India’s government and the central bank have had disagreements, but the relationship has never looked so irretrievably broken as it does now.
Before the global financial crisis, the finance ministry saw the Reserve Bank of India as an incompetent regulator, one that managed the state-dominated banking industry by keeping it puny and primitive.
In that view, Indian lenders didn’t know how to model risks, and a conservative central bank wasn’t letting them use credit derivatives to manage them. Pressure from Finance Minister P Chidambaram to open up the banking industry to foreign competition almost led to the resignation of then RBI Governor YV Reddy. The spat, which never became public, was soon overshadowed by the 2008 meltdown, when the central bank won global praise for its mistrust of high finance.
That reputation was in tatters by the time of the 2013 taper tantrum, when India was hit by massive capital outflows. Appointing the former International Monetary Fund Chief Economist Raghuram Rajan as governor helped stabilise asset prices and mend the central bank’s reputation. But a change of government in 2014, followed by an acceptance of Rajan’s old recommendation to narrow the RBI’s policy remit to the single-minded pursuit of an inflation target, revived the campaign to chip away at the institution’s authority in other matters.
Rajan strongly opposed the idea of handing supervision of the government securities market to the stock-market regulator. He also resisted subjecting the central bank’s regulatory decisions to an appellate authority. Had he failed to do so, his successor Urjit Patel’s bank cleanup drive – which has included lending restrictions on 11 state-run lenders and the ouster of CEOs at a couple of non-state banks – would have been bogged down in an appeals process.
Building pressure
Not that Patel got a free pass. When stranded power companies challenged the central bank’s February order that banks take defaulted firms to the bankruptcy tribunal, a court asked the government to consider using Section 7 of the RBI Act to start a dialogue with the monetary authority. That article, which has never been triggered, says the government may (in the public interest) give directions to the central bank after consulting with it.
Emboldened by the court order, government officials began writing letters seeking Patel’s views on everything from nonperforming power-sector assets to lending restrictions on state-run banks and a liquidity squeeze following the bankruptcy of a systemically important infrastructure lender. They didn’t invoke Section 7, but to build pressure on the governor, they cited it anyway.
This overreach has led to a delicate moment in the institution’s 83-year history. In a speech about what happens when politicians toy with central-bank independence, RBI Deputy Governor Viral Acharya brought up Argentina in 2010. That annoyed the finance ministry. Just as in the Latin American example, New Delhi is bullying the central bank to transfer some of its resources to the government.
One way to recapitalise banks would be to prune the RBI’s balance sheet by $60 billion, and use the capital freed up in process, the government’s chief economic adviser suggested in early 2017. I wrote at the time that this wouldn’t sit well with investors: There were serious questions about the RBI’s independence following an ill-conceived demonetisation adventure just a few months earlier.
What I didn’t realise then was that the bigger consequence of demonetisation was to make voodoo economics chic. Although outlawing of 86% of India’s currency failed to yield a fiscal bonanza, media reports suggest the government still believes the central bank has $50 billion in excess capital.
Fourteen years ago, when New Delhi wanted to take $5 billion a year for three years from the RBI’s foreign-exchange reserves for infrastructure, there was a lively debate, but nobody demanded the ouster of the central bank’s boss. It seems that policy-making in India, as elsewhere, has caught the Silicon Valley bug of moving fast and breaking things. There’s now open speculation that Patel may resign at an RBI board meeting Nov. 19.
The curmudgeonly RBI needs to do more to protect consumers and foster competition. But its reputation for honesty is a major asset in a country rife with corruption. And if $200 billion in bad loans keeps old doubts about the central bank’s competence alive, now at least it has the tools – such as a modern bankruptcy law – to act boldly. Why atrophy those newly acquired muscles? If inflation targeting succeeds in anchoring price expectations, the economy could operate with a permanently lower cost of capital.
For the avowedly pro-business government of Prime Minister Narendra Modi to lose sight of the benefits of such a shift (including a freer capital account) and lunge for the trite socialism of a state-directed credit binge is regressive.
Undermining the RBI in the name of the public interest, just when the institution finally has some capacity to serve the public, would be a real shame.
This article first appeared on Bloomberg.
