A macro, financial & regulatory cocktail

Future growth in output, incomes and employment will depend on how macro, financial and regulatory issues are handled now

Four months ago I had rung some alarm bells about macroeconomic developments and pressures (“Macro stability at risk”, Business Standard, July 12, 2018). While recognising the negative effects of elevated oil prices, international trade wars and the reversal in capital inflows to some emerging countries (including India), the article drew attention to some major medium-term weaknesses in India's macro-economy. In particular it cited “the deep and long-drawn crisis in India's public sector banks and the big deficit in foreign trade, caused, in large part, by the unfortunate stagnation in India’s merchandise exports…”. Both these factors continue to pressure India's macro stability today. So do persistent fiscal deficits, now running at a high 7 per cent of GDP (Centre and states combined) and the lasting impact of demonetisation on small-scale/informal sector output, employment and exports. In the last couple of months, two new adverse developments have compounded the challenges facing the nation's economic managers.

The first is the series of recent payments defaults by the large, systemically important and hydra-headed Infrastructure Leasing and Financial Services (IL&FS) Group (with nearly 350 Group companies). The defaults led to IL&FS’ AAA credit rating plummeting to junk status within weeks. With over Rs900 billion of debt owed to various external creditors (including banks and mutual funds), the shock to the financial sector is potentially large. An early consequence has been the spread of contagion risks to other non-bank financial companies (NBFCs), many of whom now find it difficult to raise funds to support their operations. As a result, credit from NBFCs (including housing finance companies), which had been growing at over 25 per cent annually in recent years (and amounting to about a quarter of banking system credit), has been reined back, thus stalling a good deal of economic activity. With many NBFCs using short-term borrowing to fund medium and long-term loans and with the market for rollovers tight, financial stress in the NBFC sector could be substantial.

The IL&FS fiasco has also spattered mud over the reputation and competence of its blue ribbon owners (including the Life Insurance Corporation and the State Bank of India), credit rating agencies, statutory auditors and concerned regulators, including even the Reserve Bank of India (RBI). That venerable institution allowed IL&FS Financial Services Ltd (I-FIN, for short), a systemically important NBFC, to carry on with over Rs50 billion of intra-group outstanding loans and investments in each of the three most recent financial years, that is, over 20 times permissible limits (according to RBI’s own guidelines) and at a time when I-FIN had massively negative capital adequacy. 

Illustration by Ajaya Kumar Mohanty

To contain the damage and salvage viable operations, the government stepped in on October 1 to sack the old IL&FS board and appoint a new board headed by veteran banker Uday Kotak. However, given IL&FS’ scale, enormous complexity, a long history of opaque functioning and its current sorry state, it remains an open question of how soon and how successfully the damage can be contained.

The second negative development has been the unseemly and dangerous, public battle between the government and the RBI. Some degree of tension between the sovereign and the central bank is quite common in many countries, including in our own history. It must also be recognised that there have been long periods of constructive cooperation between the government and RBI in carrying out major economic, banking and financial reforms and managing exogenous crises during India’s recent history. I would point to the years between 1991 and 2008 as an example. Four key ingredients of fruitful cooperation seem to have been: close and continuous interaction between the top teams in the ministry of finance (MoF) and the RBI; involvement with and support from the prime minister's office (PMO); a general framework of mutual respect between principal players despite the inevitable occasional disagreements; and a serious (though unspoken) governmental commitment to accord considerable functional autonomy to the RBI.

The present cacophony of discord between the government and RBI on major issues, aired in the media through background briefings, statements and speeches, is surely unprecedented in India. This unfortunate situation has not developed overnight. It seems to have been brewing for nearly two years, during which the healthy ingredients, noted above, appear to have been running low. Other complicating factors may have included: the continuing fragility of many public sector bank balance sheets; the new threats to lending by NBFCs; the exceptionally uncommunicative leadership at the RBI; rising pressures on the government’s fisc as expenditure implications of a pre-election budget (as well as past commitments) increase inexorably; clear signs of slow employment growth; a weakening external sector; and impending elections. In this context, the government wants to prime the pump by using a part of the RBI’s reserves and expand financial credit (especially to small and medium scale enterprises) through regulatory forbearance and other means. The RBI is, understandably, reluctant to agree given its mandate for financial stability.

If informal communications between MoF and RBI had been close and frequent, some sort of untidy, patchwork compromise might have been worked out. And that is still the best outcome for the economy and the country. However, after the several formal letters from MoF to RBI on a range of issues, apparently mentioning section 7 of the RBI Act, the acrimonious and inconclusive RBI Board meeting of October 23 and the extraordinarily outspoken lecture by RBI deputy governor Viral Acharya (no relation!) warning against government interference with RBI’s autonomy on October 26, it is difficult to be sanguine about an amicable outcome. More fireworks are possible at the next RBI Board meeting scheduled for November 19. At this point, other possible outcomes include: resignation by the RBI Governor (or his replacement at government initiative), an RBI Board resolution tilted in favour of the government’s demands; or formal instructions from the government invoking Section 7, which a reluctant RBI would have to implement. It is an unhappy state of affairs, especially in the present context of global volatility and macro stress.

This somewhat toxic cocktail of macro, financial and regulatory issues pose serious challenges to our nation’s economic and political managers in the febrile pre-election months ahead. On their handling will depend the prospects for India's growth in output, incomes and employment in the years ahead.

The writer is Honorary Professor at ICRIER and former Chief Economic Advisor to the Government of India. Views expressed are personal.