RBI vs Government Tussle: Urjit Patel Resigns, Appointment of New Chief, PCA Framework For Banks, Question of Surplus and More...

We live in interesting times.

 

Last week witnessed a lot of drama. Elections in five states, Supreme Court announcing verdict on the Rafale deal, and of course a lot more happening at the RBI. The latest developments at the RBI have considerable ramifications on the health of the economy, and hence on you and me.

 

Let’s begin by asking some fundamental questions. What does the RBI do? Why is its independence important? Who takes the key decisions related to the RBI? Why is there a confrontation between the government and the RBI? What's next?

 

What is the Mandate of the RBI?

 

The RBI is the apex supervisor and regulator of the entire monetary system in India, including, and not limited to setting interest rates, regulating the money supply, and banking regulation - with an overarching aim to maintain price stability. Why are central bankers obsessed with inflation? Because it is considered to be an important indicator of the health of the economy.

 RBI vs Government: Urjit Patel Resigns, Appointment of New Chief, PCA Framework For Banks, Question of Surplus and More...

 

How Does the Central Bank Control Inflation?

 

Inflation is influenced by the supply of and the demand for money in an economy. RBI influences the supply of money by setting the interest rates at which it lends to banks, which in turn affects the rates at which banks lend to customers. Low interest rates suggest an increased supply of money. Consumers want to buy more, industries want to manufacture more, and the money to do all this is available at a low interest rate. This leads to growth in GDP (borrow money -> make stuff -> sell for money -> return to bank -> keep the profits).


The RBI sets these interest rates via a panel called the Monetary Policy Committee, consisting of three RBI members (including the Governor), and three government officials. The Committee meets 8 times a year to set a new interest rate for the following period.

 

Therefore, low interest rates theoretically are good for GDP growth. However there is a down side. As supply of money in the economy increases because of the low interest rates, inflation also starts to increase (i.e. as supply increases, money becomes even cheaper, meaning you have to pay more to buy the same things). This hurts GDP growth in the long run, which is why the RBI has to maintain a balance between keeping the rates too high or too low.

 

Why is the RBIs Independence Important?

 

The Government does not control interest rates. Why is that? Let’s begin with investors - those who lend money in the hope of a good return. Investors detest risk and uncertainty, and prize stability above everything else. Hence, they flock to countries which have a stable government, a moderate and stable inflation rate, and a strong rule of law. This means that they can theoretically put their money in and earn a guaranteed return some time in the future. However, if the government is unstable, there is an added risk for investors - they demand a higher interest rate to lend to risky countries. This means that war torn countries find it hard to raise money, and hence unable to fuel growth, subsequently finding it harder to access money - perpetuating a self reinforcing cycle.

 

Inflation rate is a very important signal for investors - ensuring that their investment does not erode over time. Therefore, it is important for the economy to keep the metric stable.

 

So far so good.  But why would the RBIs and government’s objectives be any different? Why would there be any disagreement? Why wouldn’t the government want inflation to be stable?

 

A short and highly simplified answer follows - governments are in it for a short term of 5-10 years. In this period, their primary motive is to deliver short term GDP growth which pleases the masses and increases their chances of getting elected in the next. As described above, the easiest way to spur GDP growth in the short term is to make money cheaper (i.e. lower interest rates). But this has risks for long term growth as investors' returns erode and they start pulling out money from the country, leading to lower investments and hence lower growth. Precisely why the mandate of setting interest rates is kept away from the government's purview.

 

Who Takes the Key Decisions at RBI?

 

The Central Board of Directors is the main decision committee of the Central Bank. The Government of India appoints the directors for a four-year term comprising of a Governor, and not more than four deputy Governors; four directors to represent the regional boards — usually the Economic Affairs Secretary and the Financial Services Secretary — from the Ministry of Finance and 10 other directors from various fields.

 

The RBI is governed by a separate law called the RBI Act, which defines its autonomy and its dependence on the government.

 RBI vs Government: Urjit Patel Resigns, Appointment of New Chief, PCA Framework For Banks, Question of Surplus and More...

 

What are the Key Issues of Conflict Between the Government and the RBI today?

 

The governments wants to kick start the GDP growth which slumped in the previous quarter, just before a crucial election year. To get this done, it needs cheap money i.e. lower interest rates. In addition, the Indian banking system today is in the grips of a severe Non Performing Asset (NPAs) crisis - large loans given to industries have been defaulted on (Nirav Modi et al are just the face of the crisis). RBI sees NPAs at 12% of total loans in March 2019. This means out of every Rs 100 lent out, Rs 12 is at varying levels of risk of not being returned. Naturally this makes banks more cautious while lending, as they fear not getting the money back. Subsequently, there is less money in the economy for investments and to fuel growth.

 

To reduce these NPA levels, the RBI issued circulars to various banks under the Prompt Corrective Action (PCA) framework (which was showing results - 3 banks show signs of revival under PCA). This framework forbade some banks from lending excessively until their NPA levels reduced, further reducing the supply of money in the economy.

 

In a crucial election year, the government needs money to circulate in the economy, and the above factors mean that money is in short supply. Therefore, over the last few months the government has been pressuring the RBI via various methods (appointing its supporters on the RBI board) as well threatening to use a little known section of the RBI Act (What is Section 7 and why is it seen as an extreme act against the independence of the RBI) which allows it to issue directions to the RBI in matters of public interest - i.e. tell it what to do.

 

More details here

 

So What Happened?

 

The timeline is interesting and well documented here - all the way from private disagreements to public statements by the RBI Governors warning governments against interfering with its independence, and by the government asking the RBI to act in the public interest. This finally led to the resignation of the RBI Governor and one of his deputies last week. The government showed no hesitation in appointing Shaktikanta Das, ex bureaucrat, also responsible for the implementation of demonetisation as the new RBI Governor. In the coming days, the RBI is expected to decide on the continuation of the PCA framework for banks, thus allowing them to lend more freely. It is also expected to decide on the transfer of part of the RBIs cash reserves to the government (more money to spend). What is the use of RBIs reserves and how much should be held? The article outlines the details, but the common consensus is that RBI reserves are higher than the global average and also that higher reserves allow economies to absorb greater financial shocks.

 

RBI Governor Shaktikanta Das

What Next?

 

Now we watch closely. It is almost a given that the RBI will ease regulations allowing more money into the economy in the short term. What is more important to gauge is how investors will react to it. If they start pulling out money from the markets expecting higher inflation and/or monetary instability, it could be very bad for longer term growth. The central question however remains - how far did the government go in getting a theoretically independent entity to agree to its decisions? And how will that affect the RBI and financial institutions in the long run?

 

Until next time.

 

You can subscribe to my weekly letter series titled "Policy & Governance for Dummies" by clicking here.

 

View the letter archive by clicking here.    

 

(We are now on your favourite messaging app – WhatsApp. We highly recommend you SUBSCRIBE to start receiving your Fresh, Homegrown and Handpicked News Feed.)