Don't Mess With India's Central Bank
The first repercussions of the impending departure of Raghuram Rajan from the Reserve Bank of India could now be visible -- and it looks like those who argued the independence of India’s central bank was under threat may have been right.
Rajan declared last month that he would not be seeking the expected extension of his term -- a move widely seen as being forced on him by the Narendra Modi-led government in New Delhi, which had publicly disagreed with several of his decisions and statements as governor. This was troubling. The government appeared to be uncomfortable with its inability, under Rajan, to direct the central bank’s actions. The implications for the RBI’s institutional stability and strength -- and for the credibility of India as an investment destination -- weren’t good.
Some of Rajan’s latest speeches suggest the government is close to knocking a further hole in the RBI’s authority. The governor has spoken out against a suggestion, which is gathering force in New Delhi, to use surplus funds with the RBI -- its “contingent reserve,” set aside for emergencies -- to recapitalize stressed state-owned banks.
The government’s motivations are understandable. It has committed itself to a pretty stringent path of fiscal consolidation over the next few years, one that would bring the fiscal deficit down to three percent of gross domestic product. However it has to do this at the same time as Indian banks -- in particular, the state-controlled banks that comprise 70 percent of the sector -- are dealing with a full-blown bad loans crisis. Estimates of bad loans vary widely, but may total anywhere between six and 12 per cent of GDP. The RBI itself estimates they may hit 8.5 percent of GDP by next March.
Recapitalizing the banks is urgent – they need about $140 billion in capital by 2019, according to Fitch Ratings -- but the government has set aside very little money to do so as yet. And soon after the next federal budget is presented at the end of February 2017, Modi’s government will probably go into election mode. Polls are due in 2017 in the crucial northern state of Uttar Pradesh, and the next general elections will be just two years away at that point. It’s obviously tempting to use the RBI’s funds instead of finding money from the general budget.
Such a move would reverse years of institutional evolution at the central bank. The RBI used to own significant stakes in some major Indian banks -- a conflict of interest for the central bank, which regulates the banking sector. Even though a government-appointed committee recommended as early as 1998 that these shares be sold, it wasn’t till 2010 that the sale actually took place. Rajan’s fear is that the current administration wants to reverse this process -- and he’s right, doing so would be disastrous.
Other bad ideas for plundering the RBI’s reserves have been floated before. In 2004, some ministers wanted to tap $5 billion a year from the surplus fund to finance India’s infrastructure-building program. Fortunately, the RBI -- with some timely help from the International Monetary Fund -- managed to hold off the government, greatly enhancing its reputation for independence. (It’s worth noting that in this, it did better than the U.S. Federal Reserve, which wasn’t able to stave off a law passed by the U.S Congress last December that dipped into its surplus to pay for U.S. highways.)
An attempt to use the RBI’s rainy-day cash pile would not just dent the central bank’s independence, but also the credibility of India’s already shaky fiscal arithmetic. It would make accounting for the exact amount that the government was spending impossible, as well as have unpredictable effects on inflation. It would thus vastly set back the RBI’s efforts under Rajan to establish a reputation as an inflation-fighting central bank.
Worryingly, the government’s apparent willingness to compromise RBI independence seems in keeping with several of its recent decisions. The controversial departure of Rajan is one such. The purpose was presumably to replace him with a choice with whom the government is more comfortable, perhaps its Chief Economic Adviser Arvind Subramanian, who first suggested dipping into RBI funds in his annual economic survey earlier this year.
The fact that the government has chosen to ignore the obvious means of recapitalizing banks is also revealing. The state-owned banking sector shouldn't be bailed out using RBI funds, of course -- but not by using tax money either. Instead, it should be guided towards privatization, and funds for recapitalizing the best banks should be raised from the markets. But movement on this is slow. Modi himself doesn’t seem too sympathetic to privatization.
India’s Prime Minister came into office promising “maximum governance, minimum government.” That’s what both the RBI and the banking sector need, not renewed state control.
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