Government vs RBI - Demystifying the tussle

In the spate of resignations in the recent times at RBI, one may wonder if there is a crisis lurking around in RBI. No there isn't. Let me try to explain what this tussle is about:

The RBI and Government are at odds on three key issues:

1. Govt wants to use surplus reserves of RBI and infuse money into the struggling banks so that banks can start lending more and this would in return trigger investment and spending. 
2. Govt wants RBI to dilute to some extent the currently stringent Prompt Corrective Action framework (PAC) for stressed banks (via this framework, RBI issues strict measures which are restricting stressed banks from circulating capital).
3. Govt wants RBI to reduce the ratio of the capital that banks maintain against its assets. This is called CAR (Capital Adequacy Ratio). This basically means making it easier for the banks to lend money even when they have lower assets.

Now RBI, which has been typically a financially conservative institution, is dead against diluting these norms or giving away the surplus capital to the banks. 

Is govt doing anything unconstitutional in issuing these directives ? Absolutely not. Section #7 of the RBI act allows government to issue directives in public interest. But RBI is not liking the fact that government is issuing directives and happens to think that government is interfering with its autonomy. Rather, this is the first time in the history of RBI, that Govt ​is invoking section 7 which has not been invoked even in more severe times ​like wars and even demonetization. So RBI feels that its Autonomy is being threatened. 

​Is this tussle a good or bad thing? It is very easy to conclude (given the three resignations at Governor/Dpt. Governor levels in RBI), that the government is being non-accommodating and hurting RBI's autonomy. But it would be wrong to jump to that conclusion in a haste. Its true that Govt has been a bit pushy especially on point #1 as it seems desperate to infuse capital into the economy to trigger investments, demand and consumption. Usually previous governments have also pumped money into the economy but they have most of the time resorted to the option of external ​borrowing (World bank, IMF etc.) for these infusions. Modi Govt is strictly against borrowing money from international agencies (and that's a good thing). RBI or the Government cannot frivolously print money (and that's an excellent thing as well). So money has to be arranged from somewhere. The NDA government wants to do so by using the capital ​that has been lying locked ​within the country​ - a way never tried before and that's really ​​​​​making the RBI nervous.

The other important point coming out in this tussle is that this govt is challenging the status-quo-ist ways of operation of the RBI. But a good thing that should be noticed is that the Govt has shown openness in appointing and accepting people who have challenged it openly (even though some have left following disagreements with the Govt.). That shows that the government is at least not hiring '​yes ​men'. Its possible that during previous governments, we hardly heard about any conflicts because a) those govt appointed yes men ​who nodded to FinMin's demands; or b) they ​never thought that RBI could be forced to take such an unconventional step; or both (a) and (b). Modi is known to try out unconventional things by staying within the boundaries of constitutional framework (e.g. Demonetization).

Is there a crisis because of this disagreement? Doesn't look like. On one hand Govt looks a bit desperate, but on the other it seems that RBI is more concerned about losing its autonomy than realizing the real reason behind government wanting it to relax some of its stringent norms. RBI is of the opinion that stressed banks should fend for themselves. But in a country as huge as India, where, because of its sheer size, the population is highly dependent on Public Sector Banks (PSBs), letting those banks go dysfunctional could invoke severe hick-ups in the economy and even recessions. Its not a good idea to let such institutions sink. It becomes necessary once in a while to bail them out. The previous governments have did so too, but this government wants to do it a bit differently -

a) use the excess surplus stashed with RBI to trigger investment and consumption;

b) allow weak banks to lend even if they have capital lesser than the mandatory threshold (else it will hamper disbursements of loans to micro and small businesses); and 

c) keep some PSBs out of the the stringent prompt corrective action (PAC) framework as this is restricting credit flows from PSBs into the economy.

There is some merit in Government's argument and RBI must pay heed to it. Even the developed countries have resorted to bailing out weak banks and it is extremely necessary to do so to avoid collapses and recessions. Recessions have a domino effect on investments, and it may freeze the economy for months.

So in good faith, RBI should accept some demands of the government. Using the analogy by Raghuram Rajan where he stated that the RBI is like a the seat belt, it would be disastrous to remove that belt altogether. So why not loosen it a bit so that it gives government some space to adjust too? Especially release some capital to bail out NBFCs (Non-Banking Financial companies) if not the PSBs. In return Government should give up any effort to remove the belt and let RBI keep its autonomy. This is a non-crisis situation and a solvable one. It would be unwise to panic because of the recent resignation of Dy. Governor Viral Acharya.

Authored by: Mandar Garge (June 25th, 2019)