Thursday 1 November 2018

What’s all this brouhaha between the RBI and the Government?


The current sparring between the RBI and the Government comes at a horrible time even as the Indian economy is facing headwinds from high NPAs, higher oil prices, weak banking sector, a weakening Rupee and crisis in shadow banking sector. 


While disagreements between Central bank and the Government are neither uncommon nor unique to India. Also, it is pertinent to note that several of the incumbent RBI Governor’s predecessors, like Raghuram Rajan, Duvvuri Subba Rao have had disagreements with the government on interest rates and other policy matters.                   


So, what is different this time and why is there so much brouhaha?


The Government and the RBI are not seeing eye to eye on many issues, some of the important ones are as under:
  • Proposal on setting up a new Payment and settlement systems regulator – RBI is opposed to the idea
  • Forbearance norms to be relaxed for Power sector and other SMEs to promote credit growth – RBI is focused on cleaning up the Bank’s Balance Sheet and improving financial stability
  • Interest rate policy – government is pressuring RBI to reduce interest rates on the bank of controlled inflation.  RBI does not agree with this view as outlook for inflation given the increase in oil prices is set to increase
  • Liquidity support to the NBFC sector – RBI is tightening liquidity norms for NBFCs and is not prepared to play the liquidity backstop role
  • Easing of reserve requirements – Government wants reserve norms to be relaxed while RBI doesn’t want to change
  • Higher dividends – Government is seeking a higher dividend from the RBI to ease fiscal pressure
  • RBI is seeking more powers to regulate public sector banks in particular it wants a say in the appointment of management and Board members of these banks. Government is not conceding and maintains it has sufficient powers to regulate them.
While debates and disagreements on such issues are to be expected and even healthy to reach a well-reasoned decision, the manner of public sparring has left everyone stunned. The Finance Minister publicly rebuked the RBI by laying the blame for high NPAs squarely on the doors of RBI citing poor regulatory supervision and easy lending norms.


    














Incidentally, Indian banking sector NPAs is one of the highest amongst large economies at 11.6%.






















As the Government faces reelection next year, it wants banks to extend loans at cheaper interest rates quickly to keep the economy firing as a way to secure its re-election campaign.  But the RBI is wary of already high levels of bad debts and weak rupee threatening to add to inflation, and hence has different priorities i.e. to ensure financial stability.

The stand-off between the government and the RBI started with some non-official directors reportedly pressing for relaxation in the prompt correction action framework for weak banks, increased flow of credit to micro, small and medium enterprise sectors, and a special liquidity window for non-banking finance companies at the RBI’s last board meeting.

Frustrated with the unbending approach of the RBI, the Modi government has apparently sought to invoke a little known Section 7 that undermines RBIs autonomy, and perhaps a provision reserved for extreme circumstances.  Hence, this little known provision has never been considered in the past and this is something that has never been used even during Emergency, the economic 1991 crisis, the 2008 Global Financial Crisis or the 2013 regional crisis!

What is Section 7 of the RBI Act?

Section 7 of the RBI Act, when invoked, allows the government to consult with and give instructions to the Governor of the RBI on certain issues that it believes are serious and are in public interest. The relevant section is reproduced below:

Section 7.            Management.
  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.
  2. Subject to any such directions, the general superintendence and direction of the affairs and business of the Bank shall be entrusted to a Central Board of Directors which may exercise all powers and do all acts and things which may be exercised or done by the Bank.
  3. Save as otherwise provided in regulations made by the Central Board, the Governor and in his absence the Deputy Governor nominated by him in this behalf, shall also have powers of general superintendence and direction of the affairs and the business of the Bank, and may exercise all powers and do all acts and things which may be exercised or done by the Bank.
The Government, it appears, has sent the central bank letters seeking to overrule the RBI in a bid to push through measures that would potentially support rapid credit growth.

The Central Bank, which is meant to function autonomously and independently, has alleged that the government has been trying to interfere in its functioning. Tensions between the RBI and the government went into public domain after Deputy Governor Viral Acharya said last week that undermining Central Bank independence could be "potentially catastrophic", indicating the authority is pushing back against government pressure to relax its policies and reduce its powers ahead of a general election due next year.

In a speech last week, Deputy Governor, Viral Acharya said, "Governments that do not respect central bank independence will sooner or later incur the wrath of financial markets, ignite economic fire, and come to rue the day they undermined an important regulatory institution.”

In the wake of the above developments, there were strong indications that the RBI Governor was considering resigning from the position, a move that would have dented the government’s image severely with catastrophic effect on the financial markets, at least in the short term.

In an effort to limit the damage, the government issued a statement saying it “respects and nurtures” central bank’s autonomy.

Markets punish economies if Central Bank independence is not respected

The situation in India is similar to the Central Bank spats in countries as varied as the US, Argentina, Turkey, and this is unlikely to go away soon.  Trump has been openly criticising the FED for raising interest rates and is blaming the FED for the recent stock market decline.  Recently, Turkey got severely punished for interfering with monetary policy of the Central Bank and its currency plunged by over 50% within a short period of time dealing a severe blow to the economy.

The government is playing with fire and is treading on dangerous ground that could severely dent the external perception of the RBIs autonomy which will damaging effect that will hurt FDI, borrowing costs and eventually economic growth.

Earlier this month, the government removed the chief of the Central Bureau of Investigation in a dramatic late night order. Such actions undermine the institutional framework and cause severe long-term damage to the economy.

What next?

RBI Governor has called a board meeting on November 19 to discuss the outstanding issues that created a rift in its previous meetings.

The Finance Ministry has said that both the government and the RBI “have to be guided by public interest and the requirements of the Indian economy. The government, through these consultations, places its assessment on issues and suggests possible solutions. The government will continue to do so,” the ministry, concluding statement said.

Having recently won 23 positions on ease of doing business, the government should not fritter it away by scoring a self-goal.  International investors seek to exercise their investment decisions and draw comfort from matters such as autonomy and the credibility of the Central Bank to steer the economy and maintain financial stability.  

Let’s hope that better sense prevails and the Government exercises discretion as this has far reaching consequences and could potentially derail the economy.

3 comments:

  1. Great Article on the current situation in India about RBI and Central Government. Your analysis is excellent Sridhar ji..!

    ReplyDelete