Section 7 of the Reserve Bank of India Act, 1934 reads:
“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.”
The section is in the law, but the section has never been invoked. The power of the section lies in its non-use. What Parliament has told the government can be imagined as follows:
Scope of Section 7
You are the government, but remember there is also the Reserve Bank (RBI).
We will give you the power to issue directions but…… (pause), you are obliged to consult the Governor. Note, you must consult the Governor, not the Bank or the Board of Directors of the Bank.
We presume that you and the Governor consult each other regularly, but remember this is a statutory consultation after your normal consultations did not result in an agreement. And when you hold the statutory consultation, please bear in mind that, under the RBI Act, it is the duty of the RBI to ‘regulate the issue of bank notes and the keeping of reserves with a view to securing monetary stability’.
At the end of the statutory consultation, you and the Governor may not agree. What will you then do? Having made your point, will you leave it there and hope that, as events unfold, the Governor will change his mind? Or will you press the nuclear button and brace yourself for the inevitable fallout — the resignation of the Governor?
Hostile to RBI
The above is, of course, an imaginary conversation, but that is the spirit of the law. Recent events have made it obvious that the government did not re-play the imaginary conversation in its mind when it sat down to hold regular consultations with the Governor. The result is the unprecedented stand-off between the government and the RBI.
Let’s recall the sequence of events.
Dr Raghuram Rajan was slighted, yet he was willing to continue beyond his initial term that ended in September 2016. He was accused of not being ‘Indian enough’ and virtually forced to go. Dr Urjit Patel was brought in but, within weeks, his authority was diminished by the monumental blunder called demonetisation. In global central bank circles, Dr Patel’s reputation was damaged. Dr Patel tried to repair the damage by asserting his independence and authority. The government’s initial concern was only about interest rates but, on that issue, Dr Patel was on a strong wicket — he had the support of the Monetary Policy Committee.
Soon, the government realised that interest rate was not the only ‘hurdle to growth’; other fault lines had emerged.
Take the case of the construction sector. Demonetisation had dealt a severe blow to the construction sector. Yet stock prices of real estate firms more than doubled! Since January 2018, however, stock prices of those firms have declined by 40% (and by 21% in the last six weeks). This is not surprising, if you consider that real estate firms turned to NBFCs to repay their bank loans; NBFCs raised money by issuing commercial paper; and the paper was bought mainly by mutual funds and other fund-based investors. This circuit was hit by the collapse of IL&FS. Today, NBFCs are unable to raise fresh funds, sectors that depended on NBFCs for funds are squeezed, and small and medium firms that traditionally got credit from NBFCs are left in the lurch. There is fear and anger in the market.
The Fault Lines
The government is desperate to tackle three fault lines. The first is liquidity, especially the liquidity situation of NBFCs and their imminent redemption obligations. The second is the erosion of capital of public sector banks, insufficient capital and inability to lend that has put many of them under the RBI’s Prompt Corrective Action. The third is the opening of a ‘special window’ to provide credit to small and medium industries which were devastated by demonetisation and a flawed GST, and now hit by the NBFC crisis. It appears that the government has failed to persuade the RBI to heed its wishes. Attempts to pressure the Governor through the government’s new nominees on the RBI Board also seem to have failed.
Compounding the government’s misery is the growing gap between budgeted revenues and actual receipts. Having failed to ‘gain’ even a rupee out of demonetisation (the boast was `400,000 crore), the government has cast its eye on the reserves of the RBI. It is believed that the government asked the Governor to transfer Rs 100,000 crore in order to finance the budgeted expenditure and to meet the targeted fiscal deficit. It is believed that the Governor flatly refused. This is the spark that is about to light the powder keg.
On Wednesday, October 31, the talk of the town in both Delhi and Mumbai was that the government will issue a directive under Section 7 on one or more issues and the Governor will immediately resign in protest. Unsolicited, the government issued a statement on Wednesday that it respected the autonomy of the RBI and was holding normal consultations. If things were normal, the statement was unnecessary; if things were not normal, the statement was disingenuous!
As I conclude this essay on Friday, there is a spark and there is a powder keg. Will one be moved towards the other?