Photo: RBI (PTI)
Photo: RBI (PTI)

Opinion | The return of excess capital is RBI’s indirect mea culpa

The transfer of reserves is the least RBI can do to combat the slowdown its high rates aggravated

The decision of the central board of the Reserve Bank of India (RBI) to transfer 1.76 trillion of excess reserves this fiscal year to the government is the right one, even though we will see critics tut-tutting all the way. The decision can be analysed from three perspectives: one, RBI under governor Shaktikanta Das has succumbed to government pressure, and thus compromised its independence. Two, one can fret about whether this bonanza will be blown up on populist freebies. The third way is to look at it as RBI’s way of compensating the economy for its own missteps over the last three years.

Let’s take the first point, that the executive has browbeaten the central bank into handing over its excess cash. On the face of it, this may seem true, for the whole process was precipitated by the previous finance minister, the late Arun Jaitley, demanding compulsory consultations under Section 7 of the RBI Act last year. This was accompanied by the government appointing some noisy critics to the central bank’s board, which demanded accountability from the RBI’s executive management. This led to the departure of the previous governor, Urjit Patel last December, and Das replaced him fairly quickly. If you put two and two together, there is little doubt that government pressure was important in getting RBI to see the light on several issues.

There is, however, another side to this story. In a complex economy like India, it makes no sense for the governor and the finance ministry to act like they are on different planets. Informal consultations between the bank and the government have always been part of the architecture of monetary policy, and if this back-room channel had broken down after the change in government in 2014, it is not exactly a crime for the government to demand formal consultations on monetary and prudential policies. So, the first argument is not quite valid.

The second perspective is to see the return of excess capital as indirect encouragement to the exchequer to blow up an unearned bonanza on populist schemes, or even to use it to plug the fiscal deficit with no effort on its part whatsoever. This argument is at least partly valid, for there is no formal understanding on what this money is to be used for. 1.76 trillion looks like money for jam even after banks are recapitalized with 70,000 crore upfront, and some additional resources are used to rescue worthwhile non-bank financial companies (NBFCs) through the purchase of some of their toxic assets. This can be done either indirectly through banks, or by setting up a specific toxic assets fund. As long as the money is used only for stabilizing and cleaning up the financial system, RBI’s large transfers are kosher, even warranted. But if the money is used to bankroll the next freebie, even one that is socially-justifiable like the Ujjwala scheme, it would be wrong.

But the third way of analysing the large payout is probably the best. If RBI today has to dig deep into its excess reserves to pay dividends to the government, it is actually a form of compensating the economy for its mindless policy failures over the last few years. These policy failures include, first, its inability to flag a bad loans crisis during the United Progressive Alliance years. Former governor Raghuram Rajan had himself admitted that most of the toxic assets were generated in the over-exuberant years of 2006-08, with the problem snowballing under his watch and that of his successor. RBI was also lax in detecting systemic fraud, as had happened with the Punjab National Bank in the Nirav Modi-Mehul Choksi scandal.

The bigger area of failure is clearly monetary policy. There is little doubt that the Monetary Policy Committee (MPC), under the tutelage of the previous governor, consistently overplayed the inflation threat and maintained policy rates at very high real levels, thus worsening instability in the financial system. If rates had been cut faster and earlier, not only would banks have been able to write off their bad loans more quickly, but corporates would have been able to raise more money from both markets and private lenders to pay off their costlier loans. A falling rate regime brings banks higher treasury profits and sends stocks higher.

It is difficult to estimate how much damage RBI and the MPC did to growth and revival prospects through these twin policy failures, but it would be a fair guess that gross domestic product could have been impacted by up to 1% in each of the last three years. In other words, while the fiscal side was deflating the economy with the introduction of the goods and services tax and higher levels of tax compliance, RBI worsened the situation with its own pro-cyclical policies even as a slowdown was visible.

From today’s vantage point of observing the medium-term impact of RBI’s actions on the economy, we can safely say that its policies were directionally wrong. The transfer of excess reserves to the government—which will ultimately filter back to strengthen the economy through higher bank credit expansion, higher government spending and improved private consumption—is the least it can do to combat the slowdown it was complicit in accentuating. It will be better than a mere mea culpa.

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