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Not just inflation, new RBI guv is a stickler for fiscal responsibility too

Urjit Patel, who will take over from outgoing Raghuram Rajan next month, is also an opponent of SLR which binds central bank to facilitate government borrowing

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Besides being an inflation warrior, the Reserve Bank of India (RBI) governor designate Urjit Patel also comes across as an opponent of statutory liquidity ratio (SLR) – an instrument that binds the central bank to facilitate government borrowing – and a strong proponent of enforceable fiscal responsibility legislation, in some of the working papers co-authored by him.

In a recent paper written in December 2015, when he was still the deputy governor of RBI, he calls SLR "insidious" and said lower interest rate on government bonds acted like "higher tax on the banking sector".

This, his report says, squeezed the balance sheet of the commercial banks.

"Statutory liquidity ratio (SLR) is particularly insidious given its size, viz, 21.5% of an individual bank's net demand and time liabilities have to be earmarked for buying government securities. Back-of-the-envelope cost to banks of the SLR presented in the paper is not insignificant," says the paper titled – Challenges of Effective Monetary Policy in Emerging Economies – written by Patel and Amartya Lahiri of the University of British Columbia.

The duo try to explain the possibility of inverted monetary policy outcomes because of the statutory requirement through theoretical models in their paper.

Further, they said SLR worked against the banks as any snip in the government bank yields or policy rates reduced demand for deposits.

"A binding SLR implies that banks cannot reallocate the scarce deposits between higher return private loans and government bonds. The constraint implies that assets have to be held in fixed proportion (like a Leontief technology) which causes both components of bank assets to fall," note Patel and Lahiri in their report.

They say fall in loans implied that output and aggregate demand would get depressed in response to the interest rate cut.

"A lower interest rate on government bonds effectively acts like higher tax on the banking sector in the presence of a binding SLR constraint. Consequently, their balance sheet contracts," states the paper brought out by the two monetary economists.

Interestingly, they call for a closer scrutiny of the "optimum" choice between taxing banks and recourse to "printing presses" of the central bank against the backdrop of a large fiscal deficit.

The same paper sets a two-fold future task for the RBI; "First, perhaps re-balance the reform agenda from high profile subjects such as legislative amendments like monetary policy framework and associated institutional changes, to addressing policy-induced distortions that undermine monetary policy efficacy and transmission. Second, address the challenge of multiple roles/objectives and limited instruments".

Another report, which was penned by the newly appointed central banker in 2010 when he was working with Reliance Industries Ltd (RIL) along with Willem H Buiter of Citigroup, expresses concerns over India's deteriorating fiscal condition and compares its position with countries like Greece, Portugal, Spain, Ireland and the UK.

Here, he stresses on the need for a stringent fiscal responsibility legislation; "Since a general government debt-GDP perspective may be incorporated in India's prospective macroeconomic management approach, it may be possible to have an incentive compatible framework with an inbuilt carrot-and-stick strategy that brings in the judiciary and thus integrates the central and state governments in a manner that holds them credibly accountable and, more importantly, rewards and punishes (enforces) each other's performances".

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