Time for North Block and Mint Street to Make Peace

The bonhomie between the Mint street and North Block is over. It’s quite some time since the Finance Ministry and RBI are not Looking eye to eye. Raghuram Rajan’s tenure was not extended because Modi visualized that he might not get the support he needed for his more adventurous financial reforms. In comparison, Urjit Patel, an equally  competent and seasoned campaigner in RBI, was thought to be more amiable to toe the line of thinking of Central Government. Patel became Governor of RBI on 4th September, 2016 and Modi announced his decision of demonetisation on 8th November. Post demonetization Patel had to bear the brunt of the most unenviable task of printing and supplying currency notes over the length and breadth of the country. Patel, in spite of facing a hostile media and opposition refrained from uttering a word against the policy of demonetization.

The Finance Ministry thought that the new Governor has passed the litmus test. That it was not be started surfacing a year back. Before we analyse what transpired in the last one year, let’s take a look at the monetary policy framework of RBI a decade back, when subprime crisis in USA hit the global economy. US Fed followed an easy monetary policy to boost up the sagging economy. It reduced the federal fund rate to almost zero to revive the economy. The impact of global melt down was not so severe in India, however, RBI and the Finance Ministry worked in tandem to infuse an enormous quantum of liquidity in the market. The repo rate was reduced, in steps, from 9% to 4.75 % in the second half of the financial year 2008-09. The Cash Reserve Ratio reduced from 9% to 5 %. The Statutory Liquidity Ratio was brought down to 24% from 25%. Through these measures the liquidity made available increased by Rs 4.30 lakh crore.

Increase in credit boosts up economic growth if the the same is converted into merchandise goods and services. The Indian economy was slow to react resulting in excess money chasing fewer goods. Thus, increase in the consumer price indices was the natural outcome. The CPI went up by 15% in 2009 and continued to rise by more than 9% in subsequent years.  As a result, the RBI unleashed a tighter money policy from 2011-12 on wards. When Raghuram Rajan took over the mantle of RBI, he continued to follow the tight money policy in view of the unabated price rise in those years.

The tight money policy could be justified till 2014-15, but the rate of inflation started declining steadily from the second half of 2014-15 and through 2015-16, 2016-17 and 2017-18. The consumer price inflation is lowest at 2.3% in November 2018 from the same month of 2017. So the latest data on macro economy has highlighted lack of inflation, and raised the question if Reserve Bank of India has been too tight. Even the RBI has slashed its inflation projections to 2.7% for the second half of 2018-19, down from 4%. What is then that made the RBI Governor to keep the repo rate unchanged in the last two quarters? The policy repo rate is 4% higher than the  consumer price inflation which will reduce the demand for product in the interest sensitive sectors, such as, automobiles, housing and consumer durable goods. Resultant effect is to slow down growth in these sectors. On the other hand, by keeping the CRR and SLR unchanged investment demand in the corporate sector is adversely impacted.

Credit Crunch in MSME Sector

The double whammy of demonitisation and GST have already made huge dent on the growth prospect for the MSME sector. MSMEs account for a third of India’s GDP and employ 120 million workforce. This sector has a huge credit gap to the tune of Rs. 20 lakh crore. The banks are not willing to extend credit in view of the imposition of tighter credit norms for the fear of NPA. The share of bank credit to MSME sector has been shrinking over the last three years-from 5.9% in 2015 to 4.5% in 2018. Moreover, 11 public sector banks out of 22 have been categorized under Prompt Corrective Action (PCA) by RBI. It may be recalled that RBI imposed PCA norms on several PSBs in 2017.  Under PCA, banks are mandated to cut lending to corporates and focus on reducing  concentration of loans to certain sectors. They are restricted from opening new branches and paying dividends. Central Government and the lenders are demanding for relaxation of PCA norms. Dr. Viral Acharya, deputy governor thinks otherwise. According to him the restriction imposed is the right type of medicine required to prevent further haemorrhaging of balance sheets of these stressed banks.

Another point of difference between the Central Government and Reserve Bank is on the issue of capital adequacy ratio (CAR) following the Basel III norms. CAR is the bank’s capital to its risk exposure. In simple terms it is the amount of capital to be kept in the kitty of the bank against the credit extended to its lenders. As per the Basel III norms, it’s enough to maintain a ratio of 8%. RBI has, however, mandated to maintain a ratio of 9%. It is evident that all these measures taken by the apex bank has severely restricted the credit flow to virtually all sectors of the economy. The hawkish approach has enabled RBI to contain the inflation to a great extent, but severely impacted the growth. Further reduction in the CPI may lead to recessionary trend since the bottom line of the corporate sector will take a dip if the credit crunch policy is not eased out.

Is credit control the be all and end all policy for RBI?

As monetary authority RBI has as its objective of price stability, growth and financial stability. The weight and emphasis accorded to each of these objectives would vary depending on the overall macro economic conditions. RBI has also to fulfill the role of a regulator- it regulates commercial banks, cooperative banks, financial institutions and non-banking financial companies. It has developmental role to ensure inclusive growth, thus decisions on rural credit, credit to SMSEs and NBFCs are integral part of its policies.

NPA issue-Has it been addressed properly?

Having said that, it’s also pertinent to address the issue of exorbitant rise of Non Performance Assets (NPA) of the PSBs. Rajan was the first governor who flagged the issue of NPA during his tenure. He could visualize that here is one problem which could lead to a financial crisis if its fresh arising is not arrested and recovery/restructuring action for accumulated one is not taken forthwith. We are not going into the nitty gritty of the problem, but there is no denying the fact the PSBs had serious issues relating to governance and lack of due diligence for sanction of corporate loan. Under the directive of central bank, the PSBs started making provisions towards NPAs in their balance sheet. Now creating provision for a bad debt is the job of an accountant-easy to make and  easier to convince the auditors who are reasonably satisfied that profit is not overstated. But a manager’s job doesn’t end by⁸

creating a provision but the challenge is how and when he recovers the bad debt and inflict punishment to the personnel responsible for it. He must also make a systemic review to arrest arisings of bad debts in future.

The banks first created provision for NPA, now they are merrily writing off the amount. Look at the following statistical data revealed in the parliament by the Minister of state for Finance.

The gross non-performing asset ratio (to advances) for PSBs stood at 15% in 2017-18.

IDBI topped the list at 28%.

Only two PSBs, Vijaya Bank and Indian Bank posted profit in 2017-18.

The PSBs had to write off Rs. 1,28,229 crore in 2017-18.

India’s largest lender State Bank wrote off Rs. 39,151 crore, followed by IDBI (Rs. 12515 Crore).

There are only 22 Public Sector Banks. There are three layers of audit in these banks-internal audit, concurrent audit and statutory audit. In addition, RBI conducts periodic inspection of these banks. The monstrous growth of NPA is not a day’s phenomenon. it’s amazing that the bank management, the auditor, RBI and Finance Ministry have been mute spectators to such profligacy of public fund. To say the least, RBI has not been proactive in its role as regulator.

What is Section 7 of RBI Act

Section 7 of RBI act empowers the central government to issue specific directives to the central bank in the public interest. Section 7 has, however, never been invoked in the RBI’s history. Tensions between RBI and Government escalated when three letters were issued seeking Patel’s views on deploying central bank’s capital reserves to infuse liquidity in the economy. The Finance Ministry is of the view that RBI is holding excess reserve to the tune of Rs 4 to 4.5 lakh crore (total reserve being Rs. 9.60 lakh crore). Government has also advised to relax the norms of PCA framework for some of the PSBs. So in effect, the letters were issued to initiate consultation with the apex bank with a rider of invoking section 7 in the event of a stalemate.

Now this has raised a spate of controversy on the issue of autonomy of RBI. Is the Central Government intervening in the independent funtioning of the apex bank? In an interview to NDTV, Raghuram Rajan has said that as Chief Economic Advisor he had issued letter to the then Governor of RBI to share more fund with the centre. Again as Governor of RBI, he has received such letters from the centre.

What can the RBI do?

Autonomy of an institution is important. But an autonomous institution can not work in isolation causing instabilty in the economy. Macro economic structure of a vast country like ours is quite complex. Stakeholdrs are many. The central government is also a stakeholder. Therefore, anything that a central bank does, is required to be justified. If the problem of NPA was known from 2012, why didn’t RBI act earlier? At this point when liquidity is a major concern, the MSMEs are in dire need of capital, NBFCs are struggling to stay afloat, the monetary policy of RBI has to be tuned appropriately to meet the immediàte needs of the market. They can tackle the problem in two ways. One, increase the repo rate by 2% in two instalments in the next six months and reduce the CRR from 4% to 3.5%. CRR has been kept unchanged for the last 5 years. It’s an useful tool for the commercial bank to infuse liquidity in the market. Reduction of 100 basis point in the repo rate and reverse repo rate will do a world of good to instill confidence in the market. Two, by open market operation, a relatively lesser used tool in Indian money market but quite effective to inject the desired quantum of liquidity in the economy.

The other contentious issue of parting with the excess capital reserve by RBI needs in depth analysis. How much capital reserve is ideal, is it 8%, 16% or more. RBI holds 28% of its gross assets as reserve. Arun Jaitley thinks this is on the higher side as compared to other central banks. An independent committee headed by Y H Malegam, former Board Member of RBI didn’t recommend to transfer the past reserve to central kitty. They, however, recommended to transfer the entire profit of current year as dividend which the central bank has been doing for the last three years. This appears to be logical as RBI has the responsibility to defend the rupee against exernal shocks. Further, rupee depreciates by 10% p.a. as a result of which the FE reserve maintained by RBI is always inflated when expressed in terms of rupees.

Asking money from the kitty of RBI to meet the target of fiscal deficit is unheard of. It’s devoid of any logic. The Government has to take the responsibility for any shortfall in collection of GST or for that matter, increase in subsidy beyond budgetary allocation. The government must explore other means of revenue to meet the fiscal deficit target 3.2%.

Since the appropriate level of reserve for the central bank is one of the major flashpoints, the new governor Shaktikanta Das has decided to set up one more panel to recommend how much reserve can be considered adequate for the RBI. It would be interesting to watch the development in mint street considering his proximity to North Block.