Central bank independence and fiscal deficit in India: non-linear evidence from a logistic smooth transition regression (LSTR)

Abstract

Purpose This paper aims to examine the impact of central bank independence (CBI), both de jure and de facto, on the fiscal deficit (FD) in the case of India from 1980–1981 to 2018–2019. With the level of financial development proxied by the ratio of private credit to government as a possible source of nonlinearity, this study explores the possibility of a non-linear association between the CBI and FD. Design/methodology/approach This study estimated a logistic smooth transit regression (LSTR) to uncover the possible nonlinearity. To quantify the de jure and de facto independence of the Central Bank of India, i.e. RBI, this study follows Jasmine et al. (2019) and Cukierman et al. (1992). Findings The results reported regime dependence of the effect of CBI on FD. In both the short and long run, FD and CBI are found to be positively related during a low financial development regime, and when the economy is in a high financial development regime, FD and CBI are found to be negatively related. Moreover, an increase in GDP growth rate is found to trim the FD, whereas an increase in trade openness, oil prices, and the central bank governor (TOR) turnover rate increases it. Practical implications The findings of this study highlight the significance of the level of financial development that enables the independent central bank to ensure discipline on the part of fiscal authorities and improve fiscal balances. Moreover, robust GDP growth, more de facto independence of the central bank, and less oil price inflation would be favourable to ensure improvements in fiscal balance. The results imply the significance of the level of financial development in making central bank independence a potent tool to ensure fiscal prudence. Originality/value To the best of authors’ knowledge, no study has been conducted to understand the non-linear impact of the independence of the Reserve Bank of India on the fiscal deficit in the case of the Indian economy, subject to the level of financial development. The non-linear results provide important input to policymakers regarding the relevance of the level of financial development to the effectiveness of central bank independence and fiscal prudence on the part of the government.