Will he? Won’t he? It’s the question many in India’s business world were asking last month amid swirling rumours that Reserve Bank of India (RBI) governor Urjit Patel was going to quit because of a spat with the government. Many politicians, economists, and other experts even went so far as to dub a key RBI board meeting on November 19 a “day of reckoning” for the RBI, the government, and the economy. Despite the acrimonious run-up, there were no fireworks or resignation threats during the central bank’s nearly nine-hour board meeting. The much-dreaded but never-used Section 7 of the Reserve Bank of India Act, 1934—which allows the government to dictate policy issues to the central bank—was not invoked. Despite talk of demands to hand over the RBI’s surplus reserves to the government, there were no raids on its coffers or any concrete proposals to relax lending norms for state-owned banks under the prompt corrective action (PCA) framework. No separate liquidity tap was opened for non-banking finance companies (NBFCs) or micro, small, and medium enterprises (MSMEs).

The RBI clung to its position, but what the meeting did achieve was an agreement to relook at some of the contentious issues. They agreed that the governor would consider a scheme to restructure the stressed assets of MSMEs with loans up to ₹25 crore; set up a joint committee to determine the appropriate capital requirements for the RBI and transfer the “surplus” to the government, and postpone the capital buffer requirements of banks by a year

Still, the question is: Is this the proverbial calm before the storm or have the warring parties decided to smoke the peace pipe? It’s probably a temporary truce and tensions are likely to blow up again as the new board is more aggressive and perhaps even activist because of the presence of some unhappy bureaucrats and members with strong political affiliations. “The new board is going to debate every substantive economic policy issue far more closely and is no longer willing to be a rubber stamp like earlier boards,” says Amir Ullah Khan, economist and professor at Maulana Azad National Urdu University in Hyderabad.

More importantly, several critical questions such as which institution is sovereign or how independent should the central bank be are still grey areas. Is it the elected government or institutions entrusted with specialised policymaking mandates that have wide-ranging politico-economic effects? What kind of control does the government exercise on the RBI’s monetary policy and other functions? These questions are at the heart of a raging polemic debate since deputy governor Viral Acharya’s explosive speech in which he alleged the government was whittling down the central bank’s powers by appointing government-affiliated officials instead of experts on its board and other ad hoc interventions. S. Gurumurthy, a Rashtriya Swayamsevak Sangh ideologue and chartered account, was appointed to the board in August 2018.

The government, said the deputy governor, was trying to snip the powers of the central bank by suggesting the setting up of a separate payments regulatory board, forcing its hand on various issues such as relaxing lending norms for weak banks under the PCA framework and asking the RBI to facilitate greater bank lending to NBFCs and housing finance companies (HFCs).

Acharya went so far as to say that governments that do not respect the RBI’s independence “will sooner or later incur the wrath of financial markets, ignite economic fire, and come to rue the day they undermined an important regulatory institution”. Finance minister Arun Jaitley said the government respected the RBI’s autonomy, but stressed the importance of liquidity in the economy. “If we have to improve on this [growth] we need a certain level of credit flow as far as entrepreneurs are concerned... see that liquidity is maintained,” Jaitley said in an interview to a news channel. “We respect the autonomy [of the RBI] but, at the same time, if some sectors are starved of liquidity or credit, we will flag those issues. We do so with the RBI.”

Finance minister Arun Jaitley
Finance minister Arun Jaitley
Image : Getty Images

Both sides might have stepped back from the brink this time, but the war is far from over. And simmering tensions could well bubble over again at the next RBI board meeting on December 14 as key contentious issues such as governance issues and dividend payouts of the central bank were not addressed at the last meeting. The RBI has been most unwilling to bail out crisis-ridden NBFCs because of their flawed business model. These firms borrow funds for six months or a year, but lend to customers for a 10-year period, leading to a serious asset-liability mismatch. Once private infrastructure lender Infrastructure Leasing & Financial Services started defaulting on its debt payments, banks and mutual funds stopped lending to NBFCs, disturbing their refinancing plans. The idea of restructuring stressed standard assets of MSME borrowers is not a new one, although bankers worry it may turn out to be another “loan mela” for banks. Loans without proper due diligence or collateral can come back to haunt banks as bad debts later.

Liquidity injection remains a major bone of contention. A senior government official told Fortune India on condition of anonymity that the RBI has sucked out more money from the system in trying to protect the rupee than it had injected into the system. Credit rating agency CARE Ratings corroborates the point in a report that shows the shortfall touched ₹1.2 lakh crore on October 26 before easing to ₹69,000 crore by November 9. On the flip side, the RBI says it has injected nearly ₹40,000 crore into the system in the past two months under open market operations (OMO) and plans to continue in the future.

Arvind Virmani, former chief economic advisor to the government, believes the RBI is duty-bound to provide liquidity and ensure there is no threat of any contagion. An easy way to resolve the liquidity crisis is for the central bank to reduce the mandatory cash reserve ratio (CRR) that banks have to deposit with the RBI to tide over any crisis. Currently, the banks keep 4% of their deposits with the central bank without earning any interest. “Even a 1% reduction in the CRR is enough to release nearly ₹1.2 lakh crore into the system, without having to give in to the government’s demand for dilution of a bank’s capital norms,” says a government official.

Urjit Patel
Urjit Patel
Image : Getty Images

The RBI has agreed to discuss the 9% minimum capital requirements for Indian banks, or the ratio of a bank’s capital to its total risk, compared to the global norm of 8%. The timeline to infuse further capital under the capital conservation buffer, too, has been postponed by a year to April 1, 2020. The government had always contested the RBI’s decision to impose higher norms than mandated even under the Basel III framework by enforcing a 5.5% minimum common equity tier 1 (CET1) ratio compared to 4.5% globally. This, says the government, curbs the ability of a bank to lend, thereby impacting the growth prospects of an economy. Even a 1% reduction in the CET1 ratio can free up ₹6 lakh crore of liquidity, without any need for additional provisioning, point out government officials.

RBI officials justify their stand on the unique characteristics of the Indian banking system. It is loaded with nearly ₹10 lakh crore of bad debts, has lower provisioning norms for MSMEs compared to the West, and also has an unduly long recovery process for stressed assets. On the thorny issue of relaxing lending norms for the 11 weak public sector banks under the PCA framework, the RBI has argued that relaxing lending norms at this point would not be prudent without first strengthening their balance sheets. As former BJP finance minister Yashwant Sinha argued on a television channel, one “cannot accuse the RBI of sleeping between 2004 and 2014, and especially between 2009 and 2014 when a humongous amount of loans was given out by the banks, and at the same time ask the RBI to repeat the same mistake”.

Sunil K. Sinha, principal economist at credit rating agency India Ratings, says an easy way is the infusion of more capital into these banks. “Get a commitment from the government to bring in capital into PCA banks because 70% of Indian banks are anyway government-owned. As long as the commitment for capital comes in, there is no reason not to relax PCA guidelines.”

The bigger stand-off between the government and the RBI is on the issue of “excess reserves” that the government maintains are lying unused in the central bank’s coffers. A new joint committee of the RBI and the finance ministry will work out the details of the reserves required. Of the ₹9.63 lakh crore of reserves, ₹2.3 lakh crore is kept as retained earnings, the amount it has earned over the past 20 years. That amount cannot be touched under the RBI Act of 1934. The remaining ₹7.5 lakh crore, the apex bank’s revaluation reserves of foreign currencies accumulated over the years because of volatility in currency markets, too remains out of bounds. While the department of economic affairs secretary has tweeted the government is not keen on raiding the RBI’s coffers, a relook at the central bank’s “Economic Capital Framework” makes it clear it is eyeing the RBI’s excess funds. And in case the committee suggests that the reserves be brought down to 14% (from 27%) like most other central banks, it would lead to the transfer of ₹3.6 lakh crore to the government. As of now, it is the annual surplus of the RBI that is transferred to the government.

How much is too much? While that question will be discussed by the high-powered committee, former RBI deputy governor Rakesh Mohan says it is difficult to peg the level of right reserves as it varies depending on the economic situation. The central bank needs the reserves to conduct monetary policy operations, inject funds to shore up the rupee in times of extreme foreign exchange volatility, and buy dollars from the market when it is flooded with U.S. currency. Besides, it is also the lender of last resort, protecting the financial system from collapse. But Mohan is categorical that “using the central bank’s capital to fund government expenditures of any kind is a bad one in almost any circumstances, and essentially short-sighted”.

Another area of difference is the board’s role in monetary policy. Former finance minister P. Chidambaram argued in a TV debate that even the idea of the board directing the governor on monetary policy issues is “preposterous”. “The central bank equals the governor and if the board forces the governor to take a decision, the governor should resign,’’ he said.

In the end, it all boils down to the independence of the RBI. Differences between the RBI governor and the government can have a disastrous impact on the economy, stock markets, and currency. Any uncertainty could deter foreign portfolio investors and other investors from investing or even prompt them to pull out their investments. Recently, news that RBI governor Urjit Patel might resign sent stock markets and the rupee into a tizzy.

So what should the two parties do to ensure such public spats do not recur in the future? “There should be clear articulation from the government of its continued support of the RBI as a full-service central bank, and that it intends to strengthen its various functions as the key financial sector regulator and supervisor,” argues Mohan. On its part, the RBI needs to protect the country from financial shocks like the East Asian and the global financial crises. But till the spat is over, the financial markets will continue to remain on tenterhooks.

The story was originally published in the December 2018 issue of the magazine

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