WHY IN NEWS
- The stand-off between the government and the RBI has reached a flashpoint.
- The Reserve Bank of India (RBI) and the government give the impression that they are not on the same page even as far as an understanding of their roles is concerned.
- The RBI suggests that its independence is being violated while the government rationalises its intervention in terms of its concern for the economy.
How was the relationship between the central government and RBI?
- Since it is clear that the government and the central bank are not on the same page on these issues, their relationship is being widely debated. It has often been argued that the RBI is not an independent central bank.
- However, the real question is: should the RBI not have the operational independence to attain the objectives given to it? Former RBI governor Raghuram Rajan has explained what RBI does with the analogy of a seat belt.
- The driver—in this case, the government—has the option of not putting on the seatbelt, but in case of an accident, the damage could be severe.
- Put differently, it is in the interest of the government to respect the central bank’s mandate of maintaining financial stability.
The dispute between the Government and RBI-
- The rift between the Central Government and the RBI grew after the RBI Deputy Governor Viral Acharya said in a speech on October 26, 2018, that undermining a central bank’s independence could be “potentially catastrophic”, an indication that the regulator is pushing back hard against government pressure to relax its policies and reduce its powers.
- Acharya also said that “Governments that do not respect central bank independence will sooner or later incur the wrath of financial markets, ignite an economic fire, and come to rue the day they undermined an important regulatory institution…”
SIX CRITICAL AREAS OF CONFLICT
- The government has made repeated calls for the RBI to hand over more money from its reserves to help fund its fiscal deficit.
- The RBI currently hands over its profits earned from various activities in the form of a dividend. But the government also wants to tap a share of the RBI’s Rs. 3.6 lakh crore ($48.73 billion) of capital reserves.
- The RBI has consistently pushed back against the demand.
The aim of keeping reserves by RBI: what’s the objective of these reserves?
- The CGRA (currency and gold revaluation account) is meant to cover a situation where the rupee appreciates against one or more of the currencies in the basket.
- The basket has several currencies ranging from the dollar to the euro and the yen or if there is a decline in the rupee value of gold.
- The level of CGRA now covers about a quarter of the total currency reserves of the RBI.
- The CGRA, which serves as a risk management technique for the RBI, has shown large variations over the years due to revaluation of foreign exchange assets.
- The contingency reserve is meant to cover depreciation in the value of the RBI’s holdings of government bonds– domestic and foreign– if yields rise and their prices fall.
- The reserve is also meant to cover expenses from extraordinary events such as demonetisation, money market operations and currency printing expenses in a year of insufficient income.
- Most important of all, the contingency reserve supports the mother of all guarantees the central bank’s role as the lender of the last resort.
- The reserve is also a cover for the deposit insurance fund given that the Deposit Insurance and the Credit Guarantee Corporation (DICGC) is a wholly-owned subsidiary of the RBI.
OUT OF THE SHADOWS
- The government wants the RBI to provide more liquidity to the shadow banking sector, which has been hurt by the defaults of major financing company, Infrastructure Leasing & Financial Services (IL&FS).
- Those defaults triggered a sell-off in bonds and stocks of non-banking financial companies. The government has been asking the RBI for a dedicated liquidity window for these lenders similar to the one allowed during the 2008-2009 global financial crisis.
- The government has also been urging the RBI to relax its lending restrictions on 11 state-run banks. The curbs were imposed because the banks had a low capital base and major bad debt problems.
- The 11 public sector banks are barred from lending unless they reduce their bad debt levels, improve their capital ratios and become profitable.
- The government says the restrictions have gone too far and have reduced the availability of loans for small- and medium-sized businesses.
- The RBI is also irked by the government’s efforts to trim the central bank’s regulatory powers by proposing to set up an independent payments regulator.
- Currently, the RBI regulates all payments and settlements in the economy. The government says it wants a separate payment regulator which will be able to adapt to rapid changes in technology.
- The government appointed S Gurumurthy, a prominent BJP supporter and an affiliate of the Rashtriya Swayamsevak Sangh (RSS), to the RBI board earlier this year along with Satish Marathe, a former banker with ties to the RSS.
- Such political appointments have been unusual in the past as the RBI board’s external members have mostly been economists and industrialists.
- Traditionally, the RBI’s board has approved decisions related to internal functions of the central bank and it has not interfered in its supervisory and monetary policy functions.
Senior government officials, as well as BJP and RSS officials, are angry that the RBI decided to go public over the quarrels. Acharya made it clear he had been asked to address the independence question by Patel and in a show of unity the three other deputy governors attended his speech. In its statement concerning autonomy, the government stressed that it will keep discussions confidential.
The fuse that lit this tension is said to be Section 7 of the Reserve Bank of India Act or RBI Act, which empowers the government to issue directions to the “lender of last resort”
|Section 7 of the Reserve Bank of India (RBI) Act, 1934|
The Section 7 had never been used in independent India till now. It was neither even used when the country was close to economic crisis in 1991 and nor in the aftermath of the 2008 recession crisis.
The talks of invoking Section 7 began for the first time during the matter related to power generation which was taken up by the Allahabad High Court in which a case was filed by power producers challenging the RBI’s February 12 circular. The High Court at that time ruled that invoking of the section could be considered. However, the government at that point did not invoke the section.
It is not yet clear how this Section operates since it has never been used till now.
CENTRAL BANK’S INDEPENDENCE A WESTERN CONCEPT: RSS AFFILIATED BODY
- Matters took a political turn after the RSS-affiliated Swadeshi Jagran Manch’s leader Ashwani Mahajan said the “Reserve Bank of India governor should work in sync with the government or otherwise resign.”
- He said, “This entire talk of central bank’s independence is a Western concept.
- It is not acceptable and feasible here. India is a developing country our main priority is employment and growth of small-scale industries.
- RBI should stand with the government on these issues.” The Congress has also accused the Prime Minister Narendra Modi government of undermining the RBI’s independence.
Where Does RBI Stand in Terms of Autonomy?
- According to a paper published in the International Journal of Central Banking in 2014, RBI was listed as the least independent among 89 central banks considered under the study.
- These rankings are likely to have improved since the adoption of inflation targeting in February 2015 and the formation of Monetary policy committee in October 2016.
- However, vacancies in RBI’s board and government’s reluctance to fill them up raises questions about the decisions taken and whether proper deliberations on those decisions are being held.
- During the previous government, a Financial Sector Legislative Reforms Commission was formed which made various recommendations to cut down RBI’s powers.
- In 2013, a financial sector monitoring body, called Financial Stability Development Council was established which was to be chaired by the Finance Minister.
- In essence, the RBI Act 1934, does not empower RBI absolute autonomy. However, it does enjoy some independence when it comes to performing its regulatory and monetary functions
WHY IT MATTERS
FOR PM MODI
- The Modi government has been under pressure ahead of regional polls due at the end of 2018 because of weak farm prices and surging fuel costs, which have been hurting rural incomes. The government recently cut excise duty on gasoline and diesel, adding to pressure on its deficit.
- The budget is also being undermined by muted revenue collection from a recently introduced goods and service tax.
- Added to this, IL&FS woes have led to a liquidity crunch across much of the shadow banking sector and throttled off some lending.
- All of this could slow a $2.6 trillion economy, the world’s sixth largest, only months before the general election.
- To prevent that from happening, PM Modi is expected to spend more on populist programmes, including boosts to rural wages, fuel subsidies and buying crops at a guaranteed minimum price.
- The rift has created political and economic uncertainty. Investors want policy continuity from both the RBI and the government to ensure inflation is kept in check and economic stability is maintained.
- A persistent fall in the inflation rate since 2014 in a country that was used to volatile price pressures instilled confidence in the central bank and attracted investors. However, investors fear such hard-earned economic gains could be at risk if the government can pull the RBI’s strings.
- The RBI governor should be responsible and accountable to Parliament and not to a particular government or the ministry of finance, or minister. He can testify to Parliament twice a year. In separate testimony in both houses of Parliament, the lawmakers can ask questions of the RBI Governor and the latter can respond.
- A better way to sort out these differences and to come to a conclusion is to have a larger debate with technical experts weighing in.
- On issues of operational autonomy, the central government needs to lay off its pressure on the RBI.
- On macro issues such as exchange rate management and RBI’s dividend policy, written agreements that clearly demarcate roles and responsibilities can be thrashed out.
- The Monetary Policy Framework Agreement and the FRBM Act are good illustrations of how a mutually agreed rule-based framework can broker peace between the central bank and the executive arm of government.
- If the issues are not resolved, the tussle will undermine investor confidence and strengthens fears about institutional erosion when India is already experiencing economic turmoil.
- There is need to pay due regard to both autonomy and accountability. There has to be a forum within our democratic structure where the RBI is obligated to explain and defend its position.
- Different countries have taken different routes and by and large each model is appropriately tuned to their specific contexts.
- The oft-quoted US example is a good model to work upon.
- Presentation by the chairman of the Federal Reserve to the Congress makes for public exposure and transparency but does not take away the chairman’s autonomy.
- We need an appropriate and structured forum to strike a balance between unrestrained autonomy and blatant political intervention