The six key reasons for the falling-out between Urjit Patel and Team Modi

[Tipup]

It became evident yesterday (Dec. 10) that even the keenest industry-watchers had misjudged the extent of the rift between India’s government and its central bank.

As Urjit Patel, the governor of the Reserve Bank of India (RBI) abruptly announced his resignation, many were left stunned. After all, following a Nov. 19 board meeting, it was generally felt that the RBI had begun to mend fences with the Narendra Modi government. So even though Patel cited “personal reasons,” clearly, the tiff had reached a flashpoint.

Shortly after his resignation was announced, Patel’s immediate predecessor, Raghuram Rajan, who himself had a troubled relationship with team Modi, called the resignation a “statement of dissent.”

Patel’s departure, nine months before his term expired and ahead of the general elections next year, has huge ramifications for the Indian economy and does not augur well for the financial markets. “I think, this is something that all Indians should be concerned about because the strength of our institutions is really important for our growth, sustainable growth and equity in the economy,” Rajan said in an interview to the news channel, ET Now.

The strength and autonomy of the central bank were at the centre of the tensions between the RBI and the government. Matters escalated following an Oct. 26 speech by RBI deputy governor Viral Acharya, which warned of the “potentially catastrophic” consequences of government interference in the RBI’s affairs.

Shortly after, India’s finance minister, Arun Jaitley, returned fire and accused the RBI of sleeping on the job for its failure to check indiscriminate lending by public sector banks (PSBs) between 2008 and 2014.

Since then, the relationship has only slipped downhill, culminating in Patel’s exit. Here’s a look at how Patel and his team fell foul of the government.

RBI’s balance sheet
Every year, based on its earnings and expenditure, the central bank transfers a certain sum to the government as dividends. For the year ended June 2017, it had transferred only Rs30,659 crore ($4.23 billion), less than half of what the government expected. (The RBI follows a July to June financial year for its books of accounts.)

Eager to increase its spending and boost the economy ahead of the 2019 elections, the government had reportedly demanded that the central bank dip into its reserves and cough up a bigger sum. This was resisted by the RBI.

However, after the Nov. 19 board meet, it was decided that an expert committee will be set up to look into the economic capital framework. The details of this panel, including its composition and regulations, were to be determined by both the parties jointly.

At the end of June 2018, the RBI had total cash reserves of Rs9.6 lakh crore.

Lending restrictions
At the end of March 2018, the banking sector’s gross non-performing assets (NPAs) had risen to 11.6% of its combined loan book from 10.2% in September 2017. These are loans on which either the interest or the principal repayment has been delayed.

India’s 21 public sector banks account for a major share of these NPAs. In order to improve the health of these banks, the RBI had placed 11 of these lenders under a prompt corrective action plan. This involves certain restrictions on lending, expansion, and hiring.

The government had been pressing the RBI to relax these norms as it hampered loan availability to micro, small, and medium enterprises (MSMEs). The central bank reluctantly agreed to get its board for financial supervision to look into the issue. The BFS includes the governor, the deputy governors, and four other members from the regulator’s central board.

The government had also been hankering for a relaxation of the bad-loan rules for MSMEs. After the Nov. 19 board meeting, it had appeared that the RBI had given in to this demand.

Section 7
The tussle peaked after the government last month reportedly tried to invoke section 7 of the RBI Act for the first time in history. The section empowers the central government to give certain directions to the apex bank whenever it deems necessary. The government intended to improve the liquidity situation and get the banking regulator to relax certain bad-loan reporting norms.

However, section 7 wasn’t considered even during the 2008 financial meltdown. So deploying it now would have been unnecessary besides being unprecedented.

Liquidity crisis
The crisis at Mumbai-based Infrastructure Leasing & Financial Services spooked the markets in September, leading to a sell-off in bonds and stocks. Apart from investors and traders, banks, too, were wary of lending to non-banking financial companies, which led to a liquidity squeeze. Since then, the government has been asking the RBI to relax some norms and provide an additional window to ease the cash supply.

However, even though the RBI has stressed that it is closely watching the situation and will step in if the need arises, it has avoided getting involved till now.

Payments regulator
A week before Acharya’s speech, in a rare move, the RBI published a dissent note on its website, vehemently opposing the government’s plan to establish an independent payments regulator.

In September, an inter-ministerial committee appointed by the government had recommended that all transactions via e-wallets and cards should come under the purview of an independent regulator and not the central bank.

Team Patel had argued that there had been no reports of inefficiencies in payments in India and, therefore, there was no need to change a well-functioning system.

Board appointments
Earlier this year, the government had appointed Chennai-based accountant S Gurumurthy to the RBI’s board, a move that was reportedly not welcomed Patel’s team. Gurumurthy, a political ideologue, had been critical of Patel and his team for holding back excess cash reserves from the government and for their loan management.