Why is the government battling the RBI? Because its ability to satisfy various interest groups relies on a compliant central bank. This is a problem.
Our institutions may be under attack, but they are also fighting back. The RBI has mounted a fierce defence against a potential arm-twisting attempt by the Finance Ministry. The face-off has been owing to disputes on three key issues – Prompt Corrective Action (PCA) imposed on some PSBs, high interest rates and demands for transfer of the RBI’s surplus to the government. Predictably, the discourse has been binary — some have cheered on the RBI governor’s attempt to defend the institution’s autonomy, while others have argued that a democratically-elected government must not be hamstrung by a group of technocrats in its efforts to revive the economy.
While considering this conflict, and similar conflicts from the past, I’d urge you to consider certain structural issues — especially that of the role that rent-seeking plays in a political economy.
The rent-seeking framework finds regular application in the context of developing countries, and in issues such as industrial policy, corruption and land acquisition, among others. In this framework, the State is visualized as an entity that can distribute social, economic or political benefits (collectively termed ‘rents’) to various groups in the country. Note that rents only arise when exemptions or differential pricing mechanisms exist (priority sector lending, subsidised fuel, easier access to loans for large industrialists), allowing those who obtain rents to gain an advantage over others.
The actions of these groups – caste organizations, trade bodies, industrial associations, political parties, etc is to then actively ‘seek’ such rents by applying various pressures and incentives on the state. Any regulation can potentially change the status quo, and thus the rents enjoyed by various groups, prompting active rent-seeking behaviour.
Rent-seeking and PCA
How does this help explain the three issues involving the RBI? Consider PCA, which curbs lending activity of banks till they reach specific capital adequacy ratios. This lowers the credit available (‘rents’) to employment-generating businesses, including construction and real estate where a large proportion of workers (who would very well vote with their feet if they lose hobs) reside. Another politically powerful rent-seeking group, farmers, is also hard-hit when there is a credit squeeze. This is amplified by the facile yet highly saleable connection between industrialists (an opposite rent-seeking group) fleeing the country without paying their loans while others are denied credit.
Thus, a scramble to protect rents involves the threat of voting out the government by those groups that have lost out on rents. PCA is particularly harsh for the government because it directly impinges on the latter’s ability to distribute rents — had private sector banks been the only ones under PCA, the government could have simply compensated by increasing lending through state-run banks.
Rent-seeking and Interest Rates
If the conflict over PCA involved farmers and workers, the conflict over interest-rate policy involves a diametrically-opposite group: industrialists. For businesses, the cost of credit, or the interest rate, is a far more important metric as this directly eats into their profit margins. In the current inflation-targeting scenario (ironically pushed through by the current government) the interest-rate-determining repo rate is narrowly fixed on pursuing only one goal – curbing inflation. This keeps cost of credit high, even for the government which borrows at rates linked to the repo, when growth rates are moderating.
In the context of asset sales of businesses and high NPAs depriving them of the cheap money (‘rents’) that companies were used to, high costs lead to significant losses and drop in shareholder wealth for promoters, while dragging down the GDP growth rate. The growth-inflation conflict is textbook economics, right from the 1970s when Arthur Phillips empirically proved the trade-off between the two. It was an issue in 2013 as well, when P Chidambaram was facing off against D Subbarao.
While the government’s influence on the RBI through pliant bureaucratic appointments was assured, the creation of a Monetary Policy Committee with RBI nominees and experts has effectively meant that it is far more difficult to influence interest rates now. This reduces the scope to give out rents, thus inviting the ire of businesses that fund political parties. Attempts to call a meeting of MPC members in Delhi before its policy review have been declined, indicating a clear reduction in the interest-determining power for the Government.
Rent-seeking and Transfer of Surplus
If reports are to be believed, the government is requesting a sum of Rs 3.6 lakh crores as dividend to be transferred to itself from RBI’s yearly earnings and accumulated surpluses. Ignoring the fact that this figure is suspiciously close to the amount in invalidated notes that Government economists expected to gain through demonetization, this has significant implications for handing out rents. The biggest rents of all – subsidies on food, oil and fertilizer, come out of the fiscal expenditure of the government.
By adopting a tough fiscal policy through higher tax revenues on oil and other goods, there has been some progress on raising revenues to finance rents. However, tax revenues are still low and it is only in October that GST collections have crossed the 1-trillion figure. Added to this scenario, rising crude oil prices have led to an increased import bill and thus higher subsidy on oil to ensure fuel prices do not spiral out of control and affect the economy. Facing international applause for its tough fiscal policy and improvement in ease of doing business, the government cannot take a U-turn and significantly increase the subsidy bill without a corresponding source of revenue to pay for it.
The Way Forward
Standard recipes such as privatisation and disinvestment are unlikely to fly since governments will find all the more reason to hold on to public-sector banks if other levers are becoming defunct, as discussed earlier. The solution is to thus work within the rent-seeking framework, keeping in mind the importance of an autonomous central bank that protects the value of the Rupee, and a democratic government that must have sufficient resources at its disposal to support GDP growth. This would involve increasing the supply of alternative sources of economic benefits so that dependence on rents and rent-seeking reduces for various stakeholders.
For one, steps to create a vibrant bond market can significantly enhance access to credit. Relaxing norms for differential shareholding — allowing equity to be sold while retaining control (as is the case in US) can help promoters to leverage thousands of crores of shares without worrying about loss of control over firms. Both of these would lower credit costs and thus suit industrialist groups.
Second, an informal political understanding to not offer destructive SOPs such as farm loan waivers can reduce rent-seeking and thus allow banks to recover through PCA, although game theory would suggest strong incentives for either political party to break the understanding.
Thirdly, RBI should explore more creative ways for states and municipalities to raise funds from debt markets and overseas institutions provided the credit terms are rigorously approved by them. This can significantly reduce the fiscal need on the Government, thereby keeping the subsidy bill lower.
Lastly, subsidy reform is a key need. This government deserves credit for taking the reform agenda forward through Aadhar-enabled subsidy transfers, and creating the space to talk about subsidies rather than baulk at the prospect of mentioning it and hurting the poor. Thus rents can be re-imagined in terms of reduced corruption and greater tax revenue efficiency, which can garner more middle class votes. These solutions take time but efforts to fructify them can itself lead to a thaw on both sides, thereby creating the mutual respect that is sorely needed at this point.