Banking on politics

- November 1, 2018
| By : Vidhi Desai |

It’s in Modi’s best interests to not meddle in the working of the central bank The Reserve Bank of India (RBI) and the Narendra Modi government are at loggerheads. Media reports now suggest that the government has been sending letters to the RBI under Section 7 of the RBI Act, 1934. As per this section: […]

It’s in Modi’s best interests to not meddle in the working of the central bank

The Reserve Bank of India (RBI) and the Narendra Modi government are at loggerheads. Media reports now suggest that the government has been sending letters to the RBI under Section 7 of the RBI Act, 1934. As per this section: “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.”

Some sections of the media suggest that Section 7 has already been invoked, others suggest that Section 7 has just been mentioned in the letters. These letters apparently deal with issues like prompt corrective action of 11 public sector banks, making credit available for small and medium enterprises, etc. Section 7, a holdover of the British era which governments over the last 70 years have held on to, has never been invoked before.

In the recent past, the RBI and the Modi government haven’t seen eye to eye on more than a few issues:

  • The government wanting lower interest rates in the year leading to the Lok Sabha election next year.
  • The government wanting a stronger value of the rupee against the dollar.
  • The RBI has put 11 public sector banks, which are financially in a bad shape, under the preventive corrective action (PCA) framework. This has limited the ability of these banks to lend and to raise deposits. The government wants the RBI to dilute these norms and let these banks carry out lending.
  • In a notification, the RBI did away with half a dozen loan restructuring arrangements that were in place and which allowed banks to keep postponing the recognition of their bad loans as bad loans. This didn’t go down well with the public sector, given that they had to recognise bad loans as bad loans. This pushed up the need for fresh capital from the government to keep these banks going.
  • The finance minister Arun Jaitley blamed the RBI for indiscriminate lending between 2008 and 2014.
  • The government wants to set up a separate payments regulator to oversee the payment systems in the country. This is something that the RBI opposes. Let’s look at some of these issues in detail…

Low interest rates
In any financial system, some amount of friction between the central bank and the government is a good thing. Take this issue—every government in the world wants the central bank of the country to ensure low-interest rates, all the time. Governments want lower interest rates all the time so that people can borrow more and spend, companies can borrow and expand, and this ensures that the economy grows at a fast pace. But what the politicians and governments tend to ignore is that there are two sides to interest rates—the borrower and the saver. Unless someone is encouraged to save, someone cannot be encouraged to borrow. Hence, it is only reasonable that the interest rate on savings be good enough to encourage people to save. At any point of time, the interest rate on bank fixed deposits should be higher than the rate of inflation, in order to encourage people to postpone their consumption, and save money.

Value of rupee
In the run-up to the 2014 Lok Sabha elections, the BJP and Narendra Modi made the value of the rupee against the dollar a prestige issue. Not surprisingly, the fact that the rupee has been weak against the dollar in the recent past has been a reason for worry for the Modi led BJP. As I write this, one dollar is worth a little over ₹74.

The RBI has rightly not tried to defend the value of the rupee against the dollar at all costs. A central bank getting obsessed with defending the value of its currency at all costs is always a bad idea. It’s great to see RBI doing the right thing.

What we need to understand is that in order to defend the rupee against the dollar, the RBI needs to sell dollars and buy rupees. There are two problems here. One is that the RBI has only a certain amount of dollars that it can use. It does not have an unlimited supply, hence, getting obsessed with defending the value of the currency is inevitably a bad idea.

Also, when the RBI sells dollars and buys rupees, it sucks rupees out of the system. With not enough rupees going around in the financial system, interest rates can go up. This is something that politicians need to understand. In fact, this is something that has already happened because of whatever little the RBI has tried to defend the rupee.

PCA framework
The government wants the RBI to relax the PCA framework. The point being made here is that because of the framework, these banks cannot lend, and hence, enough lending isn’t happening. Actually, this is not true.

Let’s take a look at non-food credit growth. The banks lend money to the Food Corporation of India and other state procurement agencies, in order to primarily buy rice and wheat directly from farmers. Once these loans are subtracted from overall loans, what remains is non-food credit.

The non-food credit for the week ending October 12, grew by 14.49% in comparison to the same period last year. This is the highest growth that non-food credit has seen in over two years. Clearly, there is no shortage of credit being given out, despite 11 public sector banks being under PCA.

As Viral Acharya, deputy governor of the RBI, recently said, “This is because the reduction in lending at PCA banks is being more than offset by credit growth at healthier banks. This is indeed what one wants—efficient reallocation of credit for the real economy with a financially stable distribution of risks across bank balance-sheets.”

The fact that 11 public sector banks are under the PCA framework doesn’t seem to have made much of a difference to overall lending. Also, it is important that these banks continue to remain under the framework. This is the only way they can gradually work their way back towards some sort of a recovery.

After falling through much of PM Modi’s tenure, non-food credit has been picking up for a while now. In fact, how does lending to different sectors look? The lending to the retail sector in August 2018 grew by 18.21%. Lending to the services sector grew by a whopping 26.66%. Lending to agriculture grew by a very robust 12.42%. In fact, lending is currently growing at a rate of growth which should be faster than the nominal gross domestic product (GDP). The nominal GDP also includes the rate of inflation.

It’s when we look at lending to industry that we see issues. It grew by just 1.95%. Lending to large industry grew by 1.63%. Lending to medium enterprises grew by 6.47% and that too micro- and small industries grew by just 2.60%.

This is where the problem arises. In a year leading to the Lok Sabha elections, the government wants the RBI to ensure that banks lend more to the micro and small industry sector. Irrespective of the fact that the next year is an election year, lending to the small industries is important. But the fact of the matter is that banks are in no mood to lend to any kind of industry right now. The State Bank of India, which is not under the PCA framework, says this in its latest analyst presentation: “Personal [i.e. retail] Segment Continues to drive Loan Growth.”

When the State Bank of India is also not interested in lending much to small enterprises, there isn’t much RBI can do much about it.

Repo rate
The RBI did not raise the repo rate when its Monetary Policy Committee met in early October this year. But it has raised the repo rate twice since the beginning of this year by 25 basis points each. The rate now stands at 6.5%. The repo rate is the interest rate at which RBI lends to banks, and acts a sort of benchmark to the overall interest rate scenario.

It is worth noting here that the Federal Reserve of the US has been raising interest rates in the United States for a while now.

As interest rates in the US go up, foreign investors have been leaving India’s debt markets. The foreign investors have sold debt worth close to ₹58,000 crore during the course of this year. The arbitrage opportunity of raising money cheaply in the US and investing it in India at a higher rate of interest is not playing out as it was in the past.

In order to ensure that the foreign investor continues to stay in India, he needs to be offered a higher rate of interest. If the Federal Reserve keeps raising interest rates, the RBI at some point of time will have to follow. If it doesn’t, the value of the rupee against the dollar will fall. The larger point here is that as long as foreign investors are allowed free movement of capital from India, we can’t have both low interest rates and a stronger rupee against the dollar.

‘Indiscriminate lending’
Finance minister Arun Jaitley blamed the RBI for indiscriminate lending between 2008 and 2014. In fact, almost all of this lending happened, when the current top management of RBI was not around. Also, much of this lending was carried out by public sector banks. These banks have always been more under the control of the ministry of finance than the RBI. In fact, earlier this year, RBI governor, Urjit Patel, had told the Parliamentary Standing Committee on Finance that the RBI had inadequate control over them.

Payment regulator
As far as the new payment regulator issue is concerned, there is no reason that companies running payment systems shouldn’t come under the aegis of the RBI.

To conclude, it is best for the state of the nation that the Modi government let the RBI do its work, instead of constantly meddling with it. If the government wants to help the RBI, it can do so by appointing appropriate members to the RBI board. These must be individuals who have some experience in banking, rather than push in ideologues.