How the Centre meddled with the central bank

Viral V. Acharya, a former deputy governor of the Reserve Bank of India (RBI), credited many past governors of the central bank as his inspiration while formally launching his latest book, Quest For Restoring Financial Stability In India (Sage, ₹695) on a virtual meeting platform in July. But though he took pains to thank C. Rangarajan, Y.V. Reddy, D. Subbarao, Raghuram Rajan and Urjit Patel, there was one notable omission from this roll-call of gratitude: Bimal Jalan, RBI governor from 1997-2003. It is not known if this was deliberate or happenstance, but in many ways the exclusion also seemed to define the mix of emotions, preferences and ideologies that enveloped Mint Street during the tenure of Urjit Patel and Viral Acharya.

Both have now written books, as has become customary for all retiring central bank governors; both also seem to have synchronized their releases, though through different publishers. These are not memoirs in the genre of Y.V. Reddy’s Advice And Dissent. Nor are they kiss-and-tell potboilers: There is no vicarious pleasure to be derived from gossip about the RBI-government spat that dominated headlines during 2017-18. Both books are a collection of some old speeches and notes during their time in office, overlaid with personalized commentary.

This individualized assessment forms the superstructure for Patel’s book (Overdraft: Saving The Indian Saver, HarperCollins India, ₹599) , with his numerous speeches and Op-Eds providing the substructure. In Acharya’s case, the two exist in two distinct chambers but have a common thread. Both authors clearly do not wish to air soiled laundry but use their knowledge, data and accumulated academic wisdom to take on the government and present their side of the story.

Both books, make no mistake, are dripping with caustic criticism of government, illustrated through inexplicable changes made to extant policy architecture to benefit certain constituencies, including crony capitalists. There is rich insight into the political economy of government’s ownership of commercial banks and their employment as proxy instruments of fiscal intervention for political ends. The focus is, therefore, largely on the political impetus for policy shifts in the financial sector’s regulatory regime and how the government’s compulsion to manoeuvre—or manipulate—these changes spring from the basic nature of fiscal dominance, or a state of the economy in which the government’s spending and borrowing influences the design of monetary policy. In short, the government’s spendthrift behaviour leaves no room for an independent monetary policy.

These two issues—government’s insatiable appetite for expenditure and borrowings, and relaxing the regulatory and resolution framework for bad loans and giving a get-out-of-jail-free card to industrialists—were among the prime reasons for escalating tensions between Mint Road and New Delhi. Patel, and Acharya as his deputy, had banned government-owned banks with wayward balance sheets from additional lending till they got their houses in order. Alongside, in 2018, the monetary policy committee saw two interest rate increases (in June and August) and no rate action in April, October and December, even as the clamour for lowering interest rates was reaching fever pitch. Something had to give. Patel resigned on 10 December, five days after presiding over his last monetary policy meeting. Acharya left six months later.

Where does Bimal Jalan fit into all this? Around the time RBI increased interest rates in August 2018, overzealous mandarins in the Capital had started badgering the central bank to transfer part of its surplus to the government. An unseemly public spat ensued, a committee was set up under the chairmanship of Jalan and his final report suggested that the RBI had to part with its surplus. There could be another reason for Jalan’s exclusion: It is only during his tenure that the RBI’s monetary policy moved to a multiple-indicator approach from a single-target approach. When Raghuram Rajan, and thereafter Patel, returned to the single-target approach—flexible inflation targeting (FIT)—Jalan went public with his criticism. This must have rankled because former governors rarely criticize their successors in public.

Patel’s term in office was marked by an unwavering belief in the instrumentality of FIT, bordering almost on religious fervour. Patel had authored an excellent report in 2014 on the desirability of adopting inflation as the nominal anchor. However, the inherent mismatch between an FIT paradigm and the fluidity and flexibility woven into India’s political economy made collision inevitable. Patel failed to see that the political economy abhors rigidities, especially during elections, even though the government had initially blessed FIT. Things came to a head in 2018, months before the 2019 general election, a period when governments usually throw caution to the wind and pull out all stops on the road to electoral victory.

Acharya spells it out in his analysis: “accidents can occur swiftly…if an external sector shock in the form of a significant oil price rise coincides with the approaching of an election—when rise in government spending and increase in cash circulation create short-term stimulus and inflationary spike…my assessment is that such a scenario materialized in the summer of 2018 and the months to follow, one that the RBI sought to navigate without compromising its focus on restoring the foundations of financial stability."

Patel made his position rather intractable when, responding to the economic slowdown and ballooning bad loans that could have potentially caused systemic paralysis, he increased interest rates twice, tightened liquidity and came down with a heavy hand on weak state-owned banks, effectively stopping them from acting as government’s blunt instruments in fiscal expansionism. This particular backdrop thus informs Patel’s critique of government’s policy inconsistency; consequently, it is limited mostly to origination and (mis)management of bad loans.

Patel’s concerns are valid: Given government’s limited resources, it uses state-owned banks to generate aggregate demand and economic growth, primarily through a cheaper and easier credit regime. Apart from this policy prescription’s disastrous side effects—through weakening bank balance sheets, risk of systemic collapse and the embedding of delinquent behaviour—low interest rates and cheap credit are known to have limited scope in generating demand and growth.

It would have been instructive if Patel had also analysed the deleterious effects of demonetization, an economic shock that marked his entry to the RBI’s corner room. This harsh economic action led to a glut in savings with public sector banks that was used for indiscriminate lending to shadow banks, housing finance companies and real estate companies. In addition, demonetization was followed by the hasty introduction of an imperfect goods and services tax (GST), dealing a fatal blow to numerous small and medium enterprises already reeling under the after-effects of demonetization. Both these events eventually had an impact on bank balance sheets through the build-up of bad loans.

Yet Patel deftly skirts these momentous events that went on to define his tenure and subsequent exit. He does make substantive points about the flaws in government’s policy framework and the way this exacerbates India’s economic vulnerabilities. There is even an undertone of how the business lobby’s venal and baleful influence over government policymaking heightens economic risks. But Patel’s discourse feels a bit odd when juxtaposed against his acquiescence of demonetization and his deliberate dialling down of communication from the governor’s office (considered a critical central banking tool) to avoid comparisons with his immediate predecessor Raghuram Rajan’s public intellectual image. In contrast, Acharya was publicly critical of government meddling, much like the proverbial bad cop.

The two books should be made part of any aspiring banker’s essential reading diet. Both provide critical inputs for the ongoing debate about the policy scaffolding required for bank credit and bad loans. But, coming as they do from two former central bankers who are also successful academics, there is an inescapable, gnawing feeling of something critical missing.

Rajrishi Singhal is a policy consultant, journalist and author.