FRBM Law is Irrational. Amend it (Part II)
S Gurumurthy, Chairman, VIF

The way economists have made simple theories into complex mathematical equations has made monetary economics seem difficult to comprehend. Well-known economists, including Nobel laureate Robert Shiller and Prof Bradford DeLong, have already protested at this distortion of economics. Monetary economics is the story and dynamics of money. Money is to the economy what blood and medicine are to human body. If the economy is short financed, its growth will slacken. If it is starved of money it may even collapse. If it is excessively financed, it will lead to inflation. Originally, the state controlled the entire money supply. It is actually the other way round now. It is not governments but banks that create most of the money. Bank of England Quarterly Bulletin (Q1 2014) stated that 97 per cent of money is generated by banks, almost unregulated. Globally, governments have printed $7 trillion but the banking system has created $700 trillion — 100 times more. In India, banks are fully regulated.

Also Reead: Fiscal Deficit:Story of the Magic '3' Per cent

They generate less money than their western counterparts. But still they create and control more than half the money in the economy. The Reserve Bank of India regulates this entire money stock of money. All that the Indian government is left with is its revenues. If it needed more money to finance its deficit in budgets, it has to borrow from the money created by banks.

India and West

The quality of money supply in the West and in India differ. In the West, cash balances and bank deposits (technically known as M3 or broad money) constitute money supply by banks to the economy. But in India, the Broad Money has to be reduced by 21.5 per cent Statutory Liquidity Ratio (SLR) which the banks have to keep invested in government securities (known as Statutory Liquidity Ratio), to arrive at the actual money supply available with banks. The appropriate test for India, therefore, is the demand for credit from business in particular. But to measure the demand for credit, there is no debt or credit market in India. Credit is allocated by banks, mostly by PSU banks. The gap between credit demanded and credit provided is not known. The only yardstick available is credit expansion. The theory of money broadly followed by the guild of economists world over is that money is critical for growth and without adequate money, growth will suffer. While Milton Friedman, the celebrated Noble laureate, talked about inadequate supply of money as the cause of the Great Depression in 1930s, James Tobin spoke about inadequate demand for money as the cause. There is no doubt that either can weaken the economy.

Money supply falls

Currently, Broad Money supply in India (M3 as explained earlier) is falling year on year with more than proportionate fall in credit expansion, indicating that both the Milton phenomenon of inadequate money supply and the Tobin theory of inadequate credit expansion (taking credit expansion as equal to demand for money) are operating in the Indian economy. Time series data shows that during the period of 11 years ending 2010-11, M3 supply growth averaged 17.8 per cent. It began to come down from an average of 16.5 per cent in the two years ending 2010-11 to an average of 13.5 per cent in the three years ending 2013-14. In 2014-15 it has come down to 11.5 per cent. This is far less than the growth of nominal GDP for the year. The fall is over 45 per cent as compared to 2010-11. One explanation for the fall, coupled with the growth in the economy now, could be the role of black money. The disproportionate rise of high denomination notes (Re 500/1000) in the total currency in circulation, from Rs 5 lac cr in 2008-9 to over Rs 12 lac cr (85 per cent of the total) in 2014-15 points to more space for the informal monetary system. According to Economic Census (2013) micro businesses, which add substantially to GDP, are funded to the extent of Rs 12 lac crore, of which only 4 per cent (Rs 48000 alone) comes from banks — the balance being funded by informal monetary system.

Credit growth slides

Yet, even though gross money supply (M3) has come down in recent years, it does not appear that the banks do not have money to lend. A comparison of rise in credit to rise in deposit shows that credit rise was 112 per cent of the deposit rise in the three years ending 2012-13 — which came down to 97 per cent in 2013-14, finally to 82 per cent in 2014-15. The conclusion is also reinforced by the rise in bank deposit and bank credit as a proportion of the nominal GDP. In the two years ending 2010-11, the rise in deposit and credit as a proportion of nominal GDP was almost equal — 100 per cent. The average ratio for the next years is 93 per cent — that is the credit rise to deposit rise in relation to GDP was 93 per cent. In the year 2014-15, the ratio of credit rise to GDP fell also to almost half (54 per cent) of the ratio deposit rise to GDP. This shows that the monetary mechanism — bank credit is fatiguing and falling as a proportion of deposit and GDP. The money needed to grow the economy is not in circulation.

FRBM irrational

And now come to deficit financing and how the FRBM law, with its faked limits, acts against growth. The empirical data — of fall credit rise to deposit rise as proportion of GDP — shows that the 5 per cent financial savings, which the economists say will “go” to the business sector, is not wanted by them as their risk appetite is less. Annual credit growth has halved from 16.7 per cent in 2009-10 to less than 8 per cent. This is despite the fact that the economy has started growing from 2014-15 which means that more money is needed now for growth than in the earlier years (2012-13/2013-14) when the growth was far less. This additional money can only be supplied through fiscal expansion immediately.

Experts object to fiscal deficit because government borrowing for fiscal deficit crowds out private corporate credit needs and affects growth. The experts seem to be wrong on facts. Commercial banks, which have to invest 21.5 per cent of their deposits in government securities (SLR) have actually invested year after year far in excess — by more than a third over and above the SLR limit. This shows that the banks — read PSBs — have no avenue to lend. Or they are unwilling to lend. Empirical evidence also points to the possibility that the credit growth does not fully explain the demand for money and there is a gap between demand for money and credit growth as the PSBs do not want to take risk. Evidently there is money with banks but the banks, particularly Public Sector Banks (PSBs) are not lending.

Banks in India means largely PSBs which hold 80 per cent deposits of commercial banks. PSB officials cannot exercise their free judgement, when four institutions —Vigilance, RBI, CVC and CBI —are out to fault the lending on wisdom bestowed by adverse turn of events. The first banking reform needed is to retrain the PSB officials and make them exercise free judgement without coercive investigation.

Deficit funds growth

With credit growth falling in proportion to growth, it is the fiscal deficit which is supplementing the falling credit expansion and aiding growth. The economy seems to be running after all on the fuel of fiscal deficit, which is demonised by all. With the FRBM law virtually banning the government from creating money, the government only borrows money from the financial system and meets the fiscal deficit. This does not add to money supply. The money that shifts from banks to government is actually money not lent and lying idle with the banks. When money is lying idle with banks, fiscal expansion is not only welcome, but necessary to activate the economy. The aggregate of the credit expansion by banks and fiscal expansion (fiscal deficit of government) which constitutes money put into the economy amounted to 14.6 per cent of the nominal GDP in 2010-11 and 14 per cent in 2011-12. Even this combined number started falling later, to 12 per cent in 2012-13, 10.5 per cent in 2013-14 and just 8 in 2014-15. It means that the aggregate of monetary expansion (credit growth) and fiscal expansion (fiscal deficit) too has gone down in proportion to GDP by 55 per cent. And yet the economy has started growing. Imagine if the growth is adequately funded, how much more it can grow.

Look at it another way. Had the fiscal expansion not taken place the economy would have been starved of the money needed. For example in the year 2012-13 the credit growth was only 6 per cent, far short of the money needed to sustain the nominal GDP growth of 12.5 per cent. But for the fiscal deficit of 4.5 per cent, the growth could not have been achieved. The lesson is that when the credit expansion fails, for whatever reason, fiscal expansion (fiscal deficit) has to fill the gap. Otherwise, it may well be an invitation to recession, or even depression as it happened in US in 1930s. Aligning fiscal economy (budget deficit) to monetary economy (banking credit) does not mean bringing down fiscal deficit to the magic figure of ‘3’ per cent. It means that when the monetary mechanism fails, the fiscal mechanism has to be activated.

Another issue for debate. When there is significant fall in the aggregate money supply (M3) by 45 per cent, with the economy on the rise, there is need to borrow money from the RBI to fill the gap between growth and money supply. When FRBM was formulated M3 was on the rise and ruled above 17 per cent. Situation has turned the other way with falling M3. The prohibition in FRBM on creating money is hampering growth when the growth of broad money supply is falling. Yes, inflation is definitely an issue. Inflation is an issue whether money gets into the economy by credit expansion or by fiscal expansion. But, when the economy is rising, growth is a short term as well as long term answer to it. In 2012-13 and 2013-14 the economy was not growing. Now growth has started. If growth impulses, suffer for want of money, bigger problem than inflation will hit the economy. Will the experts rethink? Will they commend amending the irrational FRBM law, drop the ‘3’ mandated fiscal deficit and also allow borrowing from RBI whenever there is clear trend of falling credit expansion or broad money supply? Are they listening?

Post Script: Surprisingly, an expert who opposed the FRBM law in 2004 was P Chidambaram. But he was the one to fast forward its implementation in 2005.


(The author is a well-known commentator on economic and political affairs.)

Published in The New India Express on 26th February 2016. Image Sources:
(Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the official policy or position of the Vivekananda International Foundation)

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