A Piecemeal Reduction of the RBI’s Autonomy Will Not Solve India’s Liquidity Crisis

What we need now is professionalism in the finance ministry and a reminder to the RBI that it should also try and function within the broad policy directives given to it by New Delhi.

Ever since industrial growth slumped dramatically from 8.2% in 2010-11 to 2.8% in 2011-12, there has been a quiet struggle between the Reserve Bank of India (RBI) and the Ministry of Finance over who should take the final call on key decisions that decide the future of the economy.

Since 2012, industry, and increasingly the government, has leaned towards a relaxation of the high interest rate regime imposed upon the economy by the RBI in 2010 to contain resurgent inflation, and has been defending regardless of its impact upon growth till the present day.

The gloves finally came off last week, when, at the A.D Shroff memorial lecture, deputy RBI governor Viral Acharya issued an explicit warning to the present, and all future governments in Delhi, that if they did not cede unfettered independence to the RBI in the performance of its functions, they  would “incur the wrath of financial markets, ignite economic fire, and come to rue the day they undermined an important regulatory institution”.

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Four days later, it became clear that this was in response to the Narendra Modi government having invoked consultations under Section 7 of the RBI Act, which allows the government to issue directives to the RBI on what it must do, in the public interest. This clause is not as extreme as the media are portraying it to be. Its precise wording is “the Central Government may from time to time give such directions to the Bank as it may, after consultation with the Governor of the Bank, consider necessary in the public interest.” Such consultations, even if not done under Section 7, were normal from 1992 till 2003, when C. Rangarajan and Bimal Jalan were the governors of the RBI. Former governor Y.V. Reddy, who began the assertion of the RBI’s independence, also deferred to Prime Minister Manmohan Singh, when the latter virtually directed him to lower policy interest rates and relax credit controls in December 2008 after the onset of the global recession.

Today, the Modi government’s invocation of the rarely-used clause looks like an extreme measure because it has been publicised and followed by a diatribe against the RBI by finance minister Arun Jaitley, but principally because it has laid bare the unprecedented financial crisis that now grips the economy.

RBI deputy governor Viral Acharya. Credit: Reuters

RBI deputy governor Viral Acharya flagged risks of government “interference”. Credit: Reuters

Gurumurthy’s suggestion to the RBI

As more than one newspaper has reported, the bare knuckles fight was triggered by a suggestion by S. Gurumurthy of the Swadeshi Jagran Manch of the RSS (who became a part-time director on the RBI board in August) to transfer some of the reserves the RBI holds as a safeguard against foreign exchange crises to the government’s kitty. Instead of ignoring his suggestion, as scores of its predecessors have been ignored in the past by both Congress and BJP governments, Acharya chose to  describe the crisis into which a former governor of the Argentine central bank plunged the country in 2010 by resigning from his post and holding a press conference to inform the world that he had done so because the government had asked him to transfer $6.6 billion of its reserves to the treasury to enable it to pay the public debt that was maturing that year.

Not only did this cause a sharp fall in the price of Argentinian bonds, but a New York judge froze Argentina’s account with the Federal Reserve Bank of New York on the grounds that the Argentine central bank was no longer an autonomous agency but under the thumb of the country’s executive branch. The threat immanent in the anecdote was unmistakable .

What Acharya did not tell his audience though was that Gurumurthy had made this suggestion during a marathon meeting of the central bank’s board held the previous week, as a desperate remedy to a liquidity crisis in the banking system that threatened to snuff out thousands of small and medium sized enterprises by starving them of credit.

Virtually every paragraph of his speech dripped with a disdain for democracy.

To cope with this, commercial banks had already borrowed Rs 1,30,000 crores from the RBI using its short-term facility, but this could not go on for much longer. Several other part-time members had therefore also asked the RBI to ease some of the curbs on lending and taking deposits  that it imposed upon 11 public sector banks as part of its Prompt Corrective Action framework to deal with the mounting pile of bad debt. But the RBI had been unwilling to budge on this issue, while also not coming up with proposals of its own to ease the liquidity crisis.

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There were ample grounds for confrontation, but in his speech, Acharya took it to an altogether different level. He made it a point to tell his audience that he was not speaking in his personal capacity, but on behalf of the RBI. Virtually every paragraph of his speech dripped with a disdain for democracy. Shorn of it, what he said was that democratically elected governments have a short time horizon and are subject to populist pressures that they cannot resist. They cannot therefore be trusted to perform functions that require specialised knowledge, an  insulation from populist pressures and a long time-horizon.

Such functions need to be delegated to institutions, manned by experts,  that are essentially outside the democratic system. The judiciary, the election commission and preferably, as in Britain, the administration fall into this category. Managing the country’s inflation, exchange rate and money supply are also specialised functions that have been delegated to the RBI. It must therefore be given the independence it requires to do its job.

The government’s invocation of Section 7 looks like an extreme measure because it has been publicised and followed by a diatribe against the RBI by finance minister Arun Jaitley. Reuters/Saumya Khandelwal

Right only up to a point

Acharya is right only up to a point. Fighting a modern war is a highly specialised function. Maintaining battle preparedness is a long-term task and therefore needs to be shielded from the pressures of short term politics. As we are finding out to our cost, in a modern society, even running a high speed train system is a specialised function. But no one, anywhere in the world,  has suggested that an army chief, or a chairman of the joint services, should be given the same constitutional status as a Supreme Court judge or an election commissioner, much less made ‘independent’ of the government.

As H.R. Khan, a former deputy governor of the RBI, said to a wire service correspondent, independence is not the same thing as autonomy. In an increasingly specialised world, there is an urgent need for autonomy because it is the essential guarantee of professionalism. To attain high levels of professionalism, institutions have to be shielded from unpredictable changes of policy or quirky interventions in procedure.  But the institutions must work within a policy framework that is decided by a government that is answerable, directly or indirectly, to the people. They cannot take over the right to make the policy by themselves, much less oppose the policies that the government wants them to adopt.

In an increasingly specialised world, there is an urgent need for autonomy because it is the essential guarantee of professionalism.

That is what the RBI has been doing since 2007. In January 2007, it began raising interest rates and constricting the availability of credit to fight a price rise that, while it had an excess demand component in it, was mainly caused by a poor kharif harvest in 2006 and soaring world commodity prices that were being reflected by India’s now largely open economy. That the rise had almost nothing to do with domestic excess demand became apparent when, 15 months after it had begun to force interest rates up, inflation, measured by the wholesale price index, had risen by a full 9%.

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The RBI should have learned from this that the inflation of 2007 had nothing to do with domestic demand, but did no such thing and kept pushing interest rates up till July 2008 and brought them down drastically upon a direct instruction by PM Manmohan Singh. This “gross violation of the Central Bank’s independence” led to two years of 9.1% GDP growth and a rock steady exchange rate despite the lowering of the interest rates.

But the RBI learned nothing and forgot nothing. Three years later, when wholesale price inflation touched 10% in March 2010 on the back of a $1.2 trillion investment spree by China under a ‘fiscal stimulus’ programme run amok, it once again began to raise interest rates and curb credit savagely till borrowing rates, even for top-rated companies like Larsen and Toubro, touched 12%. And this time, when the Chinese two-year spending spree ended, global commodity prices crashed again in 2014. Inflation, measured by the same wholesale price index that the RBI had used to push up interest rates in 2007, turned into a deflation of more than 3%. The RBI still did not bring interest rates down.

Bengaluru: Former prime minister Manmohan Singh addresses a press meet at Karnataka Pradesh Congress Committee office during his visit to the state, ahead of the Assembly polls, in Bengaluru on Monday. Credit: PTI Photo by Shailendra Bhojak

The RBI kept pushing interest rates up till July 2008 and brought them down drastically upon a direct instruction by PM Manmohan Singh. Credit: PTI/Shailendra Bhojak/File

What the high interest rates did

The high rates did two things simultaneously: first, they killed the demand for real estate and drastically reduced the demand for consumer durables; second, they raised the cost of servicing debt to unbearable levels. The worst hit were, of course, all the infrastructure projects, for the longer was their gestation period, the greater was the pile up of interest that would have to be repaid when it began to earn revenues. One did not have to be a crooked crony capitalist, to be able to do the math and realise that the projects would never become viable and abandon them, leaving their bankers with credit notes that had become worthless pieces of paper.

Today the RBI has become a merciless schoolmaster, bent upon caning his errant pupils to within an inch of their lives. It absolutely refuses to recognise that it is, itself, the cause of their delinquency.

The crime that the Centre has committed is not that it has reigned in the RBI, but that it has given it too much freedom and stood by, paralysed by indecision, as it has systematically hurt the very sinews of the Indian economy spouting the arcane and so far unproven doctrine of “inflation targeting” to justify its action.

Monstrous betrayal of Indian capital

What neither the government nor the RBI are ready to acknowledge is their monstrous betrayal of Indian capital. For nearly 50 years after independence, the government monopolised the building of infrastructure and heavy industry. To do this, it issued treasury bonds and took loans from institutions like the Life Insurance Corporation and the Unit Trust of India at a 3% interest rate or less.  

Then, within half a decade of economic liberalisation, it vacated this sector altogether, in favour of public-private partnerships that took years to take off and are still facing teething troubles. In the meantime, accelerating growth rapidly pushed the country towards an infrastructure crisis. The gap was filled by the private sector.

Private promoters responded vigorously, especially after RBI governor Bimal Jalan, acting in concert with finance minister Yashwant Sinha, halved interest rates between 2000 and 2002. When the RBI raised the average lending rate by 3% in 2007, it not only increased the interest burden of investors, but also closed the IPO route for raising capital, leaving them no option but to borrow the capital they needed to complete their projects, at rates they knew they could not afford.

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As a result, several of them stopped further work on their projects and when no relief was offered to them, obtained Caribbean and Baltic citizenship to leave the country. Today, the value of abandoned projects has touched $150 billion and more than 200 companies are on the chopping block, including three dozen power companies that completed their investment but could not sell any electricity because they had not been provided the coal link that the government had promised them.  

If all this is apparent to me, when I am not a professional economist and do not have access to the data that the RBI and finance ministry have at their command, then why has the central bank continued with policies that have thrust virtually the entire non-agricultural economy of the country into the grip of an unprecedented liquidity crisis? The answer is that it is the RBI, which is now insisting upon “independence”, that has been systematically abusing the autonomy it was given as far back as in 1993.

Yashwant Sinha. Credit: PTI

Private promoters responded vigorously, especially after RBI governor Bimal Jalan, acting in concert with finance minister Yashwant Sinha, halved interest rates between 2000 and 2002. Credit: PTI

Using every trick in the book

It has used every trick in the book, such as refusing to distinguish between demand-pull and cost-push inflation, switching the measure of inflation from the wholesale prices that are responsive to changes in demand, to consumer prices that, in India, are almost entirely determined by shortages in supply. It has done so under the cover of doctrines such as ‘inflation targeting’, which has little relevance in a still low-level industrialising country like India.

It was to prevent a second such fall in the value of the rupee that the RBI has been clinging to high interest rates like a non-swimmer to a lifeboat.

The only justification I can find for the RBI’s refusal to lower interest rates when WPI inflation became negative and even CPI inflation fell below 5% in 2015, is that between January 2008 and March 2015, to keep their capital costs down, around 300 of India’s largest companies had borrowed Rs 4.5 lakh crore ($680 billion) abroad, mostly with maturity periods ranging from three to 20 years. Of this, 59% had been borrowed without any hedge against a fall in the value of the rupee.

The first huge devaluation, from Rs 43 in 2011 to Rs 62 in 2013, killed Kingfisher Airlines and forced star-rated enterprises like Suzlon and Jet Airways to sell the majority of their shares to foreign companies in order to survive. It was to prevent a second such fall in the value of the rupee that the RBI has been clinging to high interest rates like a non-swimmer to a lifeboat.

But this entire crisis was of the RBI’s own making. It was the 3% increase in borrowing rates in 2007 that started the rush for external commercial borrowing that continued well into the second year of Modi’s prime ministership. There is a huge volume of unimpeachable research that shows that countries with open economies cannot afford not to harmonise their interest and exchange rates continuously to maintain equilibrium. The RBI should have known when it started raising interest rates in 2007 that it would trigger an inflow of foreign capital borrowed by Indian companies. At the very least, it should have closed the automatic approval route through which companies like Reliance brought in $15 billion within three months and insisted that all future borrowing abroad be fully hedged against devaluation.

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Not only did it not do anything of the kind, but it also did not learn from the catastrophe that followed and insist that all future borrowing be hedged. Instead it clung on to high interest rates regardless of their cost to the nation till, as happened in Thailand in 1997, a sudden loss of confidence triggered another flight of foreign money from India this year. As a result, the rupee has lost 16% of its value in just over six months. IL&FS is the first victim of this crash. Many, many more will follow if the government and the RBI do not recognise the root of the problem and admit their role in causing it.

The Modi government has finally revolted against the RBI’s dominance. But it has done so sneakily, through its non-official directors on the RBI board and on a populist issue that affects thousands of small investors but whose piecemeal ad temporary resolution will do nothing to avoid the calamity that lies ahead.

Acharya is right in only one respect: such piecemeal and underhanded reduction of the RBI’s autonomy will only make the crisis worse. What we need is professionalism in the finance ministry and a clear-cut reminder to the RBI that its function is to manage money supply and interest rates only within the policy directives given to it by New Delhi. Those must focus on the resumption of industrial and employment growth.

Prem Shankar Jha is a senior journalist and author of several books.