Governments that do not respect central bank independence will sooner or later incur the wrath of financial markets." This warning by Reserve Bank of India (RBI) Deputy Governor Viral Acharya in October last year seems to have gone unheeded. Acharya is the latest key RBI official to have quit (six months before his term was to end) in the middle of tumultuous events at the RBI that have, over the past year, seen the government demand additional surplus capital, threatening to use its special powers to direct the RBI on matters such as restructuring MSME loans, releasing weak banks from tight regulatory control and Urjit Patel resigning as governor in haste citing personal reasons.
That's not all. The siege in recent months has included a bank dragging the RBI to court over stake-reduction guidelines and a quasi-judicial body like the National Company Law Appellate Tribunal (NCLAT) encroaching into its powers, saying banks should not declare the IL&FS account as a non-performing asset (NPA), and the biggest of all, the Supreme Court setting aside the RBI circular that laid down rules for one-day default by big companies and, in a separate case, asking it to disclose information about its annual inspection of banks under the Right to Information (RTI) Act.
Even as the challenges continue, the RBI, under the new Governor, Shaktikanta Das, who retired as Economic Affairs Secretary two years ago, seems to be more accommodating to the government's concerns than under the previous two incumbents - Urjit Patel and Raghuram Rajan - when it comes to easing interest rates, paying higher dividends, making life easier for weak banks and restructuring package for stressed MSMEs.
Is this behind the discontent among the RBI brass over dilution of the central bank's authority and which led to Acharya's exit? All this brings us to the question central to all this - limits of central bank independence and how it can be best preserved to ensure economic stability and growth.
Curbing Independence
Y.V. Reddy, who guided the RBI between 2003 and 2008 with conservative policies when the global economy was overheating, had a stock answer. "The Reserve Bank is totally free within the limits set by the government." The former governor, D. Subbarao, in his book - Who Moved My Interest Rate? - wrote that Reddy's answer is clever, even technically correct, but still ambiguous. Technically, the government has the power to give directions to the RBI in public interest, but only after consultations with the governor. The relationship never came to such a pass except recently when the central bank, under Urjit Patel, was forced to sit down and discuss matters with the government. Patel left without completing his full term.
Many recall that government pressures were always there. It was just that the hornet's nest was rarely stirred up. For decades, interest rates were the only big bone of contention between the RBI and the government, while the former got to work more or less freely in other areas such as regulation of financial institutions and managing the country's external balance sheet. Take the public spat between Subbarao and the Congress-led UPA government at the Centre. Subbarao, who had disagreements over the monetary policy with two finance ministers - Pranab Mukherjee and P. Chidambaram - has said in his book that there is a price to pay for not falling in line. The government went against his recommendations for reappointment of deputy governors.
A lot of changes have happened since Subbarao left in 2013. India now has a monetary policy committee (MPC) with half-a-dozen members. There is little room for the governor's discretion. In the three recent MPC meetings, Acharya had a different view than Governor Shaktikanta Das. While Das voted for a cut in policy rates, Acharya batted for status quo because of inflationary concerns and fiscal slippages. "The MPC members are independent to express their views. It is erroneous to state that Viral Acharya has a different view than the governor . What is important here is his conviction, rationale, logic and reading of the current and evolving macroeconomic situation ," says R.K. Pattnaik, a former central banker who now teaches at SPJIMR.
This is not a one-off. Globally, the rise of populist leaders promising high growth and job creation in a short period has created a problem for central banks, which are expected to ease monetary policy to help these leaders meet these goals. US President Donald Trump has often criticised the Federal Reserve interest rate tightening. "The only problem our economy has is the Fed. The Fed is like a powerful golfer who cannot score because he has no touch - he cannot putt ," he tweeted in March. In India, too, the BJP-led NDA government has been accused of interfering in the RBI's functions. A banker, Nachiket Mor, was removed from the RBI board and replaced by RSS-affiliate Swadeshi Jagran Manch Co-convener S. Gurumurthy. This is not something unique to India. The US President unsuccessfully tried to nominate two Fed critics on the Federal Reserve's seven-member board a few months ago.
Gurumurthy took centre stage during lengthy board discussions on critical issues with support from other government nominees. The board eventually forced the RBI executive to change its stand on many sensitive issues such as support to MSMEs. After a stormy board meeting in November last year, the RBI came out with a press statement with wordings like "the board decided..." and "the board advised..." Urjit Patel left in a huff after as he probably thought his authority was being undermined.
This also brings another related question to the fore: Who is the final authority - the RBI governor or the board. "The board has a governance function rather than an executive function. We should be careful not to cross the line," Raghuram Rajan had told BT when he was in Mumbai for the launch of his book, The Third Pillar. Though the line between the government and the RBI has been crossed before - such as in the 1950s when the acrimonious relationship between the then finance minister T.T. Krishnamachari and the then RBI governor Benegal Rama Rau culminated in the exit of the latter (see The Others) - such serious confrontations have been rare.
The present governor has worked with the current political establishment in the finance ministry and shares a good rapport with the government. He was recently questioned on his meeting with the finance minister before the MPC meeting given that Urjit Patel had declined a similar invitation earlier. "Even after the MPC was constituted, these meetings were going on, may be the media was not aware... so my meeting the finance minister is not anything very unusual," he had said.
The tensions between the government and the RBI may have subsided with Das's more flexible stand on several issues, but the question remains - is there a cost to be paid for this and can the damage to the institution be undone? "We believe institutions are more important than individuals and ultimately what is important is the credibility and the independence of any institution and nothing else," Soumya Kanti Ghosh, Group Chief Economic Advisor, State Bank of India, has said in a recent research paper.
Emerging Risks
In just six months, Das has surprised markets with a 75 basis points cut in the repo rate to 5.75 per cent, arguing that inflation is benign and there is space to support growth. The headline inflation may be far below the target of 4 per cent but clouds of uncertainty like the sticky core inflation remain. So do inflation risks such as future direction of crude oil prices because of geo-political risks and the government's ability to meet the fiscal deficit targets. Out of the six members, his deputy, Viral Acharya, and government appointee Chetan Ghate, an economist, voted for status quo in the last two MPC meetings. "A governor vote against a cut would have tilted the balance. A tie would have meant casting vote from the governor," says an economist. "It is too early to forget or rule out wild gyrations from geopolitical risks. Given our oil imports and the current account deficit, headline inflation responds particularly adversely to upside risk from crude oil prices," said Acharya, while talking about focussing on transmission of rates, a big issue.
The new governor's decision to pull out weak banks from the prompt corrective action framework has also created a risk for the system as these banks are still vulnerable. The objective may be to support growth as the government has provided them additional capital, but the weak architecture of public sector banks raises concerns about the additional capital going down the drain. Experts suggest the RBI should have pushed for governance reforms or merger of these banks. Abhijit Mukhopadhyay, who tracks macroeconomics at ORF, says any high value project shouldn't be financed by deposit-taking banks. "What we need is development finance institutions 2.0. Let the government be a facilitator to create an institutional framework for financing risky projects," he says.
Then there is the issue of payments by the RBI to the government. In fact, the first signs of the tensed relationship between the two had came out in the open when the government set its eyes on a larger dividend. The problem started after the demonetisation year when the RBI's income fell and expenditure (due to printing of new notes, etc) rose. The dividend fell from Rs 65,876 crore in 2015/16 to Rs 30,659 crore in 2016/17. In 2017/18, the RBI, under Urjit Patel, set aside Rs 14,190 crore as contingency fund, which angered the government as the dividend of Rs 50,004 crore fell short of its expectations. Some suggest Das has been quite generous in paying an interim dividend of Rs 28,000 crore after he landed at the RBI.
The total dividend payout reached Rs 68,000 crore in 2018/19, which was much needed by the government, struggling to meet fiscal deficit targets. The government is now looking at the RBI's surplus capital. "Of course, the government, as the owner, can make a claim. But in my considered view, as long as there is a separate balance sheet for the RBI, the accounting norms should be respected," says Pattnaik. He says the principle and rationale for parting with these liabilities need to be spelt out. Also, operational issues such as reduction in assets, in this case foreign assets, need to be looked at, apart from the impact on interest rates and exchange rates, he says.
There are reports that the Bimal Jalan Committee - set up to settle the issue of RBI surplus capital - will arrive at a surplus figure of Rs 2-3 lakh crore. Some say payment of surplus capital to the government will impact the RBI's creditworthiness. "The surplus capital, if any, should be utilised for recapitalisation of public sector banks," says Mukhopadhyay
The MSMEs also seem to be a pampered lot under Das. The RBI recently allowed restructuring of loans to MSMEs with aggregate loan exposure up to Rs 25 crore. There is a strong possibility of future NPAs coming from MSMEs whose loans are getting restructured now. An RBI panel recently suggested doubling the collateral-free Mudra loan limit to Rs 20 lakh.
The new governor has also surprised the market with a foreign exchange swap facility. This is not without risk. Raghuram Rajan was the first to use this when the rupee was crashing in the second half of 2013. The banks had then raised over $32 billion and participated in an RBI's swap facility. The rupee was stable at the time of redemption three years later and things went on smoothly. Given India's trade deficit, current account deficit and danger of oil prices rising, the future value of the rupee cannot be predicted with safety and therein lies the risk.
RBI'S Powers Under Attack
The RBI's powers have been challenged by a host of institutions, too. Kotak Mahindra Bank recently dragged the RBI to court over reduction of promoter stake. RBI regulations mandated Uday Kotak to reduce his equity shareholding to 20 per cent by December 2018 and 15 per cent by March 2020. The bank came out with a perpetual preference shares issue to reduce the stake from 29.7 per cent to 19.7 per cent. The RBI said stake dilution through issuing preference shares was not allowed and imposed a penalty. "It is not a matter which relates to the RBI's authority or undermining it. It is more a matter of interpretation of law where judicial review comes into play," says Mukesh Jain, Corporate Lawyer and Founder of Mukesh Jain & Associates.
Last month, the Supreme Court quashed the RBI's February 12 circular on single-day default. The circular sought to trigger resolution for large stressed corporates with a six-month deadline, failing which banks were given freedom to take the company to bankruptcy court. The RBI has already come out with a new circular for resolution of stressed assets. "There is no dilution of the RBI's authority. It is an issue of interpretation of the RBI's power," says Jain.
Then, in February, the appellate authority for bankruptcy cases, the NCLAT, directed banks not to classify bad loans of IL&FS and its subsidiaries as NPAs without the court's prior permission. The NCLAT later relented, though. Clearly, the RBI is passing through a challenging phase. To assuage these fears, Finance Minister Nirmala Sitharaman has announced that the government is giving the RBI the power to regulate housing finance companies.
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