The conflict between the Reserve Bank of India and the Union government seems to have reached a critical point, with media reports on Wednesday suggesting that the Centre could invoke its directive powers under the never-before-used Section 7 of the Reserve Bank of India Act.

In a press release issued on Wednesday afternoon, the government passively acknowledged these reports but took an aggressive stand against criticism that it was trying to browbeat the RBI, India’s monetary regulator, into toeing its line on a gamut of matters. These include reclassification of non-performing assets in the beleaguered power sector, transfer of dividends from RBI reserves to the government, and relaxation of prompt corrective action norms that involve the RBI’s structured and discretionary actions in respect of banks hitting certain financial trigger points, in terms of capital to risk weighted assets ratio, return on assets and non-performing assets.

The move has created a storm, and has raised concerns once again about the Narendra Modi government’s consistent efforts to undermine the independence of many of India’s institutions.

However, the central question that emerges from the Centre vs RBI battle is whether the law provides the government with overriding powers on important policy decisions that fall in the jurisdiction of the monetary regulator. If yes, what are the options before the RBI if the government wants its approval on decisions it does not concur with?

RBI’s independence

Going strictly by the text of the law, the RBI’s independence is more a matter of convention than legal certainty.

Following the liberalisation of India’s economy in the early 1990s, the Centre was forced to implement several reforms that opened up the economy. These were primarily measures to harmonise the system with the mandates of international regulatory organisations such as the International Monetary Fund and the World Bank.

One of the major reforms was according independence to the RBI. Institutions such as the International Monetary Fund insist on an independent monetary regulator to ensure consistency of decisions and freedom from political turmoil.

Section 7 of the Reserve Bank of India Act is one of the provisions in India that has bothered institutions like the International Monetary Fund. Sub-section 1 of the provision reads:

“(1) The Central Government may from time to time give such directions to the Bank as it may, after consultation with the Governor of the Bank, consider necessary in the public interest.” 

A plain reading of the law makes it clear that the provision envisages a “direction” from the Centre to the RBI. In other words, this means orders that the RBI shall implement.

The provision is qualitatively different from Constitutional provisions that call for consultations for certain decisions, which the judiciary has interpreted as “concurrence” and not just “consultation” with overriding powers for the State. For instance, Article 124 of the Constitution calls for the President to consult with the Chief Justice of India – which now means the Supreme Court collegium – in appointing judges to the top court.

Though considered a body with considerable institutional independence, the RBI is not a constitutional body. It was established under the Reserve Bank of India Act, 1934.

Crucially, Section 7 has never been invoked before. This means that the question of whether the concurrence of the RBI governor is necessary for implementing government directions made under Section 7 is yet to be tested authoritatively.

Why is this a problem? The logic used to interpret Article 124 of the Constitution could apply to Section 7 of the RBI Act as well. The Supreme Court, in the Three Judges Cases that developed the collegium system, signaled that for maintaining judicial independence, the process of appointing judges cannot just be that of consultation after which the government makes the final decision. In order to establish the independence of the court, the decision should categorically lie with the independent institution, which is the judiciary.

However, to reiterate, the independence of the RBI is not constitutional. At the most, it is only statutory, a major difference in law.

Resisting directions

Section 7 of the RBI Act was analysed in the Allahabad High Court in an order issued on August 27. The power sector has been in the doldrums for a while, resulting in a ballooning non-performing assets problem for lenders. In February, the RBI brought in new norms for the early identification of stressed assets. The banks were supposed to classify them as “special mention accounts”, with different levels indicating the duration for which the principal or interest amount has been overdue. For example, a 0 category special mention account would mean accounts whose repayment is overdue by one to 30 days. This reporting is compulsory for all borrowers with aggregate exposure of Rs 50 million or above. Banks were also required to put in place resolution plans for stressed assets.

Power producers felt that these rules were too stringent and wanted them to be relaxed. When the matter went to the Allahabad High Court, it invariably involved a discussion of Section 7. The court, while asking the Centre to explore the possibility of using this clause, nevertheless said the following on the provision:

“It is true that sub-section (1) of Section 7 of the RBI Act empowers the Central Government to issue directions from time to time to the RBI as it may, after consultation with the Governor, consider necessary in the public interest. The Central Government, however, is not expected to issue any directions, as contemplated under Section 7(1), indiscriminately or randomly. Such directions are possible when there exists sufficient material in support.”

Former RBI officials spoke to said litigation before the higher courts would be unavoidable if the Centre decided to issue the RBI directions under Section 7 of the RBI Act. “The moment you use this provision, the RBI governor becomes irrelevant,” said one former official, requesting anonymity.

In the past, even the most difficult differences between the Centre and the RBI have been resolved through discussions. One prominent instance is that of the 2008 global financial crisis, when the RBI refused to decrease interest rates, which the Congress-led United Progressive Alliance government desperately wanted in order to boost consumption. “This [discussions] is the best way because a weak regulator will be read as a weak system internationally,” said the former official.

On Wednesday, following reports of a rift between the Centre and the RBI and rumours of the likely resignation of RBI governor Urjit Patel, the rupee closed at 73.95 against the dollar, the lowest in three weeks.

The question of reputation was also the crux of a speech by RBI deputy governor Viral Acharya on October 26. He said the reserves of the RBI should be used as instruments for financial stability and not for political compulsions ahead of elections. “Governments that do not respect central bank independence will ignite economic fire and come to rue the day,” he said during a lecture in Mumbai.

Some have suggested that RBI governor Patel should resign if the Centre forces a decision on him. Acharya himself pointed to this by comparing the developments in Argentina in 2010, when the government tried to force decisions on the central bank. This led to the resignation of the bank’s top executive and turmoil in the financial markets.

But a better strategy to protect the image of the RBI would be to fight it out legally, despite the danger of short-term systemic disruptions this may entail.