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Indian government involvement in banking policy

21 November 2018 Deepa Kumar

On 19 November, the Reserve Bank of India (RBI) held a nine-hour board meeting wherein the bank agreed to review four policies in accordance with government suggestions.

  • The RBI board meeting followed media reports stating that the government had invoked Section 7 of the RBI Act, which allows for direct government involvement in central bank policy.
  • The government and the RBI reportedly both agreed on the meeting's outcome. Direct government interference in central bank policy is therefore now unlikely.
  • The government, however, is likely to increase executive scrutiny of the RBI through broadening the mandate of the RBI board and establishing internal committees.
  • This is indicative of the government's intent to increase executive control over some independent institutions. The Central Vigilance and Central Intelligence commissions are also at risk of such interference.

The Reserve Bank of India (RBI) board meeting followed a report in Indian newspaper The Economic Times on 31 October claiming that the Indian government had invoked Section 7 of the RBI Act, which allows for direct government involvement in central bank policy in matters that are considered important to the "public interest"; neither the government nor the RBI have since clarified whether Section 7 was indeed invoked. However, subsequent media reports have indicated significant government-RBI divergence on RBI policies, including the Prompt Corrective Action (PCA) framework (under which the RBI placed lending restrictions on 11 poorly performing banks) and the Economic Capital Framework (ECF, according to which the RBI decides the level of dividends that it pays to the government after maintaining reserves to protect India from future economic shocks).

Following the board meeting the RBI issued a statement announcing that it was reconsidering four of its policies, all of which the government had suggested revising. IHS Markit assesses that the recent escalation of rhetoric and government interference in RBI policymaking has been triggered by India's upcoming parliamentary elections, scheduled for the first quarter of 2019.

Direct government interference in RBI policy unlikely in pre-election outlook

Direct government interference - primarily via the invocation of Section 7 - is now unlikely, particularly since the RBI and the government reportedly agreed on the outcome of the board meeting. The ECF is a significant area of contention: to resolve this issue, a joint committee involving the RBI and the government will be formed, which IHS Markit assesses is likely to represent both sides' interests. The RBI also agreed to devise a scheme to restructure stressed assets of micro, small, and medium-sized enterprises; relaxed a deadline for banks to maintain a 0.635% capital conservation buffer by one year to March 2020; and agreed for its Board for Financial Supervision to review capital requirements for banks placed under the PCA - all of which reflected government suggestions. However, the RBI did not yield to prior government requests to provide a specific liquidity window for non-bank financial companies involved in infrastructure development, despite the latter representing a key policy tool with potential electoral importance.

Increased executive scrutiny of RBI actions via RBI board and internal panels highly likely

In addition to the RBI's agreement to review some of its policies, the fear of damage to market sentiment and increased volatility already caused by reports of Section 7's invocation is highly likely to have deterred the government from influencing policy more directly. However, the government will probably ensure longer-term executive scrutiny of the RBI, which is most likely to be implemented through a broader mandate for the RBI board. The government is also likely to demand that the RBI set up internal panels or committees - each dedicated to specific issues such as monetary policy management and foreign-exchange management - whose membership would probably include government appointees. The rationale presented for such measures is highly likely to focus on claims that unlike India's Securities Exchange Board and other financial regulators - the function of which is scrutinized either by an appellate authority or its respective board - the RBI is under-scrutinized, given that all of the bank's decisions are taken only by its governor and deputy governors, and that its board plays only an advisory role.

Outlook and implications
The apparent de-escalation of rhetoric is likely to positively affect market sentiment: on the day of the board meeting, the Bombay Stock Exchange benchmark Sensex gained by about 300 points to close at a six-week high amid expectations of a possible truce in the RBI-government dispute. However, the government's intent to increase scrutiny of RBI actions via the bank's board and dedicated in-house panels holds the potential to undermine or at least reduce long-term central bank independence.

Going forward - and continuing into the post-parliamentary election outlook - it is likely that the RBI and the government will engage in prolonged negotiations to ensure policy alignment, possibly extending this to include interest-rate setting and potentially even seeking an easing of rate policy ahead of the elections. Of the current 18-member board, four recent nominations between August and November 2018 were individuals that reportedly have close links with the government; further such nominations are likely in the post-election outlook, thus enabling increased representation of government interests in subsequent board meetings, which are called for discretionarily.

Following the revision of the four abovementioned policies, the government is likely to encourage an easing in the regulations of the Insolvency and Bankruptcy Code (IBC). In February, the RBI scrapped existing debt-restructuring schemes and mandated that a borrower would be forced into resolution proceedings under the IBC for defaulting on a loan repayment even by a single day. The government and companies in the power, steel, and sugar sectors have opposed such stringency, and are therefore likely to seek a revision of this policy.

This government's handling of its disagreements with the RBI is indicative of a broader intent to ensure that India's central government increases its control over the functioning of a number of independent institutions. Other bodies - including the Central Vigilance Commission (responsible for addressing corruption in government) and the Central Information Commission (responsible for disseminating information to the public) - are at risk of such interference. The risk of such action would be sustained in a post-election scenario in which the current government under Prime Minister Narendra Modi won a second term.

Going forward, the timeline of the review to be conducted by the committee examining the ECF will indicate the risk of a future escalation in rhetoric between the government and the RBI. Given that government demands for the RBI's "surplus reserves" are potentially motivated by a desire to fund increased public spending ahead of the elections, the review's postponement to a period after the election would raise the risk of renewed policy conflict. More immediately, Urjit Patel's continued role as RBI governor - rather than resigning as previously rumored - is indicative of an agreed compromise; Patel remaining in his post until the completion of his term would indicate a continued truce. His probable eventual resignation (although this is unlikely in the immediate term) would aid the government in establishing greater influence over central bank policy, possibly through the appointment of a more compliant governor.

Posted 21 November 2018 by Deepa Kumar, Analyst

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