On defaulters, RBI prioritises public interest

Indian Express June 20, 2023

On June 8, 2023 the Reserve Bank of India set out a framework for bank settlements with defaulters. This circular has triggered widespread criticism because it covers settlements with fraudulent and wilful defaulters implying to some that the RBI is condoning their crimes. This interpretation is not correct. On the contrary, the point of the circular is to establish safeguards so that public interest is protected when banks make such settlements. That said the circular has once again brought to fore two deeper issues in the Indian banking system: government ownership of banks and weaknesses in regulatory governance.

Let's first understand why this issue has even arisen. Why should banks settle with defaulters?

When there is a default, the primary objective of a bank is to recover as much of the loan as possible. Various options might be available to the bank for recovering the loan. The bank decides which strategy would work best, based purely on commercial judgement. For instance, the bank may want to trigger the Insolvency and Bankruptcy Code (IBC, 2016) against the borrower. Alternatively, in some cases, the bank may decide to pursue a “compromise settlement” wherein the bank and the borrower negotiate a settlement amount. It is wrong to think that the RBI has permitted something unusual. One-time settlements are part and parcel of the business of banking. The RBI has simply given a formal regulatory structure to a standard banking practice.

Some of these settlements can indeed be with wilful and fraudulent defaulters. When trying to recover a loan, a bank should not make any distinction between whether the default is wilful, fraudulent or otherwise. Irrespective of the nature of the default, it is upto the bank to decide whether a settlement is a better and quicker option instead of triggering the IBC or pursuing some other strategy. The sole motivation behind such a decision should be to maximize recovery, as speedily as possible. This will help unlock banking capital that is stuck in the wilful default or fraud categories.

What about the crimes that these defaulters may have committed?

The RBI circular makes it clear that banks should feel free to file cases against fraudulent or wilful defaulters. It explicitly states that banks will undertake settlements “without prejudice to the criminal proceeding underway against such debtors.” This separates the criminality of a particular default case from the commercial aspect of it. In other words, no, the circular does not condone any crimes. But the pursuit of a criminal action against a defaulter should not necessitate suspending commercial judgement. This distinction is vital.

That said, there are some valid concerns. One apprehension stems from the government control over the boards of public sector banks. This creates a risk that the settlement process might be misused to favour politically connected defaulters at the cost of the banks’ commercial interests. This concern may not be wholly without merits, and it is therefore incumbent upon the RBI to allow the commercially prudent decisions and prevent the politically motivated ones. Only time will tell whether the requirements and safeguards laid down by the circular will be sufficient for this purpose.

In addition, there are some broader issues that need to be highlighted.

There is ample anecdotal evidence that private sector banks have been settling with wilful defaulters for a while now. So, if banks have already been doing such settlements and various instructions to this effect have already been issued by the RBI to banks over the years, then one might ask: what was the need for this circular?

The answer possibly lies in the fact that two-thirds of the Indian banking system is owned by the government and public sector banks are more likely to come under the scrutiny of investigative agencies for any action they take. The RBI circular gives these banks the regulatory cover for settlement related decisions. In a narrow sense therefore the circular merely levels the playing field. But from a wider perspective, the fact that a circular needed to be issued underscores the distortions that the Indian banking system suffers from owing to the government ownership of banks. In a fully privately-owned banking system there would be no need for such a circular and the ensuing controversy could have been avoided.

The second broad issue concerns regulatory governance. A year ago, the RBI's Regulations Review Authority 2.0 recommended that the RBI place all draft instructions on its website for stakeholder comments and finalise them after considering the feedback. Exceptions should be made only in special circumstances. There do not appear to have been any special circumstances surrounding the June 8 circular. There were no issues related to financial stability, or fiduciary duty, or confidentiality. There does not even appear to have been any pressing urgency. At the same time, the circular is of great public interest since it applies to entities against whom criminal proceedings are underway.

Hence, the draft circular could and should have been placed on the RBI’s website for public consultation along with a discussion paper clearly explaining its rationale. Concerned stakeholders could have expressed their concerns and the RBI would have had the opportunity to assuage their misgivings by making suitable clarifications to the draft circular before notifying it. That would have saved much trouble for both the central bank and the government.

Banks are commercial enterprises and should be allowed to operate accordingly. In principle, separating a commercial decision such as loan recovery from criminal proceedings against wilful defaulters is a step in the right direction. However the situation in India is unduly complicated because of government ownership of commercial enterprises and gaps in regulatory governance. Future public discourse should focus on these fundamental problems, and not on how banks or RBI could play the role of moral police.

Is the good run of the Indian banking sector over?

Is the good run of the Indian banking sector over?, MoneyControl, June 6, 2023.

Currency withdrawal, TCS will revive uncertainty, not economy

Times of India May 24, 2023

On May 16 the government of India announced that it would impose a TCS (tax collected at source) of 20% on all international credit and debit card transactions made by Indians on their foreign travels from July 1, 2023 onwards. On May 19, the Reserve Bank of India announced that the 2000 rupee notes would be withdrawn from circulation though they would continue to be legal tender. The general consensus seems to be that both these are non-events. They will not impact many people and will not cause any real damage to the Indian economy. These predictions may well prove correct. But the interpretation misses the wood for the trees. We need to take a step back and understand that both announcements are problematic.

First, it is not clear why either of these announcements was necessary. The 2000 rupee note was introduced during the demonetisation episode of 2016 partly as a means to rapidly remonetise the economy till the time that currency notes of other denominations became available. As per the RBI’s recent notification, these notes have served their purpose, and are no longer commonly used for transactions. If this claim is correct, then why was there a need to withdraw them from circulation now instead of letting the notes become naturally redundant over time? The RBI could have simply instructed the banks to stop dispensing these notes.

Moreover, since the notes are not being demonetised and will continue to retain their value, the RBI could have also allowed users to exchange or deposit them over an unlimited period of time, instead of imposing a deadline of September 30, 2023 to do so. It is not clear why this deadline is necessary, nor is it clear why this announcement was sprung as a surprise instead of giving the users and the banks ample notice so that they could prepare for the change. Even if the 2000 rupee notes account for only 10.8% of the total notes in circulation, withdrawing them in this manner will cause inconvenience for many people, especially those in the cash-based informal sector that is still recovering from the devastating impact of the pandemic.

The rationale behind the imposition of TCS is even less clear. If the purpose is to collect information about a few people who are allegedly spending large amounts abroad using credit or debit cards thereby bypassing the foreign purchase limit of $2,50,000 permitted under the LRS (Liberalised Remittance Scheme), then this announcement is a disproportionate response because it will end up penalising every Indian who travels abroad to make perfectly legitimate international transactions. This is similar to the demonetisation episode when the entire country was inconvenienced in order to punish a few.

More fundamentally, the Indian economy has benefitted enormously from the liberalisation reforms of the early 1990s. During the last three decades, Indians have undertaken vast amounts of cross-border transactions. A significant percentage of Indians today live in a globalised world where they can easily travel to other countries for leisure or education or business purposes. We need to further encourage free flow of people and money across borders to be able to enjoy the fruits of globalisation. The ability to spend using credit or debit cards anywhere in the world is a critical element of this process. By making these purchases costlier, the recent TCS rule disrupts the financial freedom that a growing number of Indians have come to enjoy over the years, both at an individual level as well as from a business perspective.

Second, it seems ironic that these announcements were made when the country is trying to internationalise its currency, for example by using it to trade with other countries. An important pre-requisite for a currency to become international is people having confidence in it. Frequent withdrawal of currency notes without any prior warnings or increasing the cost of using the currency in other countries dent the credibility of the rupee and move India farther away from the goal of making it an international currency.

Finally, both these announcements come at a time when the Indian economy is struggling to find its feet. Forecasts by major organisations show that the economy is going to slow down in 2023-24. Much of the growth witnessed in the last year was due to the release of pent-up demand once the pandemic related mobility restrictions were fully removed. By now, that pent-up demand is exhausted. The two main engines of growth have also not been performing well. Non-oil goods exports contracted on a year on year basis in the quarter ending March 31, 2023, and private sector investment continues to be sluggish. At such a juncture, it is important for the government to create an environment in which the private sector feels confident to start investing again. Instead, the surprise withdrawal of the 2000 rupee notes bringing back memories of the 2016 demonetisation and the abrupt TCS announcement, undermine confidence in the policy framework. This kind of uncertainty discourages private investment even further.

In order to revive rapid economic growth, it is essential to ensure policy stability and predictability. The two announcements of last week are likely to create the opposite effect. This kind of sudden announcements act as a reminder that the government without any warning can introduce rules that may disrupt investment plans and hamper economic freedom. A proliferation of rules and regulations in this manner may seem non-events at first brush but cause long-term damage to the economy.

Is the RBI’s commitment to inflation targeting credible?

Is the RBI’s commitment to inflation targeting credible?, Ideas for India, May 24, 2023.

The post-pandemic credit landscape in India

The post-pandemic credit landscape in India, Ideas for India, May 8, 2023.

Don’t hit pause in the battle to contain inflation

Hindustan Times April 8, 2023

On April 6, the Reserve Bank of India (RBI) announced its first monetary policy decision of the financial year 2023-24. Going against widespread market expectations, it decided to hold the repo rate at 6.5%, pausing the rate hike cycle that began in May 2022. Unfortunately, the Monetary Policy Committee (MPC) statement does not fully explain why. All we can, therefore, do is speculate about the possible reasons behind this pause and discuss what MPC may need to do going forward.

Let's start by understanding what has changed since the last MPC meeting of February 8. There have been three main developments.

First, inflation pressures have arguably increased. Back in February, when MPC raised the repo (or policy) rate by 25 basis points, the latest data (for December 2022) showed that headline inflation had moderated to 5.7%, whereas going into the latest meeting headline, consumer price index (CPI) inflation had gone up to 6.4% in February 2023. In the run-up to both meetings, core inflation (non-food, non-fuel) remained elevated above 6%, the upper-limit of RBI’s tolerance band.

Second, the global economic environment has become significantly more uncertain compared to February, because of the turmoil in the financial markets in the US and European Union. With the collapse of a few mid-sized banks in the US and the forced take-over of the systemically important Credit Suisse by UBS, financial stability concerns resurfaced, which in turn, complicated the tasks of central bankers.

Third, the rupee-to-dollar exchange rate stabilised in recent weeks, after depreciating chronically in 2022, largely because markets now expect the US Federal Reserve to be less aggressive. The Fed has been tightening monetary policy since the start of 2022, increasing its policy rate from essentially zero to 5%, to rein in inflation which shot up to 9%, the highest in four decades. Arguably, this aggressive tightening triggered the financial instability in the US. The ensuing chaos prompted analysts to expect that the Fed will now slow down the pace of rate hikes in order to balance financial stability concerns with inflation control.

Which of these factors can help explain MPC's latest pause?

Clearly, it was not the first factor, given that inflation is still far from under control. RBI is legally mandated to bring headline CPI inflation down to 4%. Its inflation forecast for 2023-24 is 5.2%, implying that the central bank expects that inflation will remain well above target for the second consecutive year. What is more worrisome is that underlying (core) inflation is likely to be even higher, persistently hovering around 6% for several years now. The MPC statement recognises these problems, stressing the “importance of low and stable prices” and “not letting the guard down on price stability”, while pointing out that work needs to be done to “[anchor] inflation expectations” and “rein in generalisation of price pressures”. Yet, despite such a hawkish assessment, it did not vote in favour of a rate hike.

Why not? One possibility could be that the previous repo rate increases have not been fully passed on by banks to their lending and borrowing rates. So the central bank might have decided that the priority should now shift to ensuring that monetary transmission improves, either by tightening bank liquidity or exhorting banks to raise their rates. But there was no sign of any such initiative in the MPC statement.

So maybe the second factor, global uncertainty, played a key role? Perhaps RBI was worried that problems abroad could weigh on India’s growth? Apparently not. The central bank actually increased its 2023-24 GDP growth forecast, albeit marginally, to 6.5%, indicating that growth worries were likely not the major factor driving its decision.

Perhaps, then, exchange rate factors played the key role. It is certainly striking that RBI’s actions over the past year seem to have been mirroring those of the Fed. When the Fed was aggressively raising rates during 2022, RBI kept increasing its repo rate. And when the Fed decided in 2023 to slow down the pace of rate hikes, RBI responded by pausing. Hence, it is possible that there is some link between US and Indian monetary policy, perhaps motivated by a desire to protect the exchange rate by ensuring that rupee interest rates remain significantly higher than those in the US.

If indeed the pause was driven more by exchange rate factors than by domestic inflation – though RBI governor Shaktikanta Das said that monetary policy was driven by domestic factors, not international – then it needs some reflection. External considerations should not distract RBI from its primary objective of restoring price stability in the domestic economy. Traditionally, ensuring that the exchange rate remained stable against the US dollar could aid in this task, as US inflation used to be low. But times have changed. As long as inflation in developed economies remains elevated, India runs the risk of importing this high inflation.

Consequently, achieving the inflation target will require RBI to focus on exerting downward pressure on domestic inflation, especially now that high core inflation has become entrenched in the system. In particular, MPC needs to ensure that the real interest rate (the difference between the repo rate and core inflation) is firmly in positive territory if there is to be any chance of breaking the persistence of core inflation. Currently, the real rate is barely there.

Persistently high inflation hurts the poor the most. Volatile inflation can be inimical to growth, a troubling possibility given that India’s medium-term growth prospects look uncertain. Therefore, inflation control remains crucial to India’s future. Unfortunately the monetary policy decision did not throw much light on RBI’s plan to bring inflation down.

Should monetary policy be used to target financial stability?

Mint, April 2, 2023 (with Harsh Vardhan)

The recent financial market turmoil in the US triggered by the collapse of the Silicon Valley Bank has raised questions about the impact of the US Fed’s monetary policy on the stability of the banking system. More generally it has brought back to fore a fundamental question that central banks all over the world have been grappling with for a while now – should financial stability be given priority over inflation in the conduct of monetary policy? There is no easy answer to this as both problems are serious.

This issue is of crucial importance for India as well. It has been less than a decade since the Reserve Bank of India adopted inflation targeting as its monetary policy framework and under IT, the primary goal of monetary policy is achieving price stability. Expecting monetary policy to also keep an eye on financial stability, will distract attention from the central bank’s legally mandated objective, and may lead to destabilising outcomes for the economy in general.

There are some practical as well as conceptual problems in making financial stability an objective of monetary policy.

First of all, it is difficult to define financial stability. We can only see financial sector instability when it manifests for example through the failure of a systemically important bank, or the bursting of an asset price bubble, but before such an event occurs, we cannot precisely describe what is financial sector stability. Moreover, there are various institutions in the financial system involving a large number of participants that interact with each other thereby creating a complex, interconnected network. Within this system, sources of financial instability can be varied. We have seen financial instability occurring due to failures of banks, insurance companies, pension funds or mutual funds, and we have seen crises in the stock market and bond market. Ex-ante, it is often difficult to identify the specific part of this vast, complex network where a risk is building up.

Also, once instability occurs in any part of this network, given the interconnectedness, it can spread through the entire system leading to what is commonly known as contagion. It is difficult to predict whether an event of financial instability will indeed trigger a contagion, how rapidly the contagion will spread through the system or what impact it will have on different parts of the network.

Secondly, given that financial stability is difficult to define, it is also hard to measure. Often financial sector regulators use "stress tests" to assess the resilience of the system under various scenarios. Problem is that they only test for risks that they are worried about. There are many other risks beyond the obvious ones and typically those are the ones that get financial institutions into trouble, all the more making financial stability difficult to measure.

Monetary policy works best when it has clearly defined objectives and quantitative targets that guide its formulation. Given the challenges of defining and measuring, it is difficult for monetary policy to target financial stability as compared to price stability which can be both defined as well as measured. In India, for example, the IT framework clearly lays out the goal of the RBI’s monetary policy as achieving a 4% CPI (consumer price index) target. Such a clear, quantitative target is inconceivable when it comes to financial stability.

Finally, and most importantly, policymaking must be guided by the Tinbergen principle which conceives of economic policy as the relation between instruments and goals. It stipulates that the number of achievable goals is limited by the number of available policy instruments. Under the inflation targeting framework, the repo rate in India (or the Fed funds rate in the US) must be used to target inflation. It is therefore best to find another tool to address financial stability so that the Tinbergen principle can be applied.

So if monetary policy is not the answer, then what can be done to address financial instability?

Some have argued that central banks can inject liquidity to safeguard financial instability. There are three problems with this. First, injecting liquidity only makes sense when the underlying problem is illiquidity, say an irrational run against a bank with safe but illiquid assets (such as a loan to a profitable factory). But this is hardly ever the case. Usually, as in the case of SVB, runs occur because banks are insolvent i.e. the value of their assets has fallen below the value of their liabilities. In such a situation, the only solution is to inject capital. Injecting liquidity can in fact make matters worse because it enables more people to flee the ailing bank(s), thereby increasing -- not reducing – panic.

Secondly, liquidity can be a temporary solution in situations involving a credit freeze and, it may help restore confidence in the system. But it is like calling the fire brigade in the event of a fire; it is needed to douse the fire but does not help prevent future fires.

Third, addressing instability using liquidity may also mean keeping the system flooded with excess liquidity for a long time which in turn may endanger price stability.

Broad based financial stability can be achieved only by improving governance standards, and establishing strong supervisory oversight over the concerned institutions to help avoid the build-up of risks. The SVB collapse, like the Global Financial Crisis of 2008, reflected a colossal failure of governance and supervision.

In summary, in the short run, the solution to financial instability is capital; in the long run, it is better governance and supervision. Monetary policy would then be free to pursue its "natural target": price stability.

In the case of India on the other hand, price stability is a pressing concern. CPI inflation has been higher than the RBI's target level of 4% for a while now and in particular, core inflation has been remarkably stubborn at 6% for a long period of time. Hence, as the RBI gears up to announce its monetary policy decision on April 6, it needs to retain its focus on lowering the CPI inflation to the target level. The US Fed may have slowed down the pace of rate hikes in view of the latest financial market turmoil but that should not distract the RBI from prioritising domestic macroeconomic stability and inflation control.