Fiscal Dominance through Banking System: A Case Study of the Relationship between the Government and Banking system in Iran’s Economy

Abstract

Iran's economy still has a two-digit inflation rate with high fluctuations. Fiscal dominance is the main reason for the increase in monetary base and inflation. Based on conventional literature, the most important mechanism of fiscal dominance is borrowing from the central bank. After the prohibition of direct borrowing from the central bank by Iran's government, addressing budget deficits is partially done through off-budgeting operations that are achieved through the banking system. In addition to introducing the Off-budgeting mechanism of fiscal dominance through banking system, this study tries to answer the question of whether fiscal dominance in Iran is a result of the government’s borrowing from the banks and consequently, its indirect borrowing from the central bank. This paper, by using bank ledgers data from March 2007 to June 2018, shows that an increase in the level of the government’s debt to the banks has a significant positive effect on the banks’ debt to the central bank; this effect intensifies in specialized banks and privatized banks respectively. This is robust when the banks’ balance sheet status, banking health status, and macroeconomic status have controlled.