India’s interests will be best protected if the RBI stands its ground against government pressure

Central bankers are stereotyped as colourless people who indulge in boatloads of what Shashi Tharoor fans describe as circumlocution. The classic central banker quote is Alan Greenspan’s masterly, “I know you think you understand what you thought I said, but I’m not sure you realize that what you heard is not what I meant.”

RBI deputy governor Viral Acharya’s lecture on the “ongoing challenges in maintaining Independence of the RBI” broke that mould recently. The speech caused a furore because Acharya went public with a festering problem: that the RBI is at loggerheads with the Union government on multiple issues.

One casus belli is the proposal to set up a separate digital payments regulator. This, in itself, is an issue of increasing importance. The related areas of financial technology and digital payments are entirely new and growing quickly in transaction volume. While technologically driven, these are tied to banking. It is possible to make a case either way – for the RBI to continue laying down the law in this area, or to support the creation of a separate regulatory body. One issue is that of empire-building. Every bureaucracy sees continuous internecine battles for what is akin to “marketshare”, which are fought between different services, and within those services as well.

There are many other areas where the government would like to reduce the RBI’s regulatory powers. For instance, the RBI has set up stringent lending norms and hobbled 11 bankrupt banks under the prompt corrective action mechanism. This is a serious concern for the majority shareholder in all those banks – the Union government. If the mechanism is enforced, public sector banks under its purview cannot be used as channels for government largesse to be distributed to woo politically influential groups.

Another area of contention is that of lending to non-banking financial companies or NBFCs. The government is worried that credit to these companies may freeze in the aftermath of the IL&FS fiasco. Indeed, if that happens, it will affect lending further down the line to micro, small and medium enterprises or MSMEs since small/medium businesses tap non-banking financial companies for funds. Micro, small and medium enterprises are a major source of employment. If there is a lending freeze in that segment, voters will experience hardship that could, rightly or wrongly, be attributed to the government as state and general elections draw closer. On its part, the RBI does not think there is a systemic issue and it is not prepared to open the tap.

A fourth area of disagreement is that the RBI wants more control over public sector banks. It has the power to punish top management at private sector banks and has done so in the past. But it does not have the power to punish the management at public sector banks and yet these banks lend over 70% of all credit, and hold over 90% of all non-performing assets.

A fifth large area of disagreement is that the Union government wants the RBI to transfer a large chunk of its reserves as dividend to bridge the rising fiscal deficit. (We are speaking here of accumulated profits marked as “reserves” on the RBI’s balance sheet, not of foreign exchange reserves). The RBI is reluctant to increase dividends.

The RBI, like other central banks, holds contingency reserves to manage bank collapses. It transfers as dividend what it considers surplus to those needs. The central bank uses a methodology it calls Stressed Value at Risk or Stressed VAR to calculate what it may need to cope with bank crises. As of now, it holds about Rs 3.6 trillion as capital in reserves.

The government of India would like the RBI to change its mode of Value at Risk calculation to release a large chunk of that as dividend. Incidentally, the RBI’s stress tests have consistently underestimated the likely level of bank non-performing assets. It is perhaps a matter of luck that there has not been a full-blown bank collapse that has necessitated the use of those reserves.

The RBI transfers the surplus to the Centre every year as dividend. For its July 2016 to June 2017 fiscal year, it transferred Rs 30,600 crore as dividend. Economic Affairs Secretary Subhash Garg publicly asked the RBI for another Rs 13,000 crore. On March 27, 2018, it transferred Rs 10,000 crore to the government as interim dividend (this came from its July 2017 to June 2018 fiscal year). The RBI has said it will transfer Rs 50,000 crore in total for 2017-’18.

RBI vs Centre

The row between the RBI and Centre started with demonetisation, or rather, even earlier, with former governor Raghuram Rajan’s refusal to consider the scrapping of high-value Rs 1,000 and Rs 500 notes. The RBI’s current governor Urjit Patel went along with that lunacy. But it is said to have created tensions within the RBI itself since bankers did not like taking the rap for the suffering caused by a political decision. The RBI has since pursued Rajan’s policy of forcing banks to accelerate the clean-up of their balance sheets. Indeed, Patel has imposed tighter norms in the last 18 months.

The Right to Information mechanism makes it evident that while the Union government has paid lip service to sorting out the non-performing assets crisis, it has been reluctant to take concrete action against large defaulters. Rajan sent a note to the prime minister’s office in 2015, which listed large defaulters and that has evidently not been acted upon.

The government has also been trying to dilute the impact of the Insolvency and Bankruptcy Code on power sector defaulters. It has also tried to stuff the RBI board with party loyalists by inducting independent directors who are well-known RSS ideologues.

The Monetary Policy Committee has adopted an interest rate policy that may not be to the government’s liking and the optics of the RBI’s forex management has led to the government suffering flak as the rupee has fallen.

Run through that list of areas of disagreements and you realise why central banks have always been allowed a measure of independence, distanced from government control, and given regulatory authority over financial institutions.

If the RBI did everything on the government wish list, it would: 1) throw its reserves down the black hole of the fiscal deficit, leaving no funds to cope with possible future bank collapses. 2) It would forgive Rs 2 trillion worth of power sector loans, telling banks to forget about money chucked down another black hole. 3) It would allow further large sums to be lent out to non-banking financial companies, which may also go bankrupt. 4) It would continue to look the other way while public sector banks are run into the ground for political expediency. 5) It would blow up forex reserves on rescuing the rupee. 6) It would cut interest rates, potentially allowing inflation to rise.

The concept of central banks being allowed independence to set interest rates, regulate banks and take monetary policy decisions is pretty much a given globally. There is a lot of scholarly literature and historical data to indicate politicians should not be allowed a free hand to run monetary policy.

Typically, political control of monetary policy leads to extreme cyclical swings and bubbles, where hyperinflation and currency collapses are common. The politician always has an eye to re-election, or handouts of bread and the funding of circuses (or the erection of giant statues). Simply printing new notes is always a temptation, for example, for a semi-literate leader. This was common in Africa.

RBI’s independence

The RBI was launched in 1935 when India was part of the British Empire, and the Great Depression (1929-’37) was causing havoc across the world. One of its first tasks was to set the pound-rupee exchange rate. It had a set of pulls and pushes to deal with. Britain effectively milked India by forcing India to export cheap raw materials, which were processed in Britain and then re-exported with value-add. A weak rupee helped that trade strategy. But the RBI also had to prevent India from becoming a basket case, where it could not produce even the raw materials UK industry demanded.

The first RBI Governor, Sir Osborne Smith, an Australian who had been managing director of the Imperial Bank of India (now the State Bank of India), was constantly arguing about the exchange rate with the British administration, and with the Bank of England. He resigned in 1937, calling Governor-General Lord Linlithgow a “weak ass”.

Government insiders have talked about using Section 7 of the RBI Act to get the central bank to toe its line. But the government seems to have backed off slightly, perhaps for fear of triggering another run on the rupee if the RBI gets more intransigent or if Patel resigns, as he is rumoured to have threatened. But it is likely to try to continue the process of stuffing the RBI board with loyalists, and look for one to take over as the next governor.

Central banks need their independence precisely so that they cannot be browbeaten into toeing the politically expedient line. This does not mean that the RBI, or any other central bank, necessarily gets it right all the time. They make their share of blunders. But politicians with their own agenda are guaranteed to get it wrong more often than not.