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The first repercussions of the impending departure of Raghuram Rajan from the Reserve Bank of India (RBI) could now be visible—and it looks like those who argued the independence of India’s central bank was under threat may have been right. Rajan declared last month that he would not be seeking the expected extension of his term—a move widely seen as being forced on him by the Narendra Modi-led government in New Delhi. The government appeared to be uncomfortable with its inability, under Rajan, to direct the central bank’s actions. The implications for RBI’s institutional stability and strength—and for the credibility of India as an investment destination—weren’t good.

Some of Rajan’s latest speeches suggest the government is close to knocking a further hole in RBI’s authority. The governor has spoken out against a suggestion, which is gathering force in New Delhi, to use surplus funds with RBI—its “contingent reserve", set aside for emergencies—to recapitalize stressed state-owned banks.

The government’s motivations are understandable. It has committed itself to fiscal consolidation over the next few years. However it has to do this at the same time as banks—in particular, the public sector banks that comprise 70% of the sector—are dealing with a full-blown bad loans crisis. Estimates of bad loans vary widely, but may total anywhere between 6% and 12% of GDP.

Recapitalizing the banks is urgent but the government has set aside very little money to do so as yet. And soon after the next Union budget is presented at the end of February 2017, Modi’s government will probably go into election mode. Polls are due in 2017 in the crucial state of Uttar Pradesh, and the next general election will be just two years away at that point. It’s obviously tempting to use RBI’s funds instead of finding money from the general budget.

Such a move would reverse years of institutional evolution at the central bank. RBI used to own significant stakes in some major Indian banks—a conflict of interest for the central bank, which regulates the banking sector. Even though a government-appointed committee recommended as early as 1998 that these shares be sold, it wasn’t till 2010 that the sale took place. Rajan’s fear is that the current administration wants to reverse this process—and he’s right, doing so would be disastrous.

An attempt to use RBI’s rainy-day cash pile would not just dent the central bank’s independence, but also the credibility of India’s already shaky fiscal arithmetic. It would make accounting for the exact amount that the government was spending impossible, as well as have unpredictable effects on inflation. It would thus vastly set back the RBI’s efforts under Rajan to establish a reputation as an inflation-fighting central bank.

Worryingly, the government’s apparent willingness to compromise RBI independence seems in keeping with several of its recent decisions. The controversial departure of Rajan is one such. The purpose was presumably to replace him with a choice with whom the government is more comfortable, perhaps chief economic adviser Arvind Subramanian, who suggested dipping into RBI funds in his annual economic survey earlier this year.

The fact that the government has chosen to ignore the obvious means of recapitalizing banks is also revealing. The state-owned banking sector shouldn’t be bailed out using RBI funds, of course— but not by using tax money either. Instead, it should be guided towards privatization and funds for recapitalizing the best banks should be raised from the markets. But movement on this is slow. Modi himself doesn’t seem too sympathetic to privatization.

India’s prime minister came into office promising “maximum governance, minimum government". That’s what both RBI and the banking sector need, not renewed state control. BLOOMBERG

Mihir Sharma is a senior fellow at the Observer Research Foundation.

Comments are welcome at otherviews@livemint.com

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