The government appears to have backed down from its stand-off with the Reserve Bank of India (RBI), after a meeting that reportedly took place in Delhi between Governor Urjit Patel and Prime Minister Narendra Modi last Friday.

Three days later, on Monday afternoon, Secretary (Economic Affairs) Subhash Chandra Garg denied the previous week’s reports of a move to force the RBI to free up 3.6 trillion rupees (US$49.93 billion) from its statutory reserves through a reset of its risk capital framework. Significantly, he issued the clarification on Twitter, not via an official press release.

The RBI has long maintained, including in its annual report, that it is working on a framework for assessing its risk-buffer requirements in a systematic way for determining the transferable surpluses to the government every year.

At the center of this raging controversy is the RBI’s policy for determining how much statutory reserves it must maintain. Reserves are built from the RBI’s surpluses, or the difference between its earnings and spending, using formulae that have evolved over time. The balance surplus that remains after making allocations to the reserves is passed on every year to the government. The larger the reserves, the less the RBI can remit to the government as dividends.

Like any central bank, the RBI earnings comprise interest income from its holdings of government securities, its overnight lendings to commercial banks and the returns on its foreign currency assets. Expenditures range from the costs of printing currency, agency commissions paid to commercial banks to act on its behalf for government transactions, and employee costs.

As of June 30, 2018 the RBI had accumulated 6.91 trillion rupees ($95.86 billion) in its currency and gold revaluation reserve fund. This fund is meant for absorbing the losses from its interventions in money, securities and forex markets, for conduct of monetary policy and management of the exchange rate. The fund is also meant for absorbing all shocks to its assets’ valuations arising out of variations in foreign exchange rates and gold prices.

In addition, in a second reserve fund maintained for meeting unforeseen contingencies, the RBI had 2.32 rupees trillion as of June 30, 2018.

Every year, in the weeks leading up to the preparation of the Union Budget, exactly how surpluses are to be transferred is the subject of intense negotiations between the RBI and the government. The government insists year after year that the RBI is far too conservative in estimating its contingent liabilities and is building reserves in excess of reasonable requirements. The RBI, on the other hand, defends its reserves citing recommendations from technical committees on minimum levels of prudence that are necessary.

The as-yet unsettled question of how much reserves are adequate has heated up and is at the center of the public feud between the two sides. A number of committees have examined it over the years. Based on their recommendations, the RBI’s contingency fund has been downsized over the past decade from 12% to 6% of the RBI’s assets.

The conflict over the reserves, and consequently, the dividends transferable, deepened in the aftermath of demonetization. The last RBI governor Raghuram Rajan, guided by recommendations of a committee that had said the accumulated reserves had exceeded the required buffer, transferred surpluses in their entirety to the Center without making appropriations to the reserves. Following demonetization, however, the costs incurred for printing new notes pared down the surpluses, and, in turn, the RBI’s dividend payments. This upset the government’s fiscal deficit calculations.

Hostile negotiations

While the Modi government is not the first to engage with the RBI on the issue of its risk capital buffer, never before have deliberations been conducted in the atmosphere of hostility seen in recent weeks. “In India though, even as the autonomy of the reserve bank is an issue, the amount of surplus transfer or the capital requirement of the reserve bank have never been variables in defining the government-central bank relationship,” writes former RBI Governor D Subbarao in his memoir, Who Moved My Interest Rate?

Incidentally, when he was the federal finance secretary before being appointed RBI Governor, Reddy was in charge of maintaining federal government’s fiscal deficit target, and so has seen the tussle from both ends of the spectrum.

Showing unprecedented aggression, the Modi government is pressing its claim on the RBI’s capital buffer by reportedly initiating the Section 7 process of the RBI Act. This provision that allows the government to issue written directives if consultations with the Governor fail, has never been used before in the RBI’s 83-year history.

While the framework for determining the RBI’s capital buffer is not cast in stone and can be refined further in keeping with changing needs, such a move by a government in an election year raises questions of motivation. Does the move to dip into the RBI war chest reflect an inclination to woo voters with fiscal giveaways without due concern for macroeconomic stability?

Does the Modi government’s belligerence mask desperation?

A central bank’s buffer capital is its safeguard against risks. In case of a sudden asset-liabilities mismatch threatening the solvency of a financial institution, a domino of non-payments can set off a liquidity crunch and bring down the financial system. A central bank must be able to step in as a lender of last resort and prevent such a crash. More importantly, the market players must have confidence that the central bank is well-equipped to step in should such a situation arise. There are other less extreme risks the RBI’s reserves offer cover against: a sharp reduction in valuations of its holdings of government securities or foreign exchange and gold assets; and even internal fraud.

After the 1991 economic reforms, “the fiscal-monetary relationship changed”, notes former Governor Y V Reddy in his memoir, Advice and Dissent.

In it, he asserts that the central bank is expected to take a medium-to longer-term view of the economy while the government with political compulsions might be excessively concerned with the short term.

More importantly, he argues, the Reserve Bank has to be endowed with sufficient capital to act as the lender of last resort and absorb systemic risks in times of crises. It can not afford to run into losses and depend on infusion of capital from the government, without losing its independence.

Whether or not the federal Finance Ministry has been advised by the Prime Minister’s Office to tread with care in its demands on the RBI will be known on November 19, when its board meets. The Board is scheduled to take up various outstanding contentious issues. Economic affairs secretary Garg and his ministerial colleagues are ex-officio members of the board.