skeptical about the BCBS/BIS process. In most areas, international norms and standards work well. However, the BCBS/BIS process has failed badly (in this and in other respects) and should be treated with skepticism.

Equally importantly, we should be cautious about banks holding government bonds. If many Indian banks are deeply invested in Indian government bonds, then at a future date, we would potentially face a situation like that of Europe today. India's public finance is by no means in good hands. If, in the future, a fiscal crisis should occur, we should not exacerbate it by linking it to a banking crisis. It would be better to derisk banking by distancing Indian banks from the Indian State

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