The Government vs RBI conflict- real story

The Government vs RBI conflict- real story

In recent weeks, there is an agonizing trend of conflict between the government and the RBI. The RBI is accountable to the government through various constitutional provisions and regulations. They are not equal power entities.

Still, why there is the recurring conflicts between the two at a time when the economy badly needs sophisticated and careful economy management interventions from the two?

The central bank and the treasury (read Finance Ministry) are historically not good friends in most economies. You must put the Ministry of Finance (instead of the government) on the one side and central bank on the other.

Both have the power and responsibility to manage the economy through their respective fiscal and monetary policies. A coordination between the two is needed to make the economy successfully manage all the problems.

Transfer of capital reserves to the government

The latest issue of conflict is the government’ demand for the transfer of a part of the capital reserves with the RBI. RBI is having a capital reserve of 28% or around 9.5 lakh crores and is a highly capitalized central banks in the world.

The logic of capital reserve is that like commercial banks, the RBI should have enough capital to manage its liquidity operations banks (Commercial banks have a minimum CRAR of 9%).

The RBI accumulated capital from its retained profit after sharing the profit with the government. But in recent years, the government is demanding full profit transfer and is not letting the RBI to hold other reserves like contingency funds. The government has secured nearly Rs 50000 crores in 2017-18 form the RBI as profit share. RBI, in its part has deployed a ruled based Staggered Surplus Distribution Policy for sharing the profit with the government on a scientific manner.

Connection between capital reserves and the autonomy of the RBI

More than just a fund transfer, capital for RBI is highly correlated with its autonomy and independence. When there is sizable capital, the RBI need not approach the government in a contingency situation to manage its loans operations to financial institutions like banks.

Hence, when the RBI has to independently operate its liquidity interventions, sizable capital reserves gives it confidence. In the past, several central banks were recapitalized by governments when the latter lacked funds to provide liquidity to banks. This was mainly due to high level of profit transfer by the central banks to the government.

Of all issues, the capital reserve transfer is the core area of the conflict between the RBI and the government. Here, Deputy Governor Viral Acharya strongly defended capital reserves  with the RBI as a necessary buffer to smoothly manage liquidity operations that the central bank performs.

On its part, the government is trying to design a new  criteria for fixing the right size of capital reserves for the RBI (revealed by the Economic Affairs Secretary).

Emergence of the conflict

In India, the conflict between the two arose so visibly during the time of former Finance Minister P Chidambaram. At that time, the RBI Governor was not ready to reduce the repo rate in accordance with the wishes of the FM. Since then, the government introduced several steps with or without success to control the regulatory powers of the RBI.

Some recent incidents indicate that the government is in a mood to encroach the regulatory powers of the RBI.

In this angle, there are two features regarding the conflict between the RBI and the Ministry of Finance. First, the tussle is not a recent one and second, the government has been continuously making several efforts over the last few years in intervening the powers of the RBI.

Following events will reveal the areas and sequence of the conflict between the two that was severely surfaced in the last ten years. Remember, the issues are presented from a truth finder angle so that you can understand the issues and enough care is to be made while presenting them in the examination.

Time and the issueFinance Ministry The fact
2010 -Setting up of a regulatory super body – the Financial Stability and Development Council (FSDC) by the government to coordinate financial regulation functions. Finance Minister is the Chairman of FSDC.Finance Minister was made as the Chairman of FSDC.Usually, in every financial regulation bodies, the RBI Governor gets the apex authority. But here, the Finance Ministry occupied the Chairman’s role.
2012 – Continuous increase in repo rate by the RBI despite requests for repo cut by the Finance Ministry.Finance Minister P Chidambaram disappointed about the consecutive increase in Repo rate by the RBI. He says that the government will make a walk-alone in the growth path.D Subbrao was not cutting the repo rate. He said that lowering rates will add to excessive lending.
2013 – Financial Sector Legislative Reforms Commission (FSLRC) makes its recommendations.Made several recommendations that changed the relationship between the Government and the RBI, including taking away the functions of deposit insurance from the RBI.Most of the current initiatives by the government to curtail the regulatory powers of the RBI are rooted in the recommendations of the FSLRC.
2016- Constitution of the Monetary Policy Committee (MPC -takes decisions on repo rate and other monetary policy decisions.There will be three government appointed representatives in the MPC and the three remaining will be from the RBI. Previously, the RBI enjoyed majority in the Technical Advisory Committee (replaced by MPC).The RBI Governor doesn’t have veto power under the new MPC structure. He can have only a casting vote. Under the previous TAC, the RBI Governor enjoyed veto power.
2016 – Financial Sector Search and Recruitment Committee, Chaired by the Cabinet Secretary. Appointment will be made by the government from the selected list.The Committee will choose the members and heads of the RBI (including the Governor), the Securities and Exchange Board of India, the Insurance Regulatory and Development Authority.The move has imposed bureaucratic control over the selection of the RBI Governor.

 

2016: Government tries to create a public debt office with Finance Ministry by separating the debt management business from the RBI.Government will have direct control over its debt management.The removal of public debt management from the RBI reduces RBI’s ability to control liquidity and monetary policy operations. But the proposal has not been implemented by the government.
2016 – Demonetization.  The RBI Governor was not informed.Only selected persons with the Ministry including Economic Affairs Secretary Saktikanta Das administered it.The RBI was critical of the move. Hence, demonetization has weakened the power of the RBI; indicating that even on core issues, the RBI has lost its say.
2017- Proposal for the creation of a Resolution Corporation through Financial Resolution and Deposit Insurance Bill (later abandoned).The Bill was proposed to take away deposit insurance business from the RBI to the proposed Resolution Corporation.The proposal was abandoned. But again, deposit insurance is a core central banking business. Taking away the function from the RBI will be problematic.
2018 – Expansion of FSDC by including several government secretaries.The Government included several government secretaries in the FSDC. Government members increased to 8 (out of total 12 members)Expansion of FSDC diluted the representation of real regulators including the RBI, SEBI, PFRDA and IRDA.
2018 – RBI Governor says the central bank has limitations in controlling the PSBs. RBI cites 10 areas where the central bank has no power to control the PSBs.The PSBs have high level of NPAs. All the eleven banks that have high level of NPAs are PSBs.RBI cites IMF report (Financial Sector Assessment Programme Report on India (June 2018)) that there is limitations for the RBI to effectively regulate PSBs. Several statues block the RBI to regulate and discipline PSBs.
2018- The immediate issue: Proposal for the creation of Payment Regulatory Authority with Government appointed Chairman.Ministry of Finance appointed Panel under the Finance Secretary recommended a payment regulatory authority under bureaucratic chairmanship.The original consensus was to make an RBI delegate as Chairman.
2018: Prompt Corrective Action Plan on PSBs and lending norms on MSMEsThe Finance Ministry insists RBI to lighten regulations on 11 PSBs who have to face strict norms on lending because of their weak finances (high NPAs and low capital)The RBI is demanding more power on the regulation of PSBs. On the other hand, government asks for lighter measures on PSBs. The PSBs are facing difficulty because of the tough RBI regulations.
2018 Government threatens to invoke section 7 of the RBI Act for the first time since the inception of the RBI in 1935. The section powers government to issue directives to the RBI on the affairs and businesses of the RBI in consultation with the Governor.The Government-RBI interaction after the invoking of section 7 will give higher command to the government in the RBI affairs.
2018: Government insists RBI to transfer its supposedly excess capital reserves to the government to finance Recaptialisation of banks.

The transfer of the excess capital is the core area of conflict as the size of the RBI reserve is simply huge – around Rs 9.5 lakh crores.

Government says that the RBI has a capital ratio of 24% compared to its loan operations (LAF, WMO etc.) and hence there is excess reserves with it. This money should be transferred to the government to finance recapitalisation of PSBs and other fiscal operations.In recent years, the RBI has transferred high proportion of its profit to the government under the Staggered surplus Distribution Policy.

RBI’s credit operations (LAF etc.) necessitates higher capital with it when some liquidity crisis comes. This was the stance taken by Viral Acharya. History says that only a well-capitalized central bank can manage macroeconomic risks.

All these developments show that the tussle between the Finance Ministry and the government is not a short-term issue. It can be solved only with an open mindset to financial regulations from the government side. Weakening the powers of the RBI will create chaos in the financial sector and the entire economy.