Those who were expecting the Reserve Bank of India (RBI) to announce a policy rate cut shortly after finance minister Arun Jaitley presented the Union Budget would be disappointed. It is highly unlikely that RBI will be in a hurry to cut the rates, particularly after Jaitley pushed the target of limiting the fiscal deficit to 3% of gross domestic product, or GDP, by a year to fiscal year 2018. You can’t have the best of both worlds—high fiscal deficit and low interest rates.

Indeed, the fiscal deficit for the current year has been kept at 4.1% of GDP but the pace of cutting the deficit would slow as the minister seeks to boost investment. For the fiscal year starting 1 April, the target has been revised to 3.9% from 3.6%. Subsequently, it is being pared to 3.5% in 2017 and 3% in 2018. Accordingly, the Fiscal Responsibility and Budget Management Act will be amended.

The 14th Finance Commission had recommended achieving the 3.6% fiscal deficit target next year and 3% in 2017 and everybody was keenly watching whether Jaitley would stick to the target. He has chosen not to do so and possibly the Finance Commission is responsible for this. Following the Commission’s recommendations, the central government has devolved 42% share of the divisible pool of taxes to states. As a result of this, the states will get 5.24 trillion in the next fiscal year compared with 3.38 trillion in the current year. On top of that, 3.04 trillion will be transferred to states in the form of grants and commission, taking the overall flow to close to 62% of the total tax receipts of India. Clearly, Jaitley is handicapped. Without creating new avenues of resource generation, it was impossible for him to stick to 3.6% fiscal deficit target next year. However, is there any guarantee that he will not shift the goalpost once again next year or the year after?

Jaitley has singled out conquering inflation as one of the major achievements of his government. And the decline in inflation, according to him, represents a structural shift. He expects retail inflation close to 5% by March 2016—1 full percentage point lower than the RBI target—and this will create the ground for further easing of monetary policy, he says. This is a smart way of putting pressure on RBI, but the central bank may not oblige the government after the path towards fiscal consolidation gets longer and uncertain. One can expect a quarter percentage point rate cut in April when RBI announces its annual monetary policy for the next fiscal year and probably an encore later this year. Unless there is a dramatic fall in inflation, it’s hard to believe that India’s policy rate will go down below 7.25%. Higher fiscal deficit will lead to higher government borrowing. That will put pressure on interest rates and private firms will be denied money when they need it.

The government is targeting inflation below 6% and it has already entered into an agreement with RBI on this, something Jaitley had promised in his last budget. The RBI Act will be amended to provide for a monetary policy committee. Both inflation targeting and the constitution of such a committee were recommended by an RBI-appointed panel, headed by one of its deputy governors, Urjit Patel. Going by the panel’s recommendations, the monetary policy committee will have the mandate to maintain the level of inflation around a specified range and RBI will be accountable to achieve this. The Patel committee has set a target of 4% with a 2% band. The members of the monetary policy committee, according to Patel, will be the governor of RBI, both the deputy governor as well as the executive director who oversee monetary policy, and two full-time members appointed by RBI. The composition of the committee will be interesting to see and once this is set up and inflation targeting is formally accepted as a goal, RBI’s job will be easier as there will be no obvious conflict between growth and inflation and the government will not be in a position to put pressure on the central bank to cut interest rates.

Discussions on the creation of a debt management agency independent of RBI have been on for years because of the obvious conflict of interest that the central bank has by being a debt manager and a money manager. As the government’s investment banker, RBI’s objective is to keep the borrowing cost of the government low and to achieve this it can use a string of instruments including open market operations while as a monetary authority its objective is price stability, typically achieved through change in interest rates. Despite the conflict of interests, RBI has been entrusted with this job because of India’s high fiscal deficit and consequently large market borrowings. The draft code of the Financial Sector Legislative Reforms Commission (FSLRC) has proposed the creation of an independent public debt management agency—it would have an independent goal and objective but would operate as an agent of the central government. To make it a success, it should be a statutory corporation, keeping an arm’s length both from the government as well as RBI.

Among other things, the proposal to grant financial institution status to the RBI-registered large non-banking financial companies, allowing them to move the debt recovery tribunals for recovering bad loans, and creation of a comprehensive bankruptcy code will help the Indian financial system fight rogue borrowers. However, it hasn’t done much for the public sector banking industry. The money budgeted for infusing capital in them is minuscule while in his last budget speech Jaitley had said that the government would need to infuse 2.4 trillion in public sector banks by 2018 to meet the Basel-III international norms. The budget proposes to set up an autonomous bank board bureau which will identify professionals who can run the banks and help them develop capital raising plans through innovative instruments. This is, however, an interim arrangement and the government will eventually set up a holding company for its investments in public sector banks. While the wait for the holding company gets longer, the decision to empower bank boards and push mergers will jack up valuations of public sector banks and help them raise capital from market.

Tamal Bandyopadhyay, consulting editor at Mint, is adviser to Bandhan Financial Services Pvt Ltd, India’s newest bank in the making. He is also the author of Sahara: The Untold Story and A Bank for the Buck. Respond to this column at

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