Opinion | The ball was always in the government’s court
Amid speculation that Reserve Bank of India (RBI) governor Urjit Patel might quit, the government did well on Wednesday to issue a statement, highlighting that the autonomy of the central bank is essential. This should help defuse tension, at least for now.
Uncertainty in the market went up with reports that the government had invoked Section 7 of the RBI Act. Thankfully, amid all the speculation, financial markets did not panic. Section 7 (1) of the RBI Act says that “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.” Though the law says that the government can give directions after consultation with the governor, invoking the provision will clearly be seen as curtailing the central bank’s operational autonomy. This is precisely why it has never been used.
Whether the ongoing rift is amicably settled or snowballs into a full-blown crisis will solely depend on how far the government intends to push the banking regulator. As this newspaper has reported, the government, in its letters to RBI, actually threatened to invoke Section 7(1). This is certainly not the best way to address any economic challenge.
The tension between the government and the banking regulator has been simmering for a while. Aside from interest rates, there are a number of issues on which the government and the central bank have a difference of opinion. For instance, the government blamed RBI for not doing enough to avert the Punjab National Bank (PNB) fraud and excessive lending by the banking system in the aftermath of the financial crisis. To be fair, RBI should share the responsibility, but it was not the only one responsible. The PNB fraud was a result of a complete breakdown of oversight and governance in the bank. RBI has asked for more powers to regulate public sector banks (PSBs). Excessive lending by the banking system was partly a result of poor judgment of growth prospects by the entire system. A slowdown resulted in non-performing assets.
However, the real extent to which government-RBI relations had deteriorated was revealed when deputy governor Viral Acharya spoke about the independence of the central bank last week. It now appears that it was a reaction to mounting government pressure and a breakdown in communication. Among other things, Acharya highlighted issues such as the regulation of PSBs, transfer of reserves from the RBI balance sheet, and the scope of regulation in the context of a proposed payments regulator. RBI has published a dissent note on this. The issue of PSB regulation also needs closer attention.
Further, the idea of transfer of reserves will not be prudent, both for the government and the central bank. As former deputy governor Rakesh Mohan has argued (bit.ly/2OnSBba), the central bank may not be able to attain its objectives without sufficient capital. It will also not reflect well on the government if it uses central bank reserves to fund the fiscal deficit. Additionally, a one-time large transfer will shrink the size of the RBI balance sheet and affect the flow of dividend in the future.
However, that is not all. As has been reported, the government wants relaxation in the prompt corrective action (PCA) framework, which is not allowing weak banks to lend, especially at a time when non-banking financial companies are facing a liquidity crunch. Although RBI has assured that it will maintain adequate liquidity in the system, the government doesn’t seem to be convinced.
It is important to repair the balance sheet of weak banks before they can be allowed to resume normal business. Loosening the regulatory grip at this point could result in further accumulation of bad loans. Both the government and RBI have made significant progress in recognizing and addressing the bad loan issue. Relaxation in rules and regulations—either through the PCA framework or exemption in the bad loan resolution mechanism—would mean that the problem will fester and increase the cost for the economy over time.
The difference of opinion between the government and the central bank is neither new nor unique to India. However, it is worth reiterating that it is necessary for the government to respect the operational autonomy of the central bank. Undermining the ability of RBI to take decisions will affect market confidence and end up complicating the policy environment. The government has done well by taking the first step towards defusing tension. It should now build on it and avoid unnecessary conflict with the central bank. The ball was always in the government’s court.