The government and the Reserve Bank of India (RBI) have not been able to find a middle ground to resolve outstanding issues. All eyes, therefore, will be on the 19 November board meeting of the RBI. It has been reported that RBI governor Urjit Patel might resign on that day. This is certainly not what the Indian economy needs at this stage. Such an outcome would not only create confusion in financial markets but would also affect the government’s credibility. The government would be well advised to reassess its position.
One of the contentious issues is that of the central bank’s reserves. The government believes that the RBI is holding excess reserves and a part should be transferred to it. However, the RBI is of the view that it needs reserves to attain its policy objectives. In this context, the economic affairs secretary communicated last week that there is no proposal to ask the RBI to transfer funds as is being reported. The proposal under discussion is to fix the capital framework of the central bank. He also noted that the government’s fiscal math is on track. In normal circumstances, a clarification like this would have allayed anxiety in financial markets. But the situation today is more complex.
If the government believes that RBI is holding excess reserves, or is looking at its capital more conservatively, what explains the urgency to “fix” it? The issue can be amicably settled by constituting an expert committee. Such a committee would be in a better position to look into the matter in detail and recommend the appropriate level of capital for the central bank and, if necessary, also suggest ways to transfer reserves to the government. This will make the process more transparent and financial markets will be in a better position to understand the issue. It is extremely hard to make a case that the government should be forcing the central bank to reassess its reserves.
A large transfer by RBI will, at best, optically improve the fiscal position and give some room to the government to increase spending in an election year. Further, as has been highlighted in these pages before, any reduction in the size of the RBI balance sheet will affect the flow of dividend in the future.
Although the government has reiterated that it will meet fiscal targets, managing government finances will not be easy. The fiscal deficit reached 95.3% of the full year target in the first six months of the financial year. The government was in a better position during the same period last year but could not maintain the target. Therefore, it is possible that because of lower than expected indirect tax collection, the government might have to cut capital expenditure, which will affect growth. It would want to avoid this in an election year. This is also the main reason why it is aggressively pushing for a relaxation in the prompt corrective action framework and improving liquidity in the non-banking financial space.
Since it is clear that the government and the central bank are not on the same page on these issues, their relationship is being widely debated. It has often been argued that the RBI is not an independent central bank.
However, the real question is: should the RBI not have the operational independence to attain the objectives given to it? Former RBI governor Raghuram Rajan has explained what RBI does with the analogy of a seat belt. The driver—in this case the government—has the option of not putting on the seat belt, but in case of an accident, the damage could be severe. Put differently, it is in the interest of the government to respect the central bank’s mandate of maintaining financial stability.
The government undoubtedly needs such a safety measure, as the road ahead for the Indian economy is likely to be bumpy. Financial condition in global markets will continue to tighten and growth is likely to soften. With volatility in global crude prices and the uncertainty of domestic elections, policy reliability in one quarter will provide some comfort to financial markets. Continued confrontation, or pushing the central bank too far on regulatory issues, will affect investor confidence in financial markets and the ensuing uncertainty will impact growth.
A one-time transfer from the RBI will not structurally improve fiscal dynamics and is unlikely to impress investors or rating agencies. On the contrary, it will be seen as an erosion of RBI’s operational autonomy and affect capital flows in the medium to long run. The government and the RBI board would do well to carefully examine the longer-term cost of their decisions on 19 November and beyond.
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