Govt-RBI Tiff: Is there a Middle Way?

Case Code: ECON070
Case Length: 17 Pages
Period: 1935 – 2018
Pub Date: 2019
Teaching Note: Available

Price: Rs.500
Organization : RBI
Industry : -
Countries : India
Themes: Politics & Business environment

Introduction

On October 26, 2018, Viral Acharya (Viral), deputy governor of the Reserve Bank of India (RBI), India's central bank, brought a dispute between the RBI and the Indian government out into the open when he made a fiery speech at the AD Shroff Memorial1 Lecture. Viral stated, "What matters is the effective independence with which these powers (vested in the Acts governing the RBI or any central bank) can be exercised in practice.” He added, "Governments that do not respect central bank's independence will sooner or later incur the wrath of financial markets, ignite the economic fire and come to rue the day they undermined an important regulatory institution." The speech followed tough posturing by the government, warning that it would invoke the dreaded Section 7 of the RBI Act under which it could hold consultation or issue directions to the RBI.

India had witnessed innumerable rows between the RBI and the government since the RBI was established on April 1, 1935. Of these rows, the Raghuram Rajan-Arun Jaitley and the Chidambaram-D Subbarao war of words had been the most prominent. However, the 2018 spat between Urjit Patel (Urjit), then governor of the RBI, Viral, and India’s finance minister Arun Jaitley was unparalleled and it brought out into the open the fractured relationship between the RBI and the government. The row between Urjit and the government started within a month of his taking over as the RBI governor when in November 2016, the prime minister demonetized the old INR 500 and INR 1000 notes. The RBI had to bear the brunt of the criticism against the botched and delayed execution of re-monetization. However, the real blame game started with the $2 billion Punjab National Bank-Nirav Modi scam with the RBI being blamed for being a sleepy regulator. But the action which led to the actual spat was the RBI’s move to put curbs on lending by some weak state-run banks, while the government, facing national elections in 2019, was keen on ensuring that the banks continued to lend to boost economic growth. Transfer of surplus from the RBI to the government was another contentious issue between the two. The RBI and the government also differed on their approach to matters relating to the payment systems regulator and the Prompt Corrective Action (PCA) norms for banks. At the November 19, 2018 meeting of the board of directors, the RBI gave way to some of the government’s demands. The RBI made concessions on the capital adequacy of banks, while two contentious issues of transfer of surplus reserves and relaxing norms for weak banks were referred to committees. Just when everybody thought that all was fine between the RBI and the government after the November 19, 2018 board meeting, Urjit suddenly resigned as the governor of the RBI on December 10, 2018, citing personal reasons.

Due to idiosyncratic historical reasons, the relationship between the central bank-government in India had evolved very differently from that in other countries. The RBI Act, passed in 1934, aimed at giving control of the central bank to the governor-general-in-council. After the nationalization of the RBI, these powers naturally devolved on the Union government. Further, its control became tighter as Section 7 was amended in 1949, authorizing it to give such direction to the RBI as was necessary in the public interest. While the legal provisions favored the government, the economic logic for the de-facto autonomy of the RBI was very strong. Avinash M Tripathi, associate research fellow (economics) at Takshashila Institution, noted, "When the autonomy of the central bank erodes, we will be back to the days of yore. Many decisions which seem technocratic today – say increasing the benchmark interest rate for fighting inflation – will be subject to the heavy political slugfest and will have to be adjusted to the electoral cycle. Ultimately, the monetary policy will become non-credible and ineffective." Amidst this backdrop, it remained to be seen how the government and the RBI would resolve the problem of autonomy.

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