By, Acuité Economics Team

It was not just another Monday at the RBI. Monday blues aside, the central bank officials had to deal with an unusual circumstance, awaiting them at the RBI HQ. For the uninitiated, the meeting follows a difference of opinion that broke between the Government of India and the Reserve Bank of India (RBI). A situation that is in itself sacrilegious.

This becomes even more unusual when one cites elementary economics, propounding the inherent independence of the monetary side from the fiscal. The belief system being, for a typical eco-system, that is a country aspiring to successfully manage its affairs, a semblance of this kind is a requirement. The very idea behind the Hicks-Hanson model achieving an equilibrium rests on the sanctity of the money supply adjusting to market realities.

In the infinite wisdom of our founding fathers however, the business of running a democracy is complex and such unions sometimes may not be achieved naturally. In other words, there is no inflexible monolith state but a fluid structure which can adapt to a changing environment. Sensing difficult circumstances, the Government, which is also the father figure of the nation has the obligation to nudge market actors towards a corrected path. With this philosophy, Section 7 of the RBI Act came into existence; if triggered allows the Government to direct the central bank on issues considered critical and in national interest. Having said this, one has to consider the fact that despite this so called 'power to nudge', the Government of India has never really used this facility; not even during the 1969 & 1980 nationalization of 21 commercial banks, the 1975 state of emergency and the 1991 balance of payment crises.

Indeed, tough situations call for tougher decisions and the Government considers directing the RBI its moral obligation as per the current market dynamics. The Section 7 therefore acts as a safety valve of a democracy and the Government will use it to meet the desired ends.

So what does the Government want?

Two things primarily. First, the Government wants the RBI to take it easy on the commercial banks under the Prompt Corrective Action (PCA). There are 11 banks in the category, which was initiated in April 2017 and the purpose is to help banks shore up their capital base (Capital Adequacy Ratio), asset quality (Net Non Performing Loans) and profitability (Return on Assets). This is achieved by enforcing restrictions on lending operations and being future ready by having requisite buffers in place. According to the Government's perspective, the restrictive PCA has taken several banks out of action and put pressure on the already strained system. It must be considered that the liquidity situation is precarious at the moment, given the negative WACR/ Repo spread last month along with high liquidity spreads doing the rounds across banks. Not to be forgotten, the credit to deposit ratio has been hovering near the 77% mark, auguring high offtake levels. The situation is especially true because of the unattractive capital as well as money markets, which are experiencing duration risk as well as massive selling, part of the reversal of the quantitative easing (QE).

While the RBI, it seems refused to back down from its rule based PCA regulations, in what can be seen as a victory for the Government is the fact that the deadline for the Capital Conservation Buffer (CCB) has been extended by a year. As per the PCA regulations, CCB are the incremental 'minimum regulatory prescription for capital' and along with the CAR, must collectively represent 11.5% of a commercial bank's risk weighted loans outstanding/ exposure. The mandate is to meet the CCB deadline of March 2019, when the former has to be 2.5% of exposure. The said banks having met the March 2018 deadline, the buffer currently stands at 1.875%; the remaining 0.625% will now get a deadline extension of upto one year, i.e. March 2020.

The second demand of the Government is the so called 'dividend' from the RBI. While on average the central bank has been paying the Government of India annual dividends in the range of Rs. 50,000- 60,000 crore, the latter wants a higher allocation. Pertaining to this the Government has questioned RBI's Economic Capital Framework, which provisions for an unusually high contingency buffer. As per RBI's perspective, its Contingency Fund, an entry on the liability side of the RBI's balance sheet – is worth Rs. 2.5 lac crore, which in turn forms just 7% of its balance sheet. This figure is therefore much lower than even the Malegaon Committee recommendations, which proscribe a buffer of atleast 11-12%.

The Government on the other hand refuses to concur and believes that RBI has needlessly provisioned a contingency quantum, which amounts to nearly 25%. As per the Chief Economic Advisor, RBI's buffer not just includes the Contingency Fund entry but the Revaluation Gains entry as well. The entry records revaluation gains, adjusting to the expansions in the central bank's currency, bonds and gold holdings, on the asset side. This quantum, as per the Government of India amounts to Rs. 9 lac crore (combined with the original Contingency Fund entry); taking the buffer well past the 25% number – almost thirteen percentage point higher than mandated by the previous Economic Framework Committees. As a remedy, the Government of India is asking for Rs. 3.6 lac crore, or roughly 10% of the RBI's balance sheet as dividend. This amount, if paid to the Government, will help increasing Government revenue expenditure, obviating the need to raise debt in a highly volatile capital market. The situation will not only help infuse more liquidity in the system but also aid in keeping the macro stability in check. The RBI may consider this demand difficult to meet as this may potentially be inflationary; this is because, if Rs. 3.6 lac crore is paid as dividend to the Government, the Currency in Circulation (M3) may increase by a quarter in a flash. As of now, the RBI has agreed to set up an expert committee to examine the Economic Framework and the developments in this regard are still nebulous.

In addition to this, current stresses pertaining to MSME financing was discussed as well and it was decided that loans upto Rs. 25 crore could be restructured under a new scheme. We await more details on these developments and reserve our view for later. However, assessing the current situation, it is clear that the meeting was indeed extraordinary and the monetary and fiscal side interactions will never be the same again from now on.