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Focus: GS-III Indian Economy

What is the trilemma?

The sovereign (government) and the regulator (RBI) face a trilemma: It is clear that it is not possible to:

  1. have dominance of government banks (public sector banks) in the banking sector;
  2. retain independent regulation; and
  3. adhere to public debt-gross domestic product (GDP) targets.

The government along with RBI cannot hope to achieve all three points at the same time.

Let’s say the government wants the public sector banks (PSBs) to dominate the banking system and at the same time ensure that the public debt doesn’t go up.

What will happen in such a circumstance?

  • To dominate the banking system, PSBs will have to increase lending at a fast pace, which will lead to accumulation of bad loans.
  • Given that the recoveries of bad loans are minimal, the government, as the owner, will have to invest more money into the PSBs to keep them going.
  • If the government puts more money into the PSBs, its expenditure will go up.
  • It will have to borrow more money and the public debt to GDP ratio will substantially rise.

How can public debt to GDP ratio be saved from rising?

  • The central bank will have to dilute some regulations to help the PSBs in not recognizing bad loans.
  • In such a case, the government need not invest in the PSBs immediately.
  • However, the central bank will have to dilute banking regulations.

What is the issue with RBI diluting norms?

  • When RBI dilutes regulations, banks end up kicking the bad loans can down the road.
  • The government then has to recapitalize the banks in the years to come as the postponement leads to bigger problems.
  • In the process, it pushes the public debt to GDP ratio up, which is one situation that the government has been trying hard to avoid.

-Source: Livemint, Indian Express

December 2023