• Sarthak Agarwal (with inputs from The Editorial

India's Central Bank Trouble


Urjit Patel’s recent resignation from the post of Governor of The Reserve Bank of India has raised a number of questions. This comes days after the RBI meeting with the government on November’ 19 which was marked with standoffs and confrontations. So, what is the RBI vs Government standoff?


The Prime Minister Narendra Modi led government has been at loggerheads with India’s Central Bank ever since it took office. First, the eminent economist Dr. Raghuram Rajan was not offered a second term, bucking established convention, as he differed with them on resolution of banks, and interest rates. He was succeeded by Mr. Patel in September 2016, who – much to his chagrin – gave in to the demonetization of bank-notes carried out on Mr. Modi’s announcement. Now, his resignation and the ensuing discussions have revealed several points of differences between the Central Bank and the Government – and raise serious questions about the bank’s autonomy.


Among the major points of contention is the RBI’s control over ailing Public Sector Banks (PSBs), which the government wants to loosen. The RBI established the Prompt Corrective Action (PCA) mechanism for banks with high rates of bad loans aka, Non-Performing Assets, courtesy of a culture of crony-capitalism and systemic inefficiencies in insolvency processes. PCA squeezes these banks on their ability to issue fresh loans and forces them to clean up their balance sheets before being able to lend more freely. This is problematic for PM Modi and his government, since it is about to fight a very difficult election that is taking place in the midst of severe farmer distress, and low growth. They would want the banks to lend more to corporates and farmers, to engineer credit led growth, while attempting to issue loan waivers to farmers. For this second wish, and to structure a tricky balance sheet, it is an open secret that the RBI is being pressured to part with funds – perversely referred to as RBI surpluses. The government’s simplistic argument is that the money with the RBI is the ‘people’s money’, and should be spent on the ‘people’. But its important to understand this idea in a little more detail.


What are the surpluses?

As a bank, RBI performs several functions. It gives loans central and state governments as well as gives liquidity to commercial banks. For this purpose, it needs to have a sufficient amount of capital to maintain confidence during liquidity crisis by giving financial support to the relevant parties. The question arises how RBI maintains this capital. RBI was given a small paid up capital during its inception. It was able to raise it using the profits it earned by investing in domestic and foreign bonds. But, as a government’s owned entity, RBI has to submit yearly accounts to the government stating its assets and liabilities. In addition to that, RBI has to transfer dividends, i.e. a proportion of profits, to the government u/s 47 of the RBI Act.

Dr. Raghuram Rajan (back) with Dr. Urijit Patel (front).


Before 2014, the RBI was transferring a part of its profits to a Contingency Reserve and the Asset Development Reserve, both of which are essential to ensuring the stability of the rupee and financial markets in the event of a major incident. A committee instituted by Raghuram Rajan – the YH Malegam Committee – found that the reserves had become CR and ADR were sufficient and needn’t be enhanced for a considerable time. Clearly therefore, the RBI was able to transfer greater profits to the governments as dividends after the committee’s recommendations were implement. This trend continued until 2017, when there was a sharp drop in the dividends paid. While no explanation has been provided, analysts speculate that this was owing to the costs of demonetization and the expenditure in printing and servicing new currency to banks. In 2016, that dividend paid was ₹65,876 crore; this dropped to ₹30,659 crore in 2017. In 2018, it is slated to be ₹50,000 crore to the government.


The drop in the amount of dividends paid in 2017 has not been explained by the RBI. However, analysts and experts believe that this was on account of the expenditure incurred by the RBI during the bank note demonetization and printing of new currency notes. The government had also expected to reap benefits from the 2016 demonetization – it passed a law to oblige the RBI to transfer any amount written off on account of liabilities from currency notes that never returned. But, a complete account of the demonetization exercise found that virtually every single note issued returned to the banks, and after accounting for circulation in Nepal and Bhutan, it could end up being slightly greater than the earlier expected liability. So, that did not work out.


Now the government wants the RBI to transfer what is being referred to as ‘surpluses’. This is over and above the dividends it has to send every year. While there are several heads under which these monies have been accounted, an overwhelming proportion of these funds is from the accounted increase in the value of RBI’s assets. The word ‘accounted’ is important to note in this regard. These assets are divided into foreign reserves, gold, and government bonds. Of these, the bulk of the increase is in the value of foreign reserves (computed in Rupees), owing to the depreciation of the Indian Rupee in the last 3 years, particularly against the US Dollar. However, the word ‘accounted’ is critical here. This is because the increase in the value of these assets is only notional – it will not be realized until the RBI actually sells the dollars, gold, or government bonds it holds. Further, selling such massive amounts of critical assets can send markets in a tizzy, and jeopardize the power of RBI in tackling fluctuations and maintaining stability.


RBI’s Stance

So, the government wants the RBI to undertake accounting tricks to transfer this amount to the government, on paper, without actually selling the assets. The RBI under Urijit Patel opposed this demand vociferously stating three primary arguments:

  1. It needs funds to manage financial stability risks.

  2. Use of RBI funds to finance fiscal deficits is undesirable.

  3. Lastly, it feels that dictating the use of reserves affects autonomy and independence of the bank.

The resistance came in the public domain when, Dr Viral Acharya, the Deputy Governor of RBI, used a public lecture to accentuate the importance of the independence of the Central Bank. He further compared the current government’s attempt to dictate the handling of the reserve to the underlying causes of Argentina’s Crisis. RBI’s opposition is also based on this accounting trick that is being suggested. The on-paper transfer of such a large quantum of funds would entail a reduction in the capital of the Reserve Bank, seriously jeopardizing its credit rating – at AAA, it is considerably higher than that of India itself (at Baa3, it is barely in the investment grade). This credit rating allows the RBI to engage in currency swaps and engagements that India’s own credit rating would never allow.

Dr. Raghuram Rajan (left) with Prime Minister of India Mr. Narendra Modi (right).


More importantly, this exercise is essentially handing over about Rs. 1 lac crore, in cash to the new government, and is akin to printing new currency – with obvious inflationary repercussions. It will also impugn the perception that Indian democracy’s institutions are autonomous and independent, adversely impacting their credibility and the financial confidence in the country. India would stand in the same league as countries like Turkey, Venezuela, and Argentina, in the manner that they treat their institutions and economy.


Government’s Stance

The government on the other hand, wants to assert its ownership and supervision over the RBI. It has argued that Central Banks across the world transfer their surpluses to their respective governments. The government’s response, flagged out by Mr. Subhash Garg, Secretary - Economic Affairs. He argued that the government intended to bring forth a new framework for the usage of surpluses generated by RBI. This was something that the government pressed on the Mr. Patel in the Board meeting on November 19. In addition to concessions on PCA and bank lending, Mr. Patel was forced to concede a review of the RBI’s surplus management. The decision was reaffirmed by a subsequent board meeting in December, under the new Governor Mr. Shaktikanta Das. Mr. Das is a former bureaucrat who spearheaded the implementation of the banknote demonetization. He is not a career economist, which is a rarity in the institution and has raised concerns on the independence of the institution during his tenure.


Shaktikanta Das, Governor of Reserve Bank of India.


Unable to streamline the finances of PSB by injecting fresh capital using its own resources, it wants to use the transfer to inject more equity in these banks and bring them out of the PCA. It also hopes to force the RBI to relax PCA norms. The underlying reason behind this is to enhance credit generation in the economy to spur growth. To this end it wants to change the RBI’s restructuring mechanism for banks, which mandates curbs non-performing assets (NPAs). The RBI currently requires all parties defaulting for more than 180 days to be dragged to an insolvency court. The government sees this mechanism harsh and is unhappy with the short window provided.


The Way Ahead

The entire episode of Mr. Patel’s resignation leaves a bitter aftertaste. The appointment of a career bureaucrat has not helped the sentiment for most people, but at the same time, it has calmed those nervously contemplating the appointment of a yes-man. The tensions between the apex body and the government are rising. Many supporters of the government have long claimed that the regulator needs to be cut down to size. The point of view is that there’s no such thing as independence from an elected government in a democratic republic. However, at stake is not statutory, but operational independence of the RBI. The new Governor will have to demonstrate his willingness to stand the ground, so as to build trust in the economy, and ensure credibility.


The Urjit Patel resignation episode is by itself not going to change India’s economic trajectory. However, a slippery slope has been created, and it could end with the old view of the Central Bank being just an adjunct of The Finance Ministry, existing to meet the fiscal needs of the government of the day, and ready to crank the printing press on demand. The question is not of one individual but of a deeper institutional arrangement – and the economic stability of India.


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About the Author


Sarthak Agarwal is a student of Management Studies at the Shaheed Sukhdev College of Business Studies, Delhi University. He has won several national and international level business and strategy competitions, and also runs a blog where he decodes and explains articles published in The Economist Magazine.

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