RBI vs politics

Govt seeks to put re-election above RBI independence, another instance of its failure to manage India's economy properly

Few subjects are as capable of roiling the markets right now as the fate of the spat between the Reserve Bank of India and the Union government. That relations have deteriorated to a new low is unquestionable. The speech last month by Deputy Governor Viral Acharya in which he outlined the reasons, both theoretical and practical, for central bank independence was a clear salvo fired at New Delhi from Mint Street. And it is clear, given that he thanked his colleagues including Governor Urjit Patel, that the RBI’s top brass is united in defending the institution’s independence.

This is something of a turnaround from the RBI’s reputation shortly after the ill-fated demonetisation exercise, which began two years ago. It is now clear that Prime Minister Narendra Modi’s firman to withdraw 86 per cent of India’s currency from circulation was one of the poorest decisions in Indian economic history. Few lasting benefits accrued from the decision. Digitalisation and the growth of the tax rolls were occurring anyway, and there are far better ways to speed up that process. Meanwhile, all the other stated reasons — the destruction of black money, the foiling of counterfeiters, the drying up of terrorist funding and so on — were not met either. And the costs were huge; a putative recovery was killed before it could begin. Millions of jobs were lost in an economy that is already struggling to employ its young people. And small and medium enterprises should not have been given this severe injury just before the high costs they would have to undergo in order to transition to the goods and services tax, or GST. 

Illustration: Ajay Mohanty

But the RBI was another casualty. Demonetisation was the most impactful of decisions taken about the money supply in recent memory, and few could claim the RBI had any say in it. Meanwhile, the months and months it took to “count” the returned banknotes led to the central bank and its governors being tried and condemned in the court of public opinion. Worse, they began to be seen as stooges of the central government. 

That reputation has now been, thankfully, recovered. But under very unfortunate circumstances, for which the Union government is entirely to blame. Nobody wants Mr Patel to resign: The message it sends out would be awful. It would be clear to investors worldwide that the independence of India’s central bank — a pillar of its stability, and one crucial aspect of its appeal to markets — had been undermined. India cannot afford to start a war on another economic front. Thus, a governor’s resignation would be awful, an open declaration that another front has been opened; and yet Mr Patel will have no option but to resign if Section 7 of the RBI Act is openly invoked and New Delhi imposes its will on the central bank. 

What are the issues on which the government wishes to pressure the central bank? What is of note is how closely they are linked to the ruling party’s electoral agenda, and how transparent its motives are. 

Consider the question of loans to the power sector. The RBI issued a circular earlier this year that loans in which an instalment is overdue by even a day must be treated as delinquent by banks. This is part of the long overdue effort to clean up bank balance sheets. The government is worried, however, that it will impact the power sector disproportionately; Rs 300 billion of bank loans to the sector might turn delinquent unless the Supreme Court steps in this week. The government wants somebody to pay for these plants to open — if necessary, consumers, through an increase in tariffs over and above what was earlier decided. But the political issue is that stress in the power sector must be ended soon from the government’s point of view — dragging plants through the insolvency process is not in their interest. The government came to power promising 24x7 power; it is running out of time to show that it has met that promise.

Then there’s the issue over the prompt corrective action (PCA) restrictions imposed on several public sector banks with particularly weak balance sheets. From the government’s point of view, this has restricted the growth of credit. They are particularly concerned that loans to micro, small and medium enterprises — which they see as the engine of job growth — may suffer. This has become particularly urgent after the crunch in non-banking finance companies (NBFCs) brought on by the Infrastructure Leasing & Financial Services defaults. The fallout of the IL&FS crisis is spreading across the shadow banking sector. The government recognises that if NBFCs stop lending, job growth will suffer further; and it wants public sector banks to be able to pick up the slack and if necessary step in on some NBFC debt. This is not going to be possible if the RBI persists with its hard line on bank balance sheets. In other words, the political imperative of job growth is directly opposed to the bank clean-up agenda. 

Finally, the government needs money. Its failure to get growth going, thanks to its timidity on reform, means that government spending has been the only real engine of growth for much of Mr Modi’s term as prime minister. That money is now running out, given the increase in oil prices and the path of fiscal consolidation. Thus, the government has been eyeing the RBI’s reserves as a possible source of election spending. After all, demonetisation did not serve up the trillions of rupees that government-friendly economists had claimed it would. Nor has the watered-down GST the government implemented super-charged revenue. The clash here: Between the RBI’s right to determine the model by which it decides how large its reserves should be, and the government’s burning need for cash to spend pre-election.

Much of this government’s economics has been a failure. It failed to take advantage of low oil prices; it failed to fix the power sector through sustainable tariffs; it failed to revive manufacturing and thus job growth; it failed to push exports and thus stabilise the rupee. The only way the government seems able to address this litany of failures before the election is to push the RBI into a corner. But by doing so it will add yet another failure to the long list. It has already reversed the generation-long turn to trading openness that defined the Indian economy over the past 25 years. Will it now reverse the equally long trend towards genuine RBI independence? If so, this government will cement its reputation as providing the worst economic management India has had for decades. 

Email: m.s.sharma@gmail.com

Twitter: @mihirssharma