Protect the independence of the RBI

A few years ago, a visibly angry Finance Minister, responding to the Reserve Bank of India’s inaction on reducing interest rates, as desired by his government said he would “walk alone” if the RBI would not cooperate. He was referring to the growth process which requires lower interest rates, which the RBI was not willing to help with. But the extent of his displeasure, or rebuff if you will, was just that: “we will walk alone”. Contrast that episode with the current situation of a potentially unseemly spat which has threatened to spin out of control. There was speculation that the Governor of the RBI Dr. Urijit Patel may be forced to resign, in protest against the pressure mounted by the government on his organisation. The provocation seems to be around three contentious issues: that the RBI must infuse emergency liquidity to help tide over a crisis precipitated by the bankruptcy of Il&FS, that the RBI should dilute its February 12 circular and provide some leeway to the power sector borrowers, and lastly that the RBI dilute its Prompt Corrective Action (PCA) applied to eleven public sector banks, and allow some of them to issue fresh loans.

In each of these three issues, the RBI has clearly spelt out why it is standing its ground. For instance, the RBI says that it is monitoring the NBFC liquidity situation continuously, and in its assessment of the situation does not present a contagion or systemic risk. In the case of the February circular, the new framework is clean, transparent and time-bound. It gives banks 180 days to restructure a stressed loan, beyond which it automatically goes into the bankruptcy process under the new Insolvency and Bankruptcy Code (IBC). Now with the IBC in place, and it is one of the government’s brightest economic reforms, there is no need for the RBI to separately specify any loan restructuring process. But the power sector borrowers are refusing to abide by the 180-day rule. They have taken the RBI to court. If the RBI gives them relief, who is to say that some other sector, say telecom or airlines, also won’t ask for relief?

There’s no end to this slippery slope. The whole purpose of the February 12 circular was to inculcate a strong credit culture and discipline. If the power sector needs any relief, it must come from fiscal resources, not by the indulgence of the central bank. These are contentious issues about which there can be legitimate debate and discussion. But such debate or discussion must be conducted away from the public eye, otherwise the discourse will spin out of control. Very quickly the positions will harden, and the debate will be of the kind that says, ”with us or against us”, destroying any possibility of entertaining the nuance, or shades of grey that are inevitably a large part of these conversations. The RBI is always willing to re-assess its position in the light of new data. Even the great Albert Einstein once said, “if there is new evidence, I change my view”.

The friction between the RBI and the government is an inbuilt structural feature of the relationship. The government, especially in a developing economy, has a tendency to be fiscally generous, and the central bank’s job is to curb that tendency through tight monetary conditions, meaning make it costly to pursue fiscal profligacy. Elected governments tend to have a shorter time horizon for the policies they pursue. In doing so, they may take decisions whose benefits are front-loaded but whose costs are over the medium to long-term. For instance, increasing the fiscal deficit may push up growth, but may cause high inflation and higher interest rates in the future, killing growth in the longer term. Increased indebtedness can also cause the loss of confidence of foreign investors, leading to a sudden exit of dollars, causing the currency to collapse. Indeed, because of such an inbuilt tendency, lawmakers make commitment to fiscal prudence by passing a law, on fiscal responsibility.

But such a law on fiscal responsibility passed by India in 2003, did not prevent the fiscal deficit from ballooning over the limit by 2009. That was when the law was jettisoned, and a new law is being drafted. Even the great Maastricht Treaty which enshrined a limit of 3 percent fiscal deficit ratio, on all members of the European Union, was breached within a few years of its signing. Thus, in national contexts, there is a reason why the responsibility of monetary and financial stability is entrusted with an independent central bank. That independence is crucial for it to ensure that the long-term effect of fiscal policies are not harmful to the economy.

The central bank’s independence was the topic of a lecture given by Deputy Governor Viral Acharya last week in Mumbai. The strong and erudite speech By Dr. Acharya signalled the central bank’s readiness to fight to preserve institutional independence.

The Reserve Bank of India was set up 12 years before India’s independence. In the eight decades of its existence, it has distinguished itself with conduct of the highest global standards. It is among a handful of national institutions known for exemplary integrity and incorruptibility. Of course, it may have had its share of bad apples, and it may have committed policy mistakes (known only in hindsight).  But overall, its rock-solid reputation has been built over a long period, of testing times that needed tough decisions. This reputation took a bit of a dent during and immediately after demonetisation.

That was the time when the new leadership was just about settling in. Now, the Governor and his team are well anchored and it may be argued that they have had the time to take a fuller look at the economic canvas, tempered by the experience of demonetisation and informed by the well-regarded depth of inputs from within the RBI. It is alright for the government to disagree and make its point above all others. But to force that view and to be taking recourse to extreme steps like invoking powers never used before in the history of independent India may be going a bit too far. This temptation is best avoided, particularly by a government that says it is keen to clean up the mess of NPAs in the banking system.

(The writer is an economist and Senior Fellow, Takshashila Institution)