The Ministry of Finance and the Reserve Bank of India (RBI) are engaged in a dangerous game of chicken. Game theory tells us that “winning” or playing such a game to its conclusion is not in the best interest of either player. The consequences will be devastating for the country’s shaky banking system and credit and equity markets.
There are three main issues of contention between the government and the RBI:
1) The government wants to grab a big chunk (one-third from some accounts) of RBI’s capital reserve. Very prudently, the RBI is resisting this pressure citing the growing risk in the banking sector and its responsibility as the lender of last resort.
2) The government wants the RBI to be more generous in providing credit to the small and medium industry. The RBI contends that this sector’s woes come from demonetization and shoddy implementation of the goods and services tax (GST). Without structural changes to GST, additional lending to this sector will only create additional bad loans. In an irony of ironies, the government first decimated the small and medium-size industry with a hair-brained scheme like demonetization and now wants the RBI to save them by increasing credit.
3) The RBI regulates the banking sector to ensure that banks don’t go bust. It puts banks which breach regulatory requirements for minimum capital, return on assets and magnitude of non-performing assets on the Prompt Corrective Action (PCA) list. A bank on PCA is restricted from further lending. Currently, eleven of the twenty-one government-run banks are on PCA with six more on the brink. The government wants the RBI to amend its requirements and remove these banks from the PCA list so they can start lending money they don’t have. The RBI has wisely said, “nothing doing.”
Of course, this government is not going to take things lying down. It has shown in the past (demonetisation) that it enjoys flexing state power. Over the last three months, the government has repeatedly threatened to invoke a never-before-used section (Section 7) of the 1934 RBI Act which allows it to control the RBI through a central-appointed board. This step is meant to be used ONLY in an economic emergency and not to flex the government’s superior powers. Despite periods of severe economic difficulties in the past this section has never been invoked. To have the government threaten to use it now, in the last seven months of its tenure, and when the economy is supposedly growing comfortably at 7.5%, is indeed bizarre.
There is something strange going on.
But first, a quick description of the importance of an independent central bank in a modern economy.
Credit is the lifeblood of a modern economy. Too little, and it affects economic growth because companies cannot expand and consumers cannot borrow and spend. Too much, and it causes inflation which reduces the buying power of the currency and makes everyone poorer. It is therefore vital that the price and supply of credit be managed by a professional organisation staffed with trained banking professionals and experienced financial economists who have the freedom to make decisions without political or government influence.
This organisation is a country’s central bank. Almost every country has one but in varying degrees of independence. In developed economies, the central bank is virtually removed from the government in its operation and decision-making functions. The government may be able to appoint the Chairman (Governor), but it does not influence the two key decisions of the central bank—the price of credit (interest rates) and the amount of credit appropriate for the economy (money supply).
India’s central bank is the Reserve Bank of India. It has three areas of responsibility. Firstly, it is the banker of banks which makes it responsible for maintaining public confidence in the banking system. It does this by setting limits on bank lending. Secondly, it is also the government’s banker responsible for managing the country’s money supply–printing new money, destroying old bills, etc. In this role, it helps to fund the government’s fiscal deficits. Thirdly, and primarily, it protects the citizens of India by preserving the value of the currency by keeping inflation in check and maintaining the external value of the rupee.
There is an inherent conflict between the objectives of the government and the central bank due to the different time frames under which the two operate. The government consists of elected politicians whose vision is short-term, limited by the time frame of elections. In India, there is always an election around the corner, which means, a constant slew of new promises and handouts to political groups, and new welfare schemes. This largesse requires money and since there aren’t enough tax revenues to pay for these schemes, the politicians, if left to their own device, would be continuously pumping up the printing press for new money. But the RBI’s vision is more long-term. It cannot merely be a piggy bank for irresponsible government spending. It must, at all cost, maintain financial stability in the credit and equity markets. Any inconsistency in policy would spook these markets, and from the 2008 global economic disaster, we know that nervous financial markets are a recipe for economic disaster. So, unlike politicians whose survival depends on chameleon-like adaptability, the RBI is bound by the need for long-term consistency and clear policies.
To maintain long-term consistency, the RBI must remain an independent policy-making body. As things currently stand in India, while the RBI does consult with the government, it acts independently in choosing appropriate monetary policy instruments, and the RBI Governor is generally insulated from political pressure.
There is overwhelming evidence from research to show that an independent central bank is vital to keep inflation in check and promote financial stability and higher long-term economic growth. The 1970’s and 80’s were marked by periods of high global inflation, high interest rates and unstable economic growth. Starting in the 1990’s global inflation fell dramatically as countries moved towards independent central banks tasked with the objective of price stability. The Maastricht Treaty of 1992 created an independent European Central Bank fully committed to the goal of price stability. Soon afterwards independent central banks in Canada, UK, New Zealand embraced monetary stability through inflation targeting, followed immediately by central banks in Central and Eastern Europe and Latin America.
In 2013, India too embraced price stability and inflation targeting as the primary objective of an independent RBI. The government and the RBI signed the Monetary Policy Framework Agreement in 2015 which recognised the importance of price stability and inflation targeting and gave the RBI the independent authority to use all tools at its disposal to keep inflation between 2% and 6%.
The results have been remarkable. Annual inflation, which was 10% in 2012 and 9.4% in 2013, has dropped to an average of 4.2% since 2015. The government deserves some credit for maintaining the fiscal deficit to below 3.5% of GDP. But the bulk of the credit for lower inflation goes to the RBI for sticking to its mandated task of fighting inflation despite calls from politicians and old-school economists (some of whom now advise the government) to increase credit creation by lowering interest rates. Price stability is the key ingredient for economic prosperity because it creates an environment where trade and investment can prosper.
The evidence over the last three decades is clear: an independent central bank charged with a clear and defined policy provides the basis for strong monetary policy, low inflation and stable financial conditions. On the contrary, when monetary policymaking is discretionary and subject to political whims, we end up with disastrous results as witnessed recently in Argentina, Turkey and Venezuela. There is a consensus among financial economists that a country where politicians can overrule the central bank to promote excessive credit or to print too much currency is not the right place to invest because debasing the currency, promoting credit and ignoring the central bank disciplines have proved ruinous for residents and investors.
With that as background let’s put some light on the current dispute between the RBI and the government.
As the nation’s bank, the RBI generates income from lending money to the government and other commercial banks. It also maintains deposits of gold, foreign currency and currency notes which are invested in global capital markets to generate income. It uses this income for its operations and to print new bank notes. Whatever surplus is left is given to the government as a dividend after setting aside reserves to cover financial contingency.
The RBI as the lender of last resort is required to build capital reserves to protect depositors if there is a run on commercial banks. The amount it holds in reserve depends on an assessment of the risk perceived by the professionals at the bank. With India’s banking system currently facing severe stress, a prudent RBI wants to keep a ‘higher than average’ level of reserves to avoid an economic calamity.
The RBI has built up about Rs 10 lakh crore in capital reserves and the government, desperate for money to pay for election-year promises, wants to raid the cookie jar. It claims that the RBI has more reserves than it needs, and must give the surplus to the government. After all, it costs money to pay for toilets, homes and healthcare for all, loan waivers, pay revisions for government employees, OROP, MSP etc. There is no free lunch—someone has to pay for all this.
The reality is that the government has promised too many things to too many people, and now it doesn’t know how to pay for them. Its fiscal deficit has climbed over 3.5% (of GDP) and is likely to get worse. The fiscal deficit for 2018-19 is already 95 per cent of the budgeted estimate in just the first five months of this year, and this is BEFORE additional expenses related to loan waivers, the MSP hike, the recently launched healthcare scheme, and the big elephant in the room, the recapitalisation of government banks. On the revenue side, GST revenues have been about 13% below estimates and are unlikely to pick up because the government refuses to understand that the only way to increase compliance is by simplifying GST with one single tax rate across all products and services.
The government is now hoping it can raid the RBI reserves for money but the RBI says that it cannot, both legally and prudently, give up this reserve. And this is the genesis of the contention between the RBI and government.
Does the government have a case?
Chapter 4, section 47 of the RBI Act, titled “Allocation of Surplus funds” mandates the RBI to transfer the profits from its operations to the Centre in the form of a dividend. Anyone who has studied accounting knows the difference between profits and capital. The RBI Act requires ONLY that the central bank transfer its profits to the government and not the reserve capital built up over time. And in the last five years, the RBI has done so. It has given all its profit to the government—a total of Rs 2.124 lakh crores. See Table 1. In fact, as the data shows, the RBI has been more generous to the Modi government than it was to the Manmohan Singh government. During the two terms of Mr Singh, the dividend-payout rate – which is the surplus given to the government — averaged only 46.5%. This payout increased to 100% during the Modi years.
Table 1 shows the revenue, expenses, profits and reserves of the RBI. It is clear from the numbers that the Modi government’s complaints lack credibility. It is getting 100% of the profits generated by the RBI. In fact, this is the first government in the country’s history to receive every penny of the RBI’s annual profit. In the last four years, the RBI has paid as much dividend to the government as in the entire previous decade. If anything, it was the government’s self-goal, demonetisation, that resulted in a smaller surplus transferred to the government in 2016-17 (Table 1).
It is, therefore, quite rich for the government to blame the RBI for the country’s economic problems when the evidence clearly shows otherwise. If anything, the Modi government owes a big thank-you to the RBI for the bumper dividends it has received over the past four years that have helped its profligate spending and reckless management of the economy.
Table 1 ( Rupees Billion)
And here is the real irony. Because the RBI has transferred all its profits to the government, it has not added a single paisa to its contingency reserves in the last four years, despite the increased risk in the banking system. If there is a banking crisis and the RBI finds itself with inadequate liquidity guess who the government is going to blame. Yes, the fall guy will be the RBI. So, heads, the government wins, and tails, the RBI loses.
In most countries, the central bank is required to transfer a minimum mandatory amount from profits into reserves: France mandates 5%, Russia 25%, Indonesia 30%, but in India, the entire profit is being transferred to the government–nothing has been added to reserves in the past four years.
Table 2 and Figure 1 show the RBI’s capital reserves as a per cent of its total assets. The trend is indeed disturbing. RBI’s reserves have dropped steadily from 11.9% in 2009 to 7% in 2018. This is way below the minimum reserve level of 12% that the RBI’s internal analysis deems to be a safe level. That this decline in reserves comes at a time when increasing NPA’s are putting tremendous stress on the banking system should be a cause for concern to the government. It is, therefore, extremely irresponsible for the government to claim that the RBI has excess reserves and demand a part of these reserves. Firstly, there is no provision for this in the RBI Act, and secondly, the facts don’t support the government’s claim about excess reserves. On the contrary, RBI’s contingency reserves are well below what the current economic situation demands.
Table 2: Contingency + asset development reserves as a % of total assets Figure 1: RBI’s reserves are declining not increasing
It is indeed shocking, therefore, that the government thinks the RBI needs to send it more money. The RBI is not a typical public sector undertaking because it is not accountable to shareholders but to depositors. Millions of Indians depend on the banking system to ensure the safety of their life savings. In a time of crisis, the RBI will be required to inject liquidity into the financial system. It was the Federal Reserve Bank in the US that was able to pour in large amounts of its reserve capital into the financial system to contain the fallout from the 2008 Lehman crisis. Will the RBI be able to do so if there is a banking crisis? The Indian government should be concerned about this but its major focus is on the next seven months–damn the long-run.
The RBI’s reserve capital consists primarily of two parts: a contingency reserve to be used in case there is a run on the banks during a banking crisis, and an account called the currency and gold re-evaluation account (CGRA) which is the unrealized gain/loss in the value of gold and foreign exchange it holds. The value in this account fluctuates every day with the price of gold and the rupee exchange rate. As of June 2018, there was Rs 2.321 lakh crore in the contingency reserve account and Rs 6.9 lakh crores in the CGRA account.
Even if it was legally possible for the RBI to give some of this capital to the government (it is not), is it prudent to do so? In 2009-10 when the Indian economy was growing at 10% and there was no banking crisis, the balance in the contingency reserve account was Rs 1.53 lakh crore. Today, with a less robust economy and a growing NPA crisis the balance is only Rs 2.321 lakh crores. This appears to be inadequate and not an excess as the government claims.
In 2015-16, realising that the NPA problem was significantly larger than previously estimated, the RBI developed a ‘ stressed value-at-risk’ model to calculate its expected risk-buffer requirements. This model calculates the value of RBI’s losses under the worst market conditions by “stressing” all the variables that would affect its reserves, for example, volatility, interest rates, exchange rates. At that time the government approved of this methodology but now wants the central bank to go back to the old ‘value-at-risk’ model under which losses are calculated based not on the worst “possible” conditions but on “current” conditions. Again, the time inconsistency problem rears its ugly head—the government cares only about the short-term, i.e., current conditions, while the RBI is focused on the long-term, i.e., worst possible conditions.
What about the Rs 6.9 lakh crore of reserve capital in the CGRA account? In 2009 this amount was Rs 1.988 lakh crore. At that time the price of gold was Rs 1456 per gram, and the Dollar/Rupee exchange rate was 46.3. In June 2018 (the end of RBI’s latest fiscal year) gold was at Rs 3038/gm and USD/INR was at 68.4. The increase in the CGRA is, therefore, the unrealised gains on the rupee value of the gold and foreign exchange that the RBI holds.
Can the government claim this “unrealised” gain? Probably, if it invokes section 7. But the only way to realise this gain is by selling the country’s gold and foreign exchange reserves. Not only is this extremely imprudent but also makes no sense from an accounting standpoint. The asset side of RBI’s balance sheet is the gold and foreign exchange it holds, and the liability side is the currency it has issued against that. Selling assets to capture realized gains will require a commensurate reduction in liabilities i.e., currency in circulation. The net increase in capital in the system from this transaction would be zero. So if the government thinks it is getting free money by raiding these reserves it is only an illusion.
It is, therefore, hard to understand what the government expects to achieve by invoking Section 7 of the RBI Act. It already receives 100% of the RBI’s profit—more than any other government in history. And the capital reserves were never intended to be distributed to the government because they exist to protect depositors, not to pay for a politician’s election promises.
The only explanation for the government threatening to invoke section 7 is that the minions at the Finance Ministry are convinced that if they were more involved in “managing” the country’s monetary policy that somehow the economy would be in better shape. And that is a scary thought.
Politicians and bureaucrats always overestimate their capabilities but doing so at a time when the nation’s banking system faces severe crisis could have a devastating long-term impact on the economy. It was the desire to “manage” the economy and flex the muscle of state power that resulted in demonetisation. Repeating the same mistake will have the same disastrous results.
History shows us that governments that are unable to make and follow up on credible promises to the people cause great economic harm. The BJP government is guilty of making wild promises for political gains. It won in 2014 because it promised economic development based on the principles of smaller government and greater economic freedom. But once in power, it has governed with authoritarian zeal, flexing state power to control the institutions that provide checks and balances to state authority. Its Finance Minister talks a big game but appears unaware of what creates economic development. He is single-minded in his obsession with filing up the treasury and remains convinced that the only way to transform India is for the government to collect more in taxes. He needs to be reminded that institutions build a nation, and attacking the independence of the country’s central bank is not going to endear India to foreign investors.
And so after four and a half years of economic chaos, the government, instead of looking inwards and learning from history, is pointing its guns at the RBI, somehow convinced that if monetary policy were tweaked to provide “easy” money the economy would boom. The government of Venezuela, a country rich in oil, recently tried to print money to pay for the unrealistic promises it made to the people — the country is now tottering on the brink of social and economic chaos.
The Modi government needs to play its hand very carefully. Elections are not that far away, and economics plays a big part in how people vote. And when it comes to economics, what matters is not the 56 inches on the chest but the six inches between the ears. It needs to remember that an independent central bank is vital to India’s economic growth and development. Any attempt to mess with that arrangement will undoubtedly bring the wrath of financial markets. And if a contagion starts, India’s banking system, weakened by a decade of bad loans, will not have the liquidity to contain the damage.