To the Brink and Back

WHEN THE MARATHON meeting of the central board of the Reserve Bank of India (RBI) ended on November 19th, it put to rest a frenetic bout of speculation. The bank’s rather dull press release—long after financial markets had closed for the day—was something of an anti-climax. Contentious matters such as the Economic Capital Framework (ECF) of the bank, including the vexed issue of its reserves, ‘surplus’ or otherwise, a restructuring plan for Micro, Small and Medium Enterprises (MSMEs), and the quarrel over Government-owned banks put on a tight leash for Prompt Corrective Action (PCA) by the regulator, were referred to committees for further deliberations. After weeks of bitter wrangling, the two sides finally pulled back from what seemed like a destructive game of chicken that had left investors and financial markets unnerved.

So who chickened out in the end, the Government or the RBI? In Indian circumstances this question is indelicate, to put it mildly. The reality is complicated and the nuts and bolts of the relationship between the RBI and the Government is one of the most opaque and under-studied areas of India’s political economy. There are the usual anecdotes and memoirs that recount specific incidents from history. But in terms of formal models that economists sketch to understand real world events, there is very little to go on.

One insight comes from the economist Willem Buiter who wrote on the subject after the global economic crisis in 2010. His example was from Europe, where there was tension between the European Central Bank (ECB) and the Eurozone’s fiscal authorities—16 different national governments. The Mediterranean countries had run up huge debts that threatened the financial stability of the Euro area. Buiter concluded that fiscal dominance—a situation where the monetary authority gives in and monetises public debt and deficits—was the likely outcome. The ‘collision option’ where neither the ECB nor the fiscal authority gave in would have been catastrophic: a meltdown in financial markets would have been the certain outcome. In the end, the ECB did end up buying bonds under a ‘non-standard monetary policy’, better known as quantitative easing.

Buiter concluded, ‘In the real world, the usual outcome in a stand-off between the monetary and fiscal authority is fiscal dominance—the victory of fiscal authorities and the monetisation of public sector deficits and debts. Monetary dominance, in which the central bank forces the fiscal authority to cut its primary deficit to stabilise the public debt burden, is the exception to the rule. The reason is that regardless of the formal language of the laws ensuring operational independence or even operational and target independence of the central bank, when push comes to shove, the fiscal authority has the political clout to force the central bank to do its bidding.’

So where does India stand after the RBI board’s meeting? In the days since, there has been much speculation along such lines as ‘the Government has won this round’ or ‘the RBI has held its own’. These claims are oversimplified guesswork.

The issue of fiscal dominance cannot be inferred from the meeting of November 19th. As the RBI’s release noted, on key issues such as ECF, and ‘reviewing’ banks under the PCA framework, the matter has been left to technical committees. In the case of ECF, the formation of this committee is expected soon but it is plainly speculative at the moment when it will submit its findings or report. Similarly, it is the Board for Financial Supervision (BFS)—a committee of the bank that includes four directors of the central board—that will take a call on the PCA matter. The one point on which RBI allegedly ‘gave in’ was in pushing forward a year the date by which lenders would have to implement the last tranche of the Capital Conservation Buffer of 0.625 per cent, even as it maintained its prudential norm for their capital adequacy ratio: for safety, banks must have a capital base of at least 9 per cent of their risk-weighted assets. Given the stressed state of public- sector banks, this will not open the lending taps, something the Government wanted. There are technical metrics of a bank’s asset quality, which if they fall under a certain threshold, result in restraints on any further lending.

Much of the sound and fury in the days and weeks preceding the meeting was based on the assumption that the Government would ‘force’ the RBI to transfer its reserves and also let public sector banks off the PCA hook. When none of that came to pass, most headlines continued to blare that the central bank had been ‘arm-twisted’. This had more to do with cognitive dissonance than with banking or the relationship between the Government and the RBI.

Some of the speculation defies rational explanation. Take the issue of the Government laying its hands on RBI’s reserves. The first thing to note is the timing of the move, given that a general election is around the corner. If the motive is political, this should have come at least a year earlier. To speculate, say at least by October last year. These reserves are not ‘money’ in that by a flick they can land in the Union Government’s coffers. To do that, some time is required to dispose of RBI assets and hand over their proceeds to the Government. Given the amounts under speculation, anywhere from Rs 2.5 lakh crore to Rs 3.5 lakh crore, that cannot happen in a week or even a month. Even if the Government were to get hold of that money, it has hardly any time left to splurge on populist projects except perhaps simply handing out cash. For all its imperfections, that does not happen in India’s democracy.

Then consider the squeeze in lending by government- owned banks and the distress among MSMEs. The RBI release notes that, ‘The Board also advised that the RBI should consider a scheme for restructuring of stressed standard assets of MSME borrowers with aggregate credit facilities of up to Rs 250 million, subject to such conditions as are necessary for ensuring financial stability.’ Much has been made of the word ‘advised’ while ignoring the last part of this paragraph. The troubles of this sector are far more salient politically. Approximately 60 million such enterprises employed 110 million persons across the country in 2015-16 (National Sample Survey, 73rd round, 2015-16). Given the weaknesses in India’s employment generation, the shocks imparted by demonetisation and the implementation of the Goods and Services Tax (GST), it is natural that the Government would want banks to offer some relief. Any trouble in this sector is likely to have a political impact. Probably, the Government sensed this; hence the hurry for some action on this front. In this case again, ‘subject to ensuring financial stability’ implies a rider on whatever concessions the Government may have wrested from the RBI.

It is too early to conclude whether India finds itself again in an era of fiscal dominance—the norm since 1947 to 1998. That may come to pass in the months and the year ahead, or it may not. But this round of sparring between the Government and the central bank has left many rattled. After all, it was this Government that carried out a major reform in formalising the RBI’s Monetary Policy Committee framework in 2015. That was a major step forward in strengthening the operational autonomy of the central bank. No government would imperil that in the period just before elections. The political calculations on most of these issues, with the possible exception of credit for MSMEs, remain opaque. But one thing is sure: the episode has left a bitter taste all around.

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