Every country in today’s commerce driven world has an organization that acts as the Central Bank for the country. This organization is responsible for controlling and monitoring the financial as well as the banking system. The Indian central bank is the RBI or the Reserve Bank of India. Apart from its role as a regulatory body, the RBI also plays a significant part in the development strategy of the Government of India by formulating methods through which the government’s financial objectives for the overall development of the economy can be met. Hence it is very important that the RBI and the government work in tandem with each other. In this report we will address the complex interplay between the RBI and the government and its implication on the economy.
To appreciate the dynamics between the two entities, it is important to understand the modus operandi of RBI. Reserve Bank of India (RBI) is equipped with independence in formulating and implementing monetary policies in order to maintain price stability and adequate money supply in the system. RBI adopts different methods to achieve this objective and for this, it uses various tools such as Repo Rate, Reverse Repo Rate, Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR), Bank Rate, Open Market Operation (OMO) and Liquidity Adjustment Facility (LAF). Of these, Repo Rate is the most used tool by RBI as it has the maximum influence on the given money supply in the economy.
The following graph showcases the trend in inflation, growth and interest rates have been plotted for the past seven financial years from 2006-07 to 2012-13:
The Strained Relationship
Before NDA came to power in 2014, the relation between UPA and RBI’s former governor Duvvuri Subbarao had witnessed a downturn. Previously, Subbarao had been finance secretary to Chidambaram and hence had a good equation with him. He was appointed as the governor of RBI in Chidambaram’s first tenure. They had even worked together to save Indian economy during the financial global crisis. However, this did not help in solving the differences in opinion and the financial world soon witnessed a war of words between these two individuals.
There were many public pronouncements during the time of Mr. Chidambaram that made it evident that the air in between the Finance ministry and RBI governor D. Subbarao isn’t all that clear. The main reason for this was that RBI’s concern has always been to tame inflation or recession while government works for the overall growth of the country. Naturally, those concerned about the industrial collapse at that time cared little about the single-minded focus on inflation. However, the whole point of central bank independence is that it must decide monetary policy autonomously of the government and with inflation in mind. The relationship between the government and the RBI has many a time degenerated into a public spat about priorities, which has destabilized the development of this institutional arrangement. In an attempt to cover up, former Finance minister P. Chidambaram stated in his G20 meeting in Mexico that the relationship between finance minister and the governor in many other countries is same. Finance minister stated in November of 2012 “if government has to walk alone to face the challenge of growth, it would do so” – (economicstimes[dot]com). This was the consequence of keeping interest rates on hold in the half-yearly monetary policy review by Subbarao. This conflict clearly reflected the divergence of views between RBI’s actions towards monetary policy and government’s goals. Subbarao’s response was that RBI has done its part and now government needs to handle their part.
Another instance which highlighted the differences was when India registered a fall in its trade deficit in the month of June 2012 which led to the fall in the rupee. While RBI was disappointed with the latest developments, this incident gave a reason for government to cheer as oil imports, which accounts for the major share in the pie, had fallen to $12.6 bn from $15 bn in the month of May- an 18% decline contributed a sharp fall in Imports. Gold and silver imports too reduced to $1.9 billion from $4.3 billion on MoM basis. As the rupee had remained range bound (55-57), the revenue earned from the exports were also significant and with declining imports had reduced the trade deficit for the first quarter. In the midst of global slowdown, government took some bold steps to control Current Account Deficit (CAD) which did narrow down trade deficit but left a bitter taste with the RBI.
The disconnect seemed to be spreading worryingly into other fields including the government’s reappointment of Deputy Governor Subir Gokarn for an additional two-year term. Also with respect to the bank licenses in the past, the ministry’s very public pressure on the RBI to move forward with the licensing process even before the central government acquiring a sanction led to misinterpretation. In his last speech as a governor, Subbarao pin pointed at Chidambaram stating that he would say “I am often frustrated by the Reserve Bank, so frustrated that I want to go for a walk, even if I have to walk alone. But thank God, the Reserve Bank exists.” To add on to this Chidambaram added, “Subba, I know you like to walk alone but don’t dance alone.” (economictimes[dot]com). These sharp comment brought the sour equation between the RBI and government to the general public. Amidst all this, Mr. Chidambaram took the first step towards repairing the public perception about the state of the relationship. And moving ahead, the finance ministry and Reserve Bank of India tried to resolve issues impacting the ties between the two during the tenure of former governor D Subbarao.
The discussions that followed soon between Raghuram Rajan, who took over from Subbarao, and the finance ministry resulted in an informal arrangement that clearly specified the roles of the finance ministry and RBI. Under the terms of the informal framework, the finance ministry will have some say in financial sector reforms, although regulatory aspects will be RBI’s domain.
Dr. Raghuram Rajan takes over as the new Governor of RBI
On September 4, 2013, Raghuram Rajan was appointed the new Governor of the RBI. His takeover came amidst a lot of speculations about his way forward in solving the issues left behind during the tenure of his predecessor. He quickly set about executing some bold policies, which soon saw the Rupee rise up in the global market. Investors cheered his entrance into the RBI. A former International Monetary Fund chief economist who famously predicted the 2008 economic meltdown three years earlier before it struck the world, Raghuram Rajan came with rock solid credentials. “At the global level a lot of people have faith in him because he has interacted with them at the IMF,” says Kaku Nakhate, India country head at Bank of America. “Big investors really talk to him.”
Raghuram Rajan took immediate action to control the rupee’s slide. At a time when foreign fund inflow had decelerated and the government was considering a sovereign bond issue, Rajan opened a swap window for deposits from non-resident Indians. The swap window attracted $12 billion in just two months. He also sanctioned banks to borrow more overseas. These measures, along with easing in speculation of US strike on Syria and the continuation of the US Federal Reserve’s efforts to revive its economy, had improved Rupee’s stability.
Raghuram Rajan also normalized monetary policy operations by making the repo rate the most significant tool to indicate interest rates, stirring away from levers such as marginal standing facility (MSF), which is more expensive. Before he took over at the RBI, the difference between the repo rate and the MSF had widened to 300 basis points. This had encouraged large banks such as State Bank of India and ICICI Bank to raise their base lending rates, even though the repo rate was not increased. Rajan reduced the MSF rate in three phases and raised the repo rate, bringing the gap to a normal level of 100 basis points.
But as he worked his way towards achieving financial stability, India’s economy was being threatened by yet another change over.
BJP’s Landslide win, Congress humiliated
At the onset of 2014, India was gearing up for what many experts, both political and economical, termed as the biggest political battle India has ever scene. UPA government was shrouded in controversies and the Indian democracy had lost its faith in Prime Minister Dr. Manmohan Singh. With elections fast approaching, BJP’s Narendra Modi, the then chief minister of Gujarat, was campaigning aggressively and soon a Modi wave swept all over the country. While many expected the NDA government to win the 2014 elections, what happened in reality was unprecedented. Not only did NDA win the elections with 336 seats, but also BJP secured a single handed majority in the Lok Sabha winning 282 seats and the congress managed only a meager 44 out of the 58 seats won by NDA. As the world regained confidence in the Indian economy, everyone was eager to know his way forward. However, with this victory came speculations of yet another change of brass at RBI since it was evident right from the start that BJP was never confident about Rajan’s tactics to control inflation. This speculation caught the attention of the global investors and experts advised the government against such a move considering Rajan came with remarkable experience and credibility.
Beginning of new relationship: RBI & BJP
RBI’s Governor Raghuram Rajan shares a bittersweet relationship with the present BJP government and especially Finance minister Mr. Arun Jaitley that seems to be based on mutual understanding.
Points of Agreement:
In a recent interview, Jaitley said that the government will try to maintain balance between growth and inflation. It is trying to restart the investment cycle and move forward to a higher growth and better employment rate. The main strategy to curb inflation from the government’s side is to handle the food inflation and fiscal consolidation. While RBI will try to achieve the same by keeping the policy rates unchanged, as this will lead the banks to lend more to private sector, RBI has also decided to consult Jaitley while forming the monitory framework.
In a recent press conference called jointly by the Finance Minster and RBI chief, Arun Jaitley said going forward, the RBI should examine the liquidity situation, inflation and growth in setting policy rates.
Points of disagreement:
The strategies implemented by Rajan to curb inflation mainly involved increasing the repo rate. He did that 3 times in his 7 month tenure and due to this, he sure went into the good books of market experts but as far as industrial exerts and bond traders are concerned, he could not have been more wrong.
Increasing the interest rates, also discouraged many firms to invest and hire more people .This did not sit well with BJP government, as their main manifesto was all about employment. Rajan’s hawkish stance on ways of curbing inflation may have a positive impact as in making rupee stronger against dollar from 68 to 58 as well as dropping the CAD from 5% to 1%, even though it is on the cost of slow growth. Rajan defended his idea saying that Fiscal consolidation and Monitory framework are work in progress.
Another point of dissent between the RBI and BJP is FDI in retail. Rajan believes strongly that FDI is safer and better way to invest and suggests the government to open many sectors for such inflow. While Jaitley agrees with this particular idea, he vehemently is against FDI in multi brand retail ‘as of now’. This is to keep in the line, the idea of resisting foreign shareholders in Indian retail markets. In the 2014 Budget, Jaitley has outlined nearly Rs.60,000 crores in direct infrastructure investments and intends to attract more private financing in the sector where Government’s ability to spend is restricted by its own financial stability. The government, RBI and SEBI have announced a series of steps intended to encourage banks to lend to the infrastructure sector and attract investors to contribute to the equity of such firms. But according to experts, about 40% of total infrastructure loans are likely to be restructured by March 2015 as against 20% in March 2013.There are areas where the RBI could elongate the repayment period of infrastructure loans-roads and power, where it takes more time for the projects to make money than the loan repayment period. RBI is trying to incentivize the country’s lenders to raise longer-term resources by selling infrastructure bonds that are exempt from regulatory requirements like the CRR, SLR and priority sector lending. The sale of such long-term bonds had been permitted, but few banks had exercised the option, RBI wants to minimize certain regulatory pre-emptions to push banks into raising more long term resources.
The Way Forward
In his debut Independence Day’s speech, Prime Minister Narendra Modi launched “Pradhan Mantri Jan Dhan Yojana” to help the poor open bank accounts which will come with a facility of a debit card along with an insurance cover of Rs.1 Lakh. RBI has been trying to implement this scheme without much success since 2005. In fact, several thousand new bank accounts, opened under pressure from RBI, remained dormant or did not have a single transaction. RBI was also in disagreement stating that a Rs 5,000 overdraft “may not be allowed” for the 7.5 crores new bank accounts that the center is keen to open in the next year as a part of the financial inclusion drive.
Financial inclusion and empowering the poor is a necessity. There is no doubt at all that the poor are forced to borrow at significantly higher rates, are badly exploited by moneylenders and also forced to pay more for all goods and services. When rapacious micro financiers, insurers and others.1, attempted financial inclusion though micro-finance, it led to exploitation
Besides improved industrial activity, retail inflation fell to a 30-month low of 7.31 per cent in June as prices of food items, including vegetables, came down. Jaitley insisted that going forward RBI must examine the liquidity situation, inflation and growth in setting policy rates while RBI maintained status-quo on interest rate in its last two credit policies, notwithstanding the industry demand for cutting rates for boosting growth.
Committed to keeping the economy on a disinflationary course, considering CPI inflation at 8 per cent by January 2015 and 6 per cent by January 2016, RBI said that further policy tightening would not be warranted if the economy stays on this course. RBI board approved Raghuram Rajan’s broad contours of the restructuring plan, including the creation of a COO. Although there is no formal approval from the Government but statements from FM Arun Jaitley and others signal that it’s broadly in agreement with this strategy. The COO will probably be entrusted with implementing the ambitious reforms that Rajan wants, including pushing financial inclusion, differentiated banks and developing new structures for financial markets.
The RBI will also need to work with the new government in making other important decisions, including whether to remove restrictions on gold imports that have sharply narrowed the current-account deficit but are believed to have spurred in increase in smuggling.
Although RBI is an autonomous organization, for a country to pass the test of time, its central financial authority and government should be able to see eye to eye in matters. As the relationship between RBI and current ruling government BJP is fairly new, it is too soon to comment on the future of this partnership. But the positive changes happening, both big and small, are giving a fairly encouraging signal.