KYC: Know Your Central bank

Yet another resignation of the Central bank’s Governor, Urjit Patel, mentioning “personal reasons” especially during the time when the tussle between the Central Government and RBI is evident, has surely raised many eyebrows.

Earlier, Former RBI Governor Raghuram Rajan had resigned on 4 September 2016 as the 23rd Governor of India’s Central bank without willing to take an extension. The trend continued with the resignation of Former Chief Economic Advisor Arvind Subramanian who had resigned stating similar reasons.

What is the struggle about?

It first began with the difference of opinion between the Central bank and Central government over the issue of excess liquidity in the system for Non-Banking Financial Institutions (NBFIs). These differences continued with respect to dilution of Prompt Corrective Action (PCA) that the RBI puts in place to assess, monitor, control and put in place some corrective actions on banks which are weak and troubled, to ensure that they do not go bankrupt. It finally got worsened, unfortunately, over the issue of invoking of Section 7 of the RBI Act, 1934 and reserve transfers.

What is Section 7 of the RBI Act?

Section 7 of the 1934 Act empowers the central government to issue directions to the RBI in “public interest”. This Section had never been invoked earlier by any government. Vagueness of the term “public interest” is worth noting as the Act does not define it.

In his tweet on 31st Oct 2018, Former Union Minister P Chidambaram said, “We did not invoke Section 7 in 1991 or 1997 or 2008 or 2013. What is the need to invoke the provision now? It shows that government is hiding facts about the economy and is desperate.”

Economic Capital Framework of RBI: What’s the clamour all about?

Over his remark with respect to Central bank reserve transfers, Former RBI Governor Raghuram Rajan in an interview to ET Now in November, mentioned that “RBI funds belongs to government and there is no doubt about it. Since it is a fully owned subsidiary of the government, all assets belongs to them. The RBI’s reserves, but, fall into two categories and that is, revaluation reserves (which have mostly to do with the change in the rupee value of the RBI’s holdings of gold and foreign currencies) and contingent reserves (which represents plough back of a portion of the surplus earned by the RBI every year). The remaining portion gets transferred to the government as dividend.”

These contingent reserves are there to absorb any kind of shock from unforeseen economic circumstances. According to him these reserves are “for periods of stress and not for meeting normal needs”. Rationally, RBI shouldn’t pay more than the profits and therefore these reserves should not be taken out as enormous dividend.

The reserves are also build for a better credit rating. According to Moody’s, India as a country has Baa rating. It got its first upgrade in 14 years from Baa3 to Baa2 in 2017. It implies that if the government wants to borrow from the international market it would have to pay interest based on Baa rating. On the other hand, RBI as a separate capitalized entity has AAA credit rating and therefore gives the country a vehicle which can actually make promises in the international market. For a rainy day, it also helps to have one entity in the country which is well capitalized and can hold its own in international capital markets.

Another argument worth noting here is that there are no free lunches either. When the Central bank gives any amount to the government, which is more than its profit, it basically sells the equivalent amount of sovereign bonds in the market in order to avoid any inflationary pressure. So essentially, the Public sector borrowing requirements does not change and the government has the same problem financing its deficit, as it had before. Moreover, the reduction in the asset side after having sold these assets in the market, have an impact on the liquidity (both rupee and dollar) and thus on monetary management.

International Norms vis-a-vis RBI:

Bank of Japan transfers its surplus at 5%, Greece at 8%, and Turkey at 12%. US Fed is required, by law, to transfer net earnings to the US Treasury after providing for all necessary expenses of the reserve banks, legally required dividend payments, and maintaining a limited balance in a surplus fund.

In the case of RBI, in effect, the entire surplus is transferred to the government after making provisions for such reserves. Though the RBI has a target of 12% (ratio of such reserves to total assets), it has not been able to maintain this and currently the ratio is about 7%

 RBI Board: Is there a need to recast ?

Another cause of concern is the extreme change in the nature of governance of the Reserve Bank. According to Mr. Rajan, the RBI Board now takes the operational decisions whereas earlier it used to play an advisory role, which was more appropriate. No central bank in the world is a Board governed institution. The professionals in the RBI should be left to take decisions. The working principle should be such, where the board must have its say and the RBI management is allowed not to accept the inputs of the board.

The move towards giving the Board more operational authority would impinge on the professional management capacity to regulate and supervise. The Board should be comprised only of professionals instead of a variety of industrialists and politicians, if they are to be authorized with operational power. Since the present board does not consist of the former, giving them authority over the decisions of the RBI, to some extent violates the principles on which RBI used to operate and should operate.

Conclusion:

Since many things have come to head between the Central bank and the Central government especially after the tenure of Raghuram Rajan, the government of the day must take extreme care on how it proceeds further with its relationship with the RBI. The circumstances which have led to the resignation have to be analysed and reversed.