The Modi government and the Reserve Bank of India (RBI) are locked in a public feud that has taken a turn for the worse. Analysts say there is friction between the two because the government wants to step up spending ahead of next year’s general election.

The Modi administration “is eager to rev up the economy” and there are differences over how the RBI’s reserves are utilized, the Financial Times has said. However, the federal Finance Ministry has reportedly initiated consultations under Section 7 of RBI Act on three policy matters: treatment of power sector loan defaults, the quantum of dividends from the central bank to the government and the restrictions the central bank has put on public sector banks with high levels of bad loans.

Under the rules, the section’s invocation must be preceded by consultation with the RBI governor. If the two sides fail to find common ground still, the government can issue written directions to the governor in the ‘public interest’.

Section 7 is a ‘nuclear’ option that has never been invoked in the RBI’s 83-year history to date. Although disagreements have been common in the past too, including on the very issues on which talks are underway at present.

The Narendra Modi government’s move to break convention and press ahead with the section on routine policy differences attracted a sharp public response from the RBI, when deputy governor Viral Acharya told a meeting on October 26: “Governments that do not respect central bank independence will sooner or later incur the wrath of the financial markets, ignite economic fire, and come to rue the day they undermined an important regulatory institution.”

Acharya’s speech stunned the government. Finance Minister Arun Jaitley’s retort was to charge the RBI publicly with looking the other way when NPAs (non-performing assets) were piled up for years in government-run banks.

Earlier too, after the Nirav Modi fraud blew up, the government sought to lecture the RBI on its supervisory failures, advising it to keep a ‘third eye’ unfailingly open. It suggested that the burden of accountability is tilted against politicians, although regulators decide the rules of the game. Critics felt the reasoning was flawed, but the government was keen to deflect the public gaze away from its own inaction that had led to a banking paralysis.

Government vs RBI Governor

Governor Urjit Patel’s riposte evoking the ‘samundra manthan’ (Ocean Churning – an episode in Hindu mythology that explains the release of the nectar of immortality from the ocean through churning) succeeded in re-balancing the narrative by redirecting the spotlight back on to the government. The speech was seen somewhat harshly as an attempt to seek more powers and offer excuses for weakness in oversight.

But the debate on the central bank’s cramped independence was a reminder that the government continues to call the shots on the pace and quality of reform. By itself, the RBI cannot overhaul the decrepit public banking system, despite that being long overdue. Much was expected of the National Democratic Alliance (NDA) government. But its approach has lacked urgency. Its experiments, with a Banks Board Bureau, the ‘Indradhanush’ and the ‘Gyan Sangam’, have proved inadequate, as was predicted.

Even after the RBI took the lead in forcing banks to comb their books for suppressed bad loans — on their own, they would not have disclosed the threat to the economy’s stability piling up in the system — but the government has proceeded slowly on the required follow through. Fearing a political backlash, it spared stingy allocations for the re-capitalization needed to restore banks’ impaired lending capacity. It has shown zero appetite for the reforms required, even as the rot has spread and recourse to bailouts – such as the engineered LIC-IDBI Bank deal – grows.

Central bank-government tensions are a universal phenomenon. The RBI, as happens in every regime, was scapegoated also when the BJP’s sympathizers sought to create a noisy narrative ascribing the sluggishness of the economic recovery to the interest rates policy. Governments and the RBI are rarely on the same page as regards interest rates.

But the RBI’s interest rates are no longer set by its governor. The Modi government nominates three of the six members on the Monetary Policy Committee that took over the responsibility of setting interest rates from the governor in 2016. The governor is just one of six voting members. It’s unfair for the government to target him on interest rates.

A new dimension seen for the first time in the current rift is the disinformation campaign against the central bank. A sizeable section of the ruling party and its various affiliates hold the RBI’s independence to be a ‘farcical’ notion. The attempt is to frame the conflict as one of the limits of the central bank’s autonomy. But the question at the core of the rift is, who will be held responsible if the RBI acquiesces to the government once again, as it did for demonetization.

The demonetization effect

The tendency in the Modi government is to pass a disproportionate share of the blame for governance and policy failures, many of which resulted from its own decisions or procrastination, to the RBI. The institution risks irreversible reputation loss if the tendency is allowed to go on unchallenged.

Silence, as demonetization showed, is not an option for the RBI any longer. A central bank constantly under attack from the government must fight back to preserve its credibility, not just its autonomy. Hence deputy governor Acharya’s raised pitch.

A statement from the government on October 31 acknowledged that autonomy for the central bank was essential, while stressing the limits placed on it by the statute. “Both the government and the central bank, in their functioning, have to be guided by public interest,” it said, while suggesting, without confirming, that the consultation process under Section 7 may be on. Final outcomes of talks would be made public on completion of the consultation process, it said, without mentioning Section 7.

Should the government persist in pressing its point of view through invocation of the section, a situation unprecedented in the history of the RBI would arise. Governor Patel may be left with no option but to resign. For it would imply he has lost the confidence of the government, forcing routine policy issues of the central bank to be run by the “nuclear option”.