The disagreements between Reserve Bank of India (RBI) and government are deep and serious. They are apparent in speeches, tweets and observations critical of the central bank from even highways minister Nitin Gadkari. It’s not uncommon for RBI and government to disagree on issues as they have different roles. But differences have been resolved through communication at senior levels. It’s this history which makes the current friction extraordinary as informal mechanisms to resolve differences appear to have broken down.
RBI’s role is not just limited to tackling inflation or regulating banks. It’s also at the heart of the system to ensure financial stability. Consequently, its credibility is all important and must not be messed with. Any action on the government’s part that undermines the central bank’s credibility will have an impact on financial stability. At a time when India’s domestic saving is not enough to fund investment, inflow of foreign investment bridges the gap. Among other things, this inflow could dry up if RBI’s functional autonomy is seen to be undermined.
Three issues seem to be at the heart of the current friction. One, Prompt Corrective Action (PCA), an RBI regulatory constraint on fresh lending by banks with a high proportion of bad loans. Two, differences about the extent of liquidity available for NBFCs, which play a critical intermediation role in credit to small businesses. Three, the “economic capital framework” for RBI’s balance sheet. These issues have shown up in one way or the other over the last three decades. Invariably, they have been resolved through talks where a compromise has been reached or one side has been able to persuade the other.
The need of the hour is to repair channels of communication. A central bank’s unique functions make it unrealistic for it to be governed like a joint stock company through a governing board. Operational issues need regular communication between RBI and government. This is why finance ministers have consulted RBI governors even while crafting the Union Budget. Government should avoid using a nuclear option such as Section 7 to ram its view through, as it will result in long-term damage to the central bank’s credibility whose consequences would be more difficult to manage than demonetisation. That was one victory of politicians over experts which damaged the economy; this one will be catastrophic.