The current phase of disagreements between the government and the central bank began in the backdrop of the debate on RBI’s power to constitute members of the Monetary Policy Committee (MPC).
By Kalvakuntla Kavitha
The tumultuous relations between the governments and the central banks are nothing new. From the tussle between the Bank of Canada and the Coyne Affair and a similar disagreement between the US Federal Reserve and the Treasury after the Second World War in the 1950s, to the Hungarian and the Polish governments submitting proposals in their respective parliaments to reduce the autonomy of central banks in the 2000s – the conflict between governments and central banks have been a perpetual feature of the global economic history. In India however, the issue has come to a head and has revealed a serious deadlock in policymaking as the Reserve Bank of India and the government are stuck in an open and protracted internecine contestation.
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The conflict pertaining to the question as to “who controls the monetary policy” constitutes a long-standing fault line in India. The fourth RBI Governor Benegal Rama Rau had exited abruptly when the then finance minister T. T. Krishnamachari encroached into RBI turf by levying some taxes. K.R. Puri, the RBI chief appointed by Indira Gandhi had to quit on policy disagreements with the Janata Party government in 1977 and R.N. Malhotra had to leave in 1990 after Chandrashekhar became the PM. Similarly, the 22nd Governor D Subbarao had a public spat with the then Finance Minister P. Chidambram over regulation of interest rates and indeed Raghuram Rajan and Urujit Patel are no outliers when it comes to the contrasting modus operandi of the RBI and the government.
However, the different this time is an unprecedented action of the government sending a direction to the RBI under the Section 7 of the RBI Act which will allow it to issue directions and virtually dictate actions to the Central Bank Governor on issues related to liquidity of Non-Banking Financial Companies (NBFCs), recapitalisation of weak banks, and lending to small and medium enterprises. That this section has been invoked by the government, is testimony to the extraordinary degree of discord and divergent views on policy between the government and RBI. At stake is the Indian lending industry worth ₹100 lakh crore and the nation’s economic future.
Anatomy of the RBI-Government Conflict
In India the conflict between the government and the central bank revolves around three axes – (1) Who controls the monetary policy (primarily interest rates); (2) the issue of regulation of the non-performing assets – extension of the first axis of conflict; and (3) who controls the boards and the appointments of people who will formulate monetary policy. Out of these the first two issues are primary domains of conflict which spill into the third domain of appointments and other power struggles.
The current phase of disagreements between the government and the central bank began in the backdrop of the debate on RBI’s power to constitute members of the Monetary Policy Committee (MPC). While this debate was settled somewhat amicably in 2014 resulting in an equal representation of RBI officials and government nominees, it was an indicator of an impending storm. The spat between the two came out in the open with the government’s decision to go ahead with demonetisation, even when an astute Raghuram Rajan pointed out that currency replacement came within the exclusive ambit of the RBI. Unfortunately, the government prevailed, causing severe damage to the informal sector, farming sector and small businesses. The snowballing pressure on the RBI coupled with the government’s intransigence led to the eventual resignation of Raghuram Rajan, but the cycle of government’s encroachment on the mandate of the central bank as well as the deterioration of India’s economic condition continued.
The row between the apex bank and the RBI has now reached an inflection point and has escalated as the government began to blame the RBI on NPAs in the backdrop of the Nirav Modi scam. Finance Minister Arun Jaitley jibed that “Regulators ultimately decide the rules of the game and they have to have a third eye which should be perpetually open. Unfortunately, in the Indian system, we politicians are accountable but regulators are not.” On the other hand, according to the RBI, the government has not been able to buckle the NPAs in the public sector banks and RBI has only minimal regulatory power on the same. While before 2009, it were the private banks which ran the largest accounts of NPAs, the RBI was able to ring-fence them and put them back in shape. Now the tables have turned and of the ₹10.25 trillion NPAs in India, public sector banks (PSBs) account for nearly ₹8.97 trillion i.e. 87% of the total NPAs. The onus of regulation lies now with the government. Even under such a condition, the government has been reckless enough to argue for usurping of RBI’s forex reserves to recapitalize the PSBs which could throw the currency and the economic stability of the nation into perils. What seems to be happening is an attempt at arm-twisting the RBI by the government to attain the promised fiscal deficit target of 3.3% which it has failed to deliver faced with a dip in GST collection.
What about the Economy?
Nearing the elections, it is natural that the government wants to infuse liquidity into the economy. The RBI’s Prompt and Corrective Action norms (PCA norms) on the other hand guided by the internationally accepted Basel standards, has put lending restrictions on 11 banks to force them to salvage sticky loans rather than giving out new risky loans and this has hamstrung the government’s ability to extend capital to the people. As David Mayes has rightly pointed out, seekers of bank loans are also voters and any restriction in extending liquidity to them could severely impact the vote bank.
However, the larger questions for the economy that arise are follows – whether it is wiser to inject liquidity into the economy or to be cautious and salvage the NPAs first? And whether it is prudent to let the central bank to remain independent in its policymaking or should the government which is eventually answerable to the people call the shots on monetary policy? Economic history favors RBI’s side of the argument. In the United States in the year 1972, President Richard Nixon had famously pressured Chairman Arthur Burns to refrain from reducing market liquidity in advance of Nixon’s 1972 re-election campaign by keeping rates low even though inflation was a growing threat. As a result, the US economy entered a period of extended stagflation soaring into double-digits and it took years of high interest rates and unemployment to tame it. It was a lesson learnt in favor of maintaining the autonomy of central banks.
As far as injecting liquidity in the economy is concerned however, the scenarios are more contextual and complicated than what meets the eye. As Dr. Kaushik Basu has stated “the management of inflation cannot be reduced to a mechanical engineering problem where the formula connecting what is to be done by the government or the RBI and what will be achieved is written in stone”. In India for example, empirical studies have shown that 82% of the NPAs come from big corporates with MSMEs making up only 9.6% of the NPAs and farmers making up just 1% of the same. While, MSME’s that contribute to 32% of the Gross Value Added and 42% of the total population involved in agriculture, a blanked freeze on liquidity would not only be unfair, given the data, but could also stymie overall economic growth. Indeed, a logical way out of the deadlock would be to tighten the grip on NPAs in the public sector banks and restrict unchecked lending to big businesses, while at the same time stimulating the economy by making credit more accessible for farmers and small businesses which are less likely to default as compared to big corporates. This would not only stimulate economic growth but will also put the burden of accountability where it belongs.
A Shortcoming of Policy Design
In a seminal study published by the International Monetary Fund, Pierre L. Silkos (2002) has described that the conflict between the central banks and the government are a recurring pattern wherein fiscal policy takes primacy over monetary policy and vice-versa. Nevertheless, according to Silkos, the conflict is inevitable, yet most of it can be resolved through better “legislative design”. He recommends that statutes should be designed in a manner that recognize the possibility of a conflict on monetary policy between the government and the central bank. Having done this, the statutes must ensure accountability on part of the government and greater disclosure on part of the central bank. Moreover, the governments need to appreciate that central banks are required to be essentially forward looking while the central banks need to understand that the ultimate responsibility of the state of the economy lie with the government. Hence, the quality of the communication between the central bank, the government, and the public at large is imperative for the success of monetary policy. Unfortunately, the domain of effective cross stakeholder communications in monetary policy is an area that has only received scant attention and has been researched by only a few scholars (such as Pierre Silkos and Alan Blinder).
In the absence of such systems and the shortcomings of the existing statutes what happens is that the disagreement on monetary policy becomes brute power politics. The issue of the constitution of the Payments Regulatory Board (PRB) is only a case in point. Currently, the payment systems which include things like Mobile Banking systems, NEFT transfers, credit cards and even ATMs (among other payment systems) in the country are overseen by the Board for Regulation and Supervision of Payment and Settlement Systems (BPSS) – a sub-committee of the Central Board of the Reserve Bank of India. With a PRB in place headed by a government appointee, there will be a severe dent on the autonomy as well as the capacity of the RBI in operationalizing important aspects of its monetary policy related to payments systems and settlements. Indeed, the dissent note issued by the apex bank has unequivocally stated that there is no need to fix a system which isn’t broken.
What is to be done?
In India, today more than any other time in the past there is a need for policymakers to focus on the national interest and look beyond the noise. Maintaining a steady rate of economic growth which ensures equity, making good on the promises of reducing fiscal deficit targets, and putting systems in place that establish clear expectations from the government and the RBI while also making provisions for conflict management between the two is the need of the hour. We need the rights coordination and institutional strength to improve our fiscal deficit. We are a growing economy. We cannot fall prey to the dissonance of hollow promises and disruptions of institutional erosions. We need to ensure access to capital to those who need it the most – the small businesses and the farming sector. Most importantly, we need to respect our institutions and help rather than hinder their objectives.