Sustainability of Debt

death scythe

For economies with fractional reserve-generated fiat money, balancing the budget is characterized by an exponential growth D(t) ≈ D0(1 + r)t of any initial debt D0 subjected to interest r as a function of time t due to the compound interest; a fact known since antiquity. At the same time, besides default, this increasing debt can only be reduced by the following five mostly linear, measures:

(i) more income or revenue I (in the case of sovereign debt: higher taxation or higher tax base);

(ii) less spending S;

(iii) increase of borrowing L;

(iv) acquisition of external resources, and

(v) inflation; that is, devaluation of money.

Whereas (i), (ii) and (iv) without inflation are essentially measures contributing linearly (or polynomially) to the acquisition or compensation of debt, inflation also grows exponentially with time t at some (supposedly constant) rate f ≥ 1; that is, the value of an initial debt D0, without interest (r = 0), in terms of the initial values, gets reduced to F(t) = D0/ft. Conversely, the capacity of an economy to compensate debt will increase with compound inflation: for instance, the initial income or revenue I will, through adaptions, usually increase exponentially with time in an inflationary regime by Ift.

Because these are the only possibilities, we can consider such economies as closed systems (with respect to money flows), characterized by the (continuity) equation

Ift + S + L ≈ D0(1+r)t, or

L ≈ D0(1 + r)t − Ift − S.

Let us concentrate on sovereign debt and briefly discuss the fiscal, social and political options. With regards to the five ways to compensate debt the following assumptions will be made: First, in non-despotic forms of governments (e.g., representative democracies and constitutional monarchies), increases of taxation, related to (i), as well as spending cuts, related to (ii), are very unpopular, and can thus be enforced only in very limited, that is polynomial, forms.

Second, the acquisition of external resources, related to (iv), are often blocked for various obvious reasons; including military strategy limitations, and lack of opportunities. We shall therefore disregard the acquisition of external resources entirely and set A = 0.

As a consequence, without inflation (i.e., for f = 1), the increase of debt

L ≈ D0(1 + r)t − I − S

grows exponentially. This is only “felt” after trespassing a quasi-linear region for which, due to a Taylor expansion around t = 0, D(t) = D0(1 + r)t ≈ D0 + D0rt.

So, under the political and social assumptions made, compound debt without inflation is unsustainable. Furthermore, inflation, with all its inconvenient consequences and re-appropriation, seems inevitable for the continuous existence of economies based on fractional reserve generated fiat money; at least in the long run.

Single Asset Optimal Investment Fraction


We first consider a situation, when an investor can spend a fraction of his capital to buy shares of just one risky asset. The rest of his money he keeps in cash.

Generalizing Kelly, we consider the following simple strategy of the investor: he regularly checks the asset’s current price p(t), and sells or buys some asset shares in order to keep the current market value of his asset holdings a pre-selected fraction r of his total capital. These readjustments are made periodically at a fixed interval, which we refer to as readjustment interval, and select it as the discrete unit of time. In this work the readjustment time interval is selected once and for all, and we do not attempt optimization of its length.

We also assume that on the time-scale of this readjustment interval the asset price p(t) undergoes a geometric Brownian motion:

p(t + 1) = eη(t)p(t) —– (1)

i.e. at each time step the random number η(t) is drawn from some probability distribution π(η), and is independent of it’s value at previous time steps. This exponential notation is particularly convenient for working with multiplicative noise, keeping the necessary algebra at minimum. Under these rules of dynamics the logarithm of the asset’s price, ln p(t), performs a random walk with an average drift v = ⟨η⟩ and a dispersion D = ⟨η2⟩ − ⟨η⟩2.

It is easy to derive the time evolution of the total capital W(t) of an investor, following the above strategy:

W(t + 1) = (1 − r)W(t) + rW(t)eη(t) —– (2)

Let us assume that the value of the investor’s capital at t = 0 is W(0) = 1. The evolution of the expectation value of the expectation value of the total capital ⟨W (t)⟩ after t time steps is obviously given by the recursion ⟨W (t + 1)⟩ = (1 − r + r⟨eη⟩)⟨W (t)⟩. When ⟨eη⟩ > 1, at first thought the investor should invest all his money in the risky asset. Then the expectation value of his capital would enjoy an exponential growth with the fastest growth rate. However, it would be totally unreasonable to expect that in a typical realization of price fluctuations, the investor would be able to attain the average growth rate determined as vavg = d⟨W(t)⟩/dt. This is because the main contribution to the expectation value ⟨W(t)⟩ comes from exponentially unlikely outcomes, when the price of the asset after a long series of favorable events with η > ⟨η⟩ becomes exponentially big. Such outcomes lie well beyond reasonable fluctuations of W (t), determined by the standard deviation √Dt of ln W (t) around its average value ⟨ln W (t)⟩ = ⟨η⟩t. For the investor who deals with just one realization of the multiplicative process it is better not to rely on such unlikely events, and maximize his gain in a typical outcome of a process. To quantify the intuitively clear concept of a typical value of a random variable x, we define xtyp as a median of its distribution, i.e xtyp has the property that Prob(x > xtyp) = Prob(x < xtyp) = 1/2. In a multiplicative process (2) with r = 1, W (t + 1) = eη(t)W (t), one can show that Wtyp(t) – the typical value of W(t) – grows exponentially in time: Wtyp(t) = e⟨η⟩t at a rate vtyp = ⟨η⟩, while the expectation value ⟨W(t)⟩ also grows exponentially as ⟨W(t)⟩ = ⟨eη⟩t, but at a faster rate given by vavg = ln⟨eη⟩. Notice that ⟨lnW(t)⟩ always grows with the typical growth rate, since those very rare outcomes when W (t) is exponentially big, do not make significant contribution to this average.

The question we are going to address is: which investment fraction r provides the investor with the best typical growth rate vtyp of his capital. Kelly has answered this question for a particular realization of multiplicative stochastic process, where the capital is multiplied by 2 with probability q > 1/2, and by 0 with probability p = 1 − q. This case is realized in a gambling game, where betting on the right outcome pays 2:1, while you know the right outcome with probability q > 1/2. In our notation this case corresponds to η being equal to ln 2 with probability q and −∞ otherwise. The player’s capital in Kelly’s model with r = 1 enjoys the growth of expectation value ⟨W(t)⟩ at a rate vavg = ln2q > 0. In this case it is however particularly clear that one should not use maximization of the expectation value of the capital as the optimum criterion. If the player indeed bets all of his capital at every time step, sooner or later he will loose everything and would not be able to continue to play. In other words, r = 1 corresponds to the worst typical growth of the capital: asymptotically the player will be bankrupt with probability 1. In this example it is also very transparent, where the positive average growth rate comes from: after T rounds of the game, in a very unlikely (Prob = qT) event that the capital was multiplied by 2 at all times (the gambler guessed right all the time!), the capital is equal to 2T. This exponentially large value of the capital outweighs exponentially small probability of this event, and gives rise to an exponentially growing average. This would offer condolence to a gambler who lost everything.

We generalize Kelly’s arguments for arbitrary distribution π(η). As we will see this generalization reveals some hidden results, not realized in Kelly’s “betting” game. As we learned above, the growth of the typical value of W(t), is given by the drift of ⟨lnW(t)⟩ = vtypt, which in our case can be written as

vtyp(r) = ∫ dη π(η) ln(1 + r(eη − 1)) —– (3)

One can check that vtyp(0) = 0, since in this case the whole capital is in the form of cash and does not change in time. In another limit one has vtyp(1) = ⟨η⟩, since in this case the whole capital is invested in the asset and enjoys it’s typical growth rate (⟨η⟩ = −∞ for Kelly’s case). Can one do better by selecting 0 < r < 1? To find the maximum of vtyp(r) one differentiates (3) with respect to r and looks for a solution of the resulting equation: 0 = v’typ(r) = ∫ dη π(η) (eη −1)/(1+r(eη −1)) in the interval 0 ≤ r ≤ 1. If such a solution exists, it is unique since v′′typ(r) = − ∫ dη π(η) (eη − 1)2 / (1 + r(eη − 1))2 < 0 everywhere. The values of the v’typ(r) at 0 and 1 are given by v’typ(0) = ⟨eη⟩ − 1, and v’typ(1) = 1−⟨e−η⟩. One has to consider three possibilities:

(1) ⟨eη⟩ is realized at r = 0 and is equal to 0. In other words, one should never invest in an asset with negative average return per capital ⟨eη⟩ − 1 < 0.

(2) ⟨eη⟩ > 1 , and ⟨e−η⟩ > 1. In this case v’typ(0) > 0, but v’typ(1) < 0 and the maximum of v(r) is realized at some 0 < r < 1, which is a unique solution to v’typ(r) = 0. The typical growth rate in this case is always positive (because you could have always selected r = 0 to make it zero), but not as big as the average rate ln⟨eη⟩, which serves as an unattainable ideal limit. An intuitive understanding of why one should select r < 1 in this case comes from the following observation: the condition ⟨e−η⟩ > 1 makes ⟨1/p(t)⟩ to grow exponentially in time. Such an exponential growth indicates that the outcomes with very small p(t) are feasible and give dominant contribution to ⟨1/p(t)⟩. This is an indicator that the asset price is unstable and one should not trust his whole capital to such a risky investment.

(3) ⟨eη⟩ > 1 , and ⟨e−η⟩ < 1. This is a safe asset and one can invest his whole capital in it. The maximum vtyp(r) is achieved at r = 1 and is equal to vtyp(1) = ln⟨η⟩. A simple example of this type of asset is one in which the price p(t) with equal probabilities is multiplied by 2 or by a = 2/3. As one can see this is a marginal case in which ⟨1/p(t)⟩ = const. For a < 2/3 one should invest only a fraction r < 1 of his capital in the asset, while for a ≥ 2/3 the whole sum could be trusted to it. The specialty of the case with a = 2/3 cannot not be guessed by just looking at the typical and average growth rates of the asset! One has to go and calculate ⟨e−η⟩ to check if ⟨1/p(t)⟩ diverges. This “reliable” type of asset is a new feature of the model with a general π(η). It is never realized in Kelly’s original model, which always has ⟨η⟩ = −∞, so that it never makes sense to gamble the whole capital every time.

An interesting and somewhat counterintuitive consequence of the above results is that under certain conditions one can make his capital grow by investing in asset with a negative typical growth rate ⟨η⟩ < 0. Such asset certainly loses value, and its typical price experiences an exponential decay. Any investor bold enough to trust his whole capital in such an asset is losing money with the same rate. But as long as the fluctuations are strong enough to maintain a positive average return per capital ⟨eη⟩ − 1 > 0) one can maintain a certain fraction of his total capital invested in this asset and almost certainly make money! A simple example of such mind-boggling situation is given by a random multiplicative process in which the price of the asset with equal probabilities is doubled (goes up by 100%) or divided by 3 (goes down by 66.7%). The typical price of this asset drifts down by 18% each time step. Indeed, after T time steps one could reasonably expect the price of this asset to be ptyp(T) = 2T/2 3−T/2 = (√2/3)T ≃ 0.82T. On the other hand, the average ⟨p(t)⟩ enjoys a 17% growth ⟨p(t + 1)⟩ = 7/6 ⟨p(t)⟩ ≃ 1.17⟨W (t)⟩. As one can easily see, the optimum of the typical growth rate is achieved by maintaining a fraction r = 1/4 of the capital invested in this asset. The typical rate in this case is a meager √(25/24) ≃ 1.02, meaning that in a long run one almost certainly gets a 2% return per time step, but it is certainly better than losing 18% by investing the whole capital in this asset.

Of course the properties of a typical realization of a random multiplicative process are not fully characterized by the drift vtyp(r)t in the position of the center of mass of P(h,t), where h(t) = lnW(t) is a logarithm of the wealth of the investor. Indeed, asymptotically P (h, t) has a Gaussian shape P (h, t) =1/ (√2π D(r)t) (exp(−(h−vtyp(r)t)2)/(2D(r)t), where vtyp(r) is given by eq. (3). One needs to know the dispersion D(r) to estimate √D(r)t, which is the magnitude of characteristic deviations of h(t) away from its typical value htyp(t) = vtypt. At the infinite time horizon t → ∞, the process with the biggest vtyp(r) will certainly be preferable over any other process. This is because the separation between typical values of h(t) for two different investment fractions r grows linearly in time, while the span of typical fluctuations grows only as a √t. However, at a finite time horizon the investor should take into account both vtyp(r) and D(r) and decide what he prefers: moderate growth with small fluctuations or faster growth with still bigger fluctuations. To quantify this decision one needs to introduce an investor’s “utility function” which we will not attempt in this work. The most conservative players are advised to always keep their capital in cash, since with any other arrangement the fluctuations will certainly be bigger. As a rule one can show that the dispersion D(r) = ∫ π(η) ln2[1 + r(eη − 1)]dη − v2typ monotonically increases with r. Therefore, among two solutions with equal vtyp(r) one should always select the one with a smaller r, since it would guarantee smaller fluctuations. Here it is more convenient to switch to the standard notation. It is customary to use the random variable

Λ(t)= (p(t+1)−p(t))/p(t) = eη(t) −1 —– (4)

which is referred to as return per unit capital of the asset. The properties of a random multiplicative process are expressed in terms of the average return per capital α = ⟨Λ⟩ = ⟨eη⟩ − 1, and the volatility (standard deviation) of the return per capital σ = √(⟨Λ2⟩ – ⟨Λ⟩2. In our notation, α = ⟨eη⟩ – 1, is determined by the average and not typical growth rate of the process. For η ≪ 1 , α ≃ v + D/2 + v2/2, while the volatility σ is related to D ( the dispersion of η) through σ ≃ √D.


Activists’ Position on New Development Bank, Especially in the Wake of 2nd Annual Meetings Held at New Delhi (31st March – 2nd April). Part 1.


This is an uncut version and might differ largely from the Declaration which the Civil society Organizations put up. It is also inspired by inputs from the Goa Declaration. So, here goes:

Peoples’ Forum on BRICS is a forum of peoples’ movements, activists, trade unions, national-level networks and CSOs. We intend to win our demands for social, economic and environmental justice. We heard testimonies confirming that the BRICS countries and corporations are reinforcing the dominant neoliberal, extractivist paradigm. Negative trends in the areas of global and local politics, and on issues of economics, environment, development, peace, conflict and aggressive nationalism, or social prejudice based on gender, race, caste, sexual orientation are not being reversed by the BRICS, but instead are often exacerbated. The BRICS speak of offering strong alternatives to the unfair North-dominated regimes of trade, finance, investment and property rights, climate governance, and other multilateral regimes. But on examination, we find these claims unconvincing.The victories we have won already on multiple fronts – such as halting numerous multinational corporations’ exploitation, gaining access to essential state services, occupying land and creating agricultural cooperatives,  and generating more humane values in our societies – give us momentum and optimism.

Our experience with other Multilateral Development Banks in the past have had bitter experiences with their involvement leaving a trail of destruction and irreparable damage involving devastation of the ecologies, forced eviction and displacement, inadequate policies of rehabilitation and resettlement, catalyzing loss of livelihoods and responsible for gross human rights violations. Despite having redress mechanisms, these MDBs have proven to carry forward their neoliberal agenda with scant respect for environment and human rights. Not only have their involvement resulted in the weakening of public institutions on one hand, their have consciously incorporated sharing the goods with private players and furthering their cause under the name of growth-led development, ending extreme poverty and sharing prosperity on the other. Moreover, with Right to Dissemination of Information forming one of the pillars of these MDBs, concerns of transparency and accountability are exacerbated with a dearth of information shared, inadequate public consultations and an absolute lack of Parliamentary Oversight over their involvement in projects and at policy-levels. There are plenty of examples galore with privatizing basic amenities like drinking water and providing electricity that have backfired, but nevertheless continued with. In other words, MDBs have stripped the people of the resources that commons.

The Forum views the emergence of New Development Bank in the context of:

  1. Threat to Democracy with an upsurge of right-wing nationalism, not only in BRICS, but also beyond on the global scale.
  2. As a result of this threat, state repression is on an upswing and aggravated under different norms, growth-led development being one among them.
  3. Widespread ecological destruction, with catastrophic rates of species loss, pollution of land and air, freshwater and ocean degradation, and public health threats rising, to which no BRICS country is immune.
  4. The precarious health of the economy and continuing financial meltdown, reflected in the chaos that several BRICS’ stock and currency markets have been facing, as well as in our countries’ vulnerability to crisis-contagion if major European banks soon fail in a manner similar to the US-catalyzed meltdown in 2008-09.
  5. The longer-term crisis of capitalism is evident in the marked slowdown in international trade and in declining global profit rates, especially evident in the three BRICS countries (South Africa, Russia and Brazil) which have negative or negligible GDP growth.
  6. Addition to commodity crashes, one cause of the economic crisis is the deregulatory, neoliberal philosophy adopted by BRICS governments, which puts corporate property rights above human and environmental rights; in the guise of development.
  7. The new generation of Bilateral Trade and Investment Treaties will potentially have adverse impacts on lives and livelihoods of people across the BRICS and their hinterlands, and need complete rethinking.
  8. The world’s workers are losing rights, farmers are suffering to the point of suicide, and labour casualisation is rampant in all our countries, with the result that BRICS workers are engaged in regular protest, including the strike by 180 million Indian workers which inspired the world on 2 September 2016.
  9. The social front, the threat to our already-inadequate welfare policies is serious, especially in Brazil’s coup regime but also across the BRICS where inadequate social policies are driving people on the margins to destitution.
  10. 10.Patriarchy and sexual violence, racism, communalism, caste discrimination, xenophobia and homophobia run rampant in all the BRICS, and because these forces serve our leaders’ interests, they are not addressing the structural causes, perpetuating divide-and-rule politics, and failing to dissuade ordinary people from contributing to oppression.

New Development Bank calls itself Green. However, the Bank is shrouded under a veil of secrecy. The website of the Bank lacks information about its activities to the extent that more than official records, one has to rely on secondary and tertiary sources of information. Not that such information isn’t forthcoming officially, it is the nature of unproven, untested environmental and social safeguards that is the point of contentious concerns for the communities who might adversely impacted by the projects financed by the Bank in their backyards. Unlike the World Bank and the Asian Development Bank, which somewhat robust safeguards to be followed and grievance redress mechanisms (not discounting sometimes questionable efficacies though), the NDB is yet to draft any such operational guidelines and redressal. Although speculative at large, such an absence could be well off the mark in meeting established benchmarks. Due to the lack of such mechanisms, communities may face threats of displacement, evictions, ecological destruction, loss of livelihoods, and severe curtailment of basic rights to life. These issues have recurred for decades due to projects funded by other multilateral development banks. Moreover, as a co-financier with other development institutions, the intensity of NDB’s seriousness on the objectives of promoting transparency, accountability and probity stands questioned. Furthermore, the NDB intends to be “fast, flexible and efficient”, without sacrificing quality. The Bank will use various financial instruments to ‘efficiently’ meet the demands of member states and clients. This is where things could get a little murkier, as NDB too has agendas of economic development dominating social and political developments, and the possibilities of statistical number jugglery to establish the supremacy of the ‘gross economic development’ sometimes trampling on human rights and environmental concerns. Consequently, the economic measures taken on many occasions forgo the human capital in a relentless pursuit of development agenda.

NDB could likely put issues concerning the marginalized on the back-burner in its accelerated economic means without justifying the ends. Whatever be the underlying philosophy of development finance, questions of sustainability from both social and ecological perspective should always be decided along with genuinely informed peoples’ participation. This is possible only when the information is transparently disseminated and there are measures for qualifying accountability rather than quantifying it. Furthermore, the NDB seems to have learnt no lessons from other MDBs with not only an absence of safeguards and dependency on country systems, but with all the more reliance on national development financial institutions which are liable to be relaxed in specific cases. The NDB has not engaged with the people directly and its engagement with the CSOs is a farce considering that there is massive absence of communities, marginalized groups, indigenous peoples who are likely to face the brunt of its investments. Free Prior and Informed Consent (FPIC) does not even exist in its dictionary. Adding to the woes is the accelerated pace of investing in projects without the policies being in place.

Everywhere that people’s movements have made alternative demands – such as democracy, peace, poverty eradication, sustainable development, equality, fair trade, climate justice – the elites have co-opted our language and distorted our visions beyond recognition. While we criticize the way world power is created and exercised, the BRICS leaders appear to simply want power sharing and a seat at the high table. For example, the BRICS New Development Bank is working hand-in-glove with the World Bank; the Contingent Reserve Arrangement empowers the International Monetary Fund; and the Asian Infrastructure Investment Bank serves mainly corporate interests – and all these financial institutions, despite their rhetoric of transformation, are opaque and non-transparent to people in BRICS countries, with no accountability mechanisms or space for meaningful participation by our movements. We have raised constructive critiques of BRICS in our plenaries and workshops. But beyond the analysis, we understand that only people’s power and activism, across borders, can make change. This Forum has found many routes forward for cross-cutting BRICS internationalism on various issues. We intend to win our demands for social, economic and environmental justice. The victories we have won already on multiple fronts – such as halting numerous multinational corporations’ exploitation, gaining access to essential state services, occupying land and creating agricultural cooperatives,  and generating more humane values in our societies – give us momentum and optimism.

Yield Curve Dynamics or Fluctuating Multi-Factor Rate Curves


The actual dynamics (as opposed to the risk-neutral dynamics) of the forward rate curve cannot be reduced to that of the short rate: the statistical evidence points out to the necessity of taking into account more degrees of freedom in order to represent in an adequate fashion the complicated deformations of the term structure. In particular, the imperfect correlation between maturities and the rich variety of term structure deformations shows that a one factor model is too rigid to describe yield curve dynamics.

Furthermore, in practice the value of the short rate is either fixed or at least strongly influenced by an authority exterior to the market (the central banks), through a mechanism different in nature from that which determines rates of higher maturities which are negotiated on the market. The short rate can therefore be viewed as an exogenous stochastic input which then gives rise to a deformation of the term structure as the market adjusts to its variations.

Traditional term structure models define – implicitly or explicitly – the random motion of an infinite number of forward rates as diffusions driven by a finite number of independent Brownian motions. This choice may appear surprising, since it introduces a lot of constraints on the type of evolution one can ascribe to each point of the forward rate curve and greatly reduces the dimensionality i.e. the number of degrees of freedom of the model, such that the resulting model is not able to reproduce any more the complex dynamics of the term structure. Multifactor models are usually justified by refering to the results of principal component analysis of term structure fluctuations. However, one should note that the quantities of interest when dealing with the term structure of interest rates are not the first two moments of the forward rates but typically involve expectations of non-linear functions of the forward rate curve: caps and floors are typical examples from this point of view. Hence, although a multifactor model might explain the variance of the forward rate itself, the same model may not be able to explain correctly the variability of portfolio positions involving non-linear combinations of the same forward rates. In other words, a principal component whose associated eigenvalue is small may have a non-negligible effect on the fluctuations of a non-linear function of forward rates. This question is especially relevant when calculating quantiles and Value-at-Risk measures.

In a multifactor model with k sources of randomness, one can use any k + 1 instruments to hedge a given risky payoff. However, this is not what traders do in real markets: a given interest-rate contingent payoff is hedged with bonds of the same maturity. These practices reflect the existence of a risk specific to instruments of a given maturity. The representation of a maturity-specific risk means that, in a continuous-maturity limit, one must also allow the number of sources of randomness to grow with the number of maturities; otherwise one loses the localization in maturity of the source of randomness in the model.

An important ingredient for the tractability of a model is its Markovian character. Non-Markov processes are difficult to simulate and even harder to manipulate analytically. Of course, any process can be transformed into a Markov process if it is imbedded into a space of sufficiently high dimension; this amounts to injecting a sufficient number of “state variables” into the model. These state variables may or may not be observable quantities; for example one such state variable may be the short rate itself but another one could be an economic variable whose value is not deducible from knowledge of the forward rate curve. If the state variables are not directly observed, they are obtainable in principle from the observed interest rates by a filtering process. Nevertheless the presence of unobserved state variables makes the model more difficult to handle both in terms of interpretation and statistical estimation. This drawback has motivated the development of so-called affine curve models models where one imposes that the state variables be affine functions of the observed yield curve. While the affine hypothesis is not necessarily realistic from an empirical point of view, it has the property of directly relating state variables to the observed term structure.

Another feature of term structure movements is that, as a curve, the forward rate curve displays a continuous deformation: configurations of the forward rate curve at dates not too far from each other tend to be similar. Most applications require the yield curve to have some degree of smoothness e.g. differentiability with respect to the maturity. This is not only a purely mathematical requirement but is reflected in market practices of hedging and arbitrage on fixed income instruments. Market practitioners tend to hedge an interest rate risk of a given maturity with instruments of the same maturity or close to it. This important observation means that the maturity is not simply a way of indexing the family of forward rates: market operators expect forward rates whose maturities are close to behave similarly. Moreover, the model should account for the observation that the volatility term structure displays a hump but that multiple humps are never observed.

Fiscal Responsibility and Budget Management (FRBM) Act

The Government appointed a five-member Committee in May 2016, to review the Fiscal Responsibility and Budget Management (FRBM) Act and to examine a changed format including flexible FRBM targets. The Committee formation was announced during the 2016-17 budget by FM Arun Jaitely. The Panel was headed by the former MP and former Revenue and Expenditure Secretary NK Singh and included four other members, CEA Arvind Subramanian, former Finance Secretary Sumit Bose, the then Deputy Governor and present governor of the RBI Urjit Patel and Nathin Roy. There was a difference of opinion about the need for adopting a fixed FRBM target like fiscal deficit, and the divisive opinion lay precisely in not following through such a fixity in times when the government had to spend high to fight recession and support economic growth. The other side of the camp argued it being necessary to inculcate a feeling of fiscal discipline. During Budget speech in 2016, Mr Jaitley expressed this debate:

There is now a school of thought which believes that instead of fixed numbers as fiscal deficit targets, it may be better to have a fiscal deficit range as the target, which would give necessary policy space to the government to deal with dynamic situations. There is also a suggestion that fiscal expansion or contraction should be aligned with credit contraction or expansion, respectively, in the economy.

The need for a flexible FRBM target that allowed higher fiscal deficit during difficult/recessionary years and low targets during comfortable years, gives the government a breathing space to borrow more during tight years. In it report submitted in late January this year, the committee did advocate for a range rather than a fixed fiscal deficit target. Especially, fiscal management becomes all the more important post-demonetisation and the resultant slump in consumption expenditure. The view is that the government could be tempted to increase public spending to boost consumption. but, here is the catch: while ratings agencies do look at the fiscal discipline of a country when considering them for a ratings upgrade, they also look at the context and the growth rate of the economy, so the decision will not be a myopic one based only on the fiscal and revenue deficits.

Fiscal responsibility is an economic concept that has various definitions, depending on the economic theory held by the person or organization offering the definition. Some say being fiscally responsible is just a matter of cutting debt, while others say it’s about completely eliminating debt. Still others might argue that it’s a matter of controlling the level of debt without completely reducing it. Perhaps the most basic definition of fiscal responsibility is the act of creating, optimizing and maintaining a balanced budget.

“Fiscal” refers to money and can include personal finances, though it most often is used in reference to public money or government spending. This can involve income from taxes, revenue, investments or treasuries. In a governmental context, a pledge of fiscal responsibility is a government’s assurance that it will judiciously spend, earn and generate funds without placing undue hardship on its citizens. Fiscal responsibility includes a moral contract to maintain a financially sound government for future generations, because a First World society is difficult to maintain without a financially secure government.

But, what exactly is fiscal responsibility, fiscal management and FRBM. So, here is an attempt to demystify these.

Fiscal responsibility often starts with a balanced budget, which is one with no deficits and no surpluses. The expectations of what might be spent and what is actually spent are equal. Many forms of government have different views and expectations for maintaining a balanced budget, with some preferring to have a budget deficit during certain economic times and a budget surplus during others. Other types of government view a budget deficit as being fiscally irresponsible at any time. Fiscal irresponsibility refers to a lack of effective financial planning by a person, business or government. This can include decreasing taxes in one crucial area while drastically increasing spending in another. This type of situation can cause a budget deficit in which the outgoing expenditures exceed the cash coming in. A government is a business in its own right, and no business — or private citizen — can thrive eternally while operating with a deficit.

When a government is fiscally irresponsible, its ability to function effectively is severely limited. Emergent situations arise unexpectedly, and a government needs to have quick access to reserve funds. A fiscally irresponsible government isn’t able to sustain programs designed to provide fast relief to its citizens.

A government, business or person can take steps to become more fiscally responsible. One useful method for government is to provide some financial transparency, which can reduce waste, expose fraud and highlight areas of financial inefficiency. Not all aspects of government budgets and spending can be brought into full public view because of various risks to security, but offering an inside look at government spending can offer a nation’s citizens a sense of well-being and keep leaders honest. Similarly, a private citizen who is honest with himself about where he is spending his money is better able to determine where he might be able to make cuts that would allow him to live within his means.

Fiscal Responsibility and Budget Management (FRBM) became an Act in 2003. The objective of the Act is to ensure inter-generational equity in fiscal management, long run macroeconomic stability, better coordination between fiscal and monetary policy, and transparency in fiscal operation of the Government.

The Government notified FRBM rules in July 2004 to specify the annual reduction targets for fiscal indicators. The FRBM rule specifies reduction of fiscal deficit to 3% of the GDP by 2008-09 with annual reduction target of 0.3% of GDP per year by the Central government. Similarly, revenue deficit has to be reduced by 0.5% of the GDP per year with complete elimination to be achieved by 2008-09. It is the responsibility of the government to adhere to these targets. The Finance Minister has to explain the reasons and suggest corrective actions to be taken, in case of breach.

FRBM Act provides a legal institutional framework for fiscal consolidation. It is now mandatory for the Central government to take measures to reduce fiscal deficit, to eliminate revenue deficit and to generate revenue surplus in the subsequent years. The Act binds not only the present government but also the future Government to adhere to the path of fiscal consolidation. The Government can move away from the path of fiscal consolidation only in case of natural calamity, national security and other exceptional grounds which Central Government may specify.

Further, the Act prohibits borrowing by the government from the Reserve Bank of India, thereby, making monetary policy independent of fiscal policy. The Act bans the purchase of primary issues of the Central Government securities by the RBI after 2006, preventing monetization of government deficit. The Act also requires the government to lay before the parliament three policy statements in each financial year namely Medium Term Fiscal Policy Statement; Fiscal Policy Strategy Statement and Macroeconomic Framework Policy Statement.

To impart fiscal discipline at the state level, the Twelfth Finance Commission gave incentives to states through conditional debt restructuring and interest rate relief for introducing Fiscal Responsibility Legislations (FRLs). All the states have implemented their own FRLs.

Indian economy faced with the problem of large fiscal deficit and its monetization spilled over to external sector in the late 1980s and early 1990s. The large borrowings of the government led to such a precarious situation that government was unable to pay even for two weeks of imports resulting in economic crisis of 1991. Consequently, Economic reforms were introduced in 1991 and fiscal consolidation emerged as one of the key areas of reforms. After a good start in the early nineties, the fiscal consolidation faltered after 1997-98. The fiscal deficit started rising after 1997-98. The Government introduced FRBM Act, 2003 to check the deteriorating fiscal situation.

The implementation of FRBM Act/FRLs improved the fiscal performance of both centre and states.

The States have achieved the targets much ahead the prescribed timeline. Government of India was on the path of achieving this objective right in time. However, due to the global financial crisis, this was suspended and the fiscal consolidation as mandated in the FRBM Act was put on hold in 2007- 08.The crisis period called for increase in expenditure by the government to boost demand in the economy. As a result of fiscal stimulus, the government has moved away from the path of fiscal consolidation. However, it should be noted that strict adherence to the path of fiscal consolidation during pre crisis period created enough fiscal space for pursuing counter cyclical fiscal policy.the main provisions of the Act are:

  1. The government has to take appropriate measures to reduce the fiscal deficit and revenue deficit so as to eliminate revenue deficit by 2008-09 and thereafter, sizable revenue surplus has to be created.
  2. Setting annual targets for reduction of fiscal deficit and revenue deficit, contingent liabilities and total liabilities.
  3. The government shall end its borrowing from the RBI except for temporary advances.
  4. The RBI not to subscribe to the primary issues of the central government securities after 2006.
  5. The revenue deficit and fiscal deficit may exceed the targets specified in the rules only on grounds of national security, calamity etc.

Though the Act aims to achieve deficit reductions prima facie, an important objective is to achieve inter-generational equity in fiscal management. This is because when there are high borrowings today, it should be repaid by the future generation. But the benefit from high expenditure and debt today goes to the present generation. Achieving FRBM targets thus ensures inter-generation equity by reducing the debt burden of the future generation. Other objectives include: long run macroeconomic stability, better coordination between fiscal and monetary policy, and transparency in fiscal operation of the Government.

The Act had said that the fiscal deficit should be brought down to 3% of the gross domestic product (GDP) and revenue deficit should drop down to nil, both by March 2009. Fiscal deficit is the excess of government’s total expenditure over its total income. The government incurs revenue and capital expenses and receives income on the revenue and capital account. Further, the excess of revenue expenses over revenue income leads to a revenue deficit. The FRBM Act wants the revenue deficit to be nil as the revenue expenditure is day-to-day expenses and does not create a capital asset. Usually, the liabilities should not be carried forward, else the government ends up borrowing to repay its current liabilities.

However, these targets were not achieved because the global credit crisis hit the markets in 2008. The government had to roll out a fiscal stimulus to revive the economy and this increased the deficits.

In the 2011 budget, the finance minister said that the FRBM Act would be modified and new targets would be fixed and flexibility will be built in to have a cushion for unforeseen circumstances. According to the 13th Finance Commission, fiscal deficit will be brought down to 3.5% in 2013-14. Likewise, revenue deficit is expected to be cut to 2.1% in 2013-14.

In the 2012 Budget speech, the finance minister announced an amendment to the FRBM Act. He also announced that instead of the FRBM targeting the revenue deficit, the government will now target the effective revenue deficit. His budget speech defines effective revenue deficit as the difference between revenue deficit and grants for creation of capital assets. In other words, capital expenditure will now be removed from the revenue deficit and whatever remains (effective revenue deficit) will now be the new goalpost of the fiscal consolidation. Here’s what effective revenue deficit means.

Every year the government incurs expenditure and simultaneously earns income. Some expenses are planned (that it includes in its five-year plans) and other are non-planned. However, both planned and non-planned expenditure consists of capital and revenue expenditure. For instance, if the government sets up a power plant as part of its non-planned expenditure, then costs incurred towards maintaining it will now not be called revenue deficit because it is towards maintaining a “capital asset”. Experts say that revenue deficit could become a little distorted because by reclassifying revenue deficit, it is simplifying its target.


access to reserve funds. A fiscally irresponsible government isn’t able to sustain programs designed to provide fast relief to its citizens.