The rift between Reserve Bank of India (RBI) and the government escalated in the public domain after the speech by Viral Acharya, deputy governor of RBI. While delivering the AD Shroff Memorial Lecture in Mumbai on October 26, 2018, Acharya warned the government about the potentially catastrophic effects of undermining the central bank's independence.
The government was unhappy with the speech. It wants the RBI to relax prompt correction action framework, dilute disclosure norms for defaults, pay a higher dividend to the government, and open special refinance window for mutual funds, NBFCs, and housing finance companies among other demands. The government is reportedly also asking the central bank to hand over a part of its surplus reserves. Missing from the ongoing fierce debate on central bank independence Vs. intervention has been two crucial issues — factors that led to the current slugfest and haste to address the problem through short-term measures.
Since the introduction of economic reforms in India, RBI has been increasingly sensitive to inflation. Since then, concern to keep the value of the money constant became the primary objective of the RBI. Barring the year of global economic recession, RBI has been hawkish despite the signs of gloomy economic growth in the recent past. The government has long been pursuing the inflation-obsessed RBI to cut benchmark rates, but the central bank has been reluctant to soften its hawkish stance.
Importantly, the shock in interest rate is less effective compared to money base targeting. Such an interest rate policy cannot control the inflation due to supply-side bottlenecks; rather the RBI should curb the credit growth in the economy.
Moreover, hike in interest rates hardly influences inflation due to the growing imbalance between excess growth in the service sector and near stagnation in commodity producing sectors — agriculture and manufacturing. However, RBI does not acknowledge such inflation because such admission is inconsistent with its neoclassical framework.
Nonetheless, thanks to RBI, inflation has dropped from double-digits to single digit. But of late, the higher interest rates have been good for foreign investors but have been hurting domestic investment. Moreover, evidence suggests that foreign-invested firms were less engaged with export markets compared to that of non-FDI firms.
Credit Market Frictions
In the post global financial crisis period, RBI and the government encouraged domestic credit, particularly banks lending to large and small firms. When the domestic credit was found either inadequate or expensive, firms were encouraged to borrow in foreign currency. RBI relaxed the norms to borrow in foreign currency; and enhanced the caps on foreign investment.
Even the infrastructure sector, which does not enjoy natural hedge (forex earning) borrowed in foreign currency due to relaxed norms. However, structural flaws in the credit market were not fixed even after the quick recovery of the economy from the global shock. Such continued encouragement to foreign currency debt is counterproductive when the Nation is following is an export-led growth strategy since the early 1990s.
Now, the rupee depreciation has increased the cost of such loans and repayments; the balance sheets of the financial intermediaries especially the banks are under stress, as firms are unable to replay their domestic debt suggest a kind of twin crisis. Despite rupee depreciation, the possibilities of increase in the exports are bleak. The exchange rate depreciation deteriorates the balance sheets of the export firms through the foreign liabilities and bank-lending channel and nullifies the traditional competitiveness effect. Furthermore, empirical research shows that countries without better credit markets experience lower exports than those with a higher level of financial development. Thus, the hawkish stance not only constrains the export firms from reaping the benefits of depreciation but hurt the growth of small and medium enterprises (SMEs) which suffer due to lack of credit. The faux pas in the macroeconomic framework adopted since the 1990s was equally responsible for the current situation. The agriculture sector remains largely neglected whereas the liberalization of the manufacturing sector alone was considered as a panacea to problems of growth and structural bottlenecks remain unaddressed .
The tussle between the RBI and Government is not new as India witnessed such spats innumerable times. The current rift is less about the independence of the central bank and more about an attempt to find the short-term solutions to the problem by both the parties. RBI and Government have to negotiate and better to address the structural flaws. Inflation targeting is essential, but RBI should not accord it the status of doctrine especially when sources of inflation are also due to supply-side factors and sectoral imbalance. RBI needs to explore other policy instruments instead of the interest rate channel. The easing of interest rate not only boosts domestic investment but also reduces the dependence on foreign investment and debt and indirectly facilitate the exports. Hence, the demand of government easing of rates is legitimate.
At the same time, addressing the problem of non-performing assets (NPAs) is indispensable to make the credit market efficient and vibrant and hence, the government has to realise the importance of stringent measures. No doubt, NBFCs need some liquidity stimulus, which RBI has provided twice, but it does not help if those responsible for the crisis go unpunished.
It has now become indispensable to develop the bond market to reduce the dependence of industry on bank lending. Then banks can cater to the needs of SMEs and agriculture efficaciously. The government is answerable to the people, and legitimately, economic growth will be its concern. At the same, RBI reserves are not the source for government expenses. Instead, the government can tweak the fiscal deficit target, and such budgetary stimulus will be more effective than the monetary measures.
The RBI is the custodian of financial and macroeconomic stability and best judge of the markets; undermining its independence will have an adverse effect. It is equally important to understand that the democratically elected government has the mandate to serve and its concerns always do not lead to political business cycles. The wrath of the masses equally needs to be understood. Therefore, RBI and the government need to reach common ground and address the inherent weakness in the policy framework.
Gourishankar S Hiremath is Assistant Professor of Economics at Indian Institute of Technology Kharagpur. The views expressed are personal.
First Published: IST