Raghuram Rajan’s last fight: resisting opaque India bank funding plan

JUST DAYS after Raghuram Rajan announced plans to a return to academia, he’s battling to preserve the Reserve Bank of India’s (RBI) independence.

The government this month revived a proposal to dip into the central bank’s emergency funds to recapitalize commercial lenders hurt by rising bad loans. The idea was first floated in February by the Finance Ministry’s top economic adviser, Arvind Subramanian, a candidate to succeed Rajan as RBI governor.

The plan involves shrinking the RBI’s balance sheet by as much as 4 trillion rupees ($ 59 billion), according to a document obtained by Bloomberg. The cash would then be injected into state-run banks, paring the RBI’s equity-to-asset ratio to 19% from 31.5% — still above the median of 11% at three dozen major central banks.

The proposal would be a major contrast to how other large economies have handled bank rescues, from the US savings-and-loan debacle in the 1980s to the banking crises in the Nordic region and Japan in the 1990s to the global financial crisis in 2008. In each case, fiscal authorities — not central banks — have injected capital.

‘OPAQUE AND DEVIOUS’

Using the RBI as a piggy bank would avoid a deterioration in the budget deficit. The risk is that the central bank would be seen as a government tool, and — as a part owner of lenders — have mixed objectives as it conducts monetary policy. Rajan has sought to strengthen the RBI’s independence, in part through setting an inflation target.

“At a minimum, it looks opaque and devious,” said Viral Acharya, a professor of economics at New York University’s Stern School of Business.

“Setting a precedent to compromise central bank risk management for public-sector bank recapitalization could lead to repeat and more devious interventions that over time could be perceived as an attack on central bank independence.”

The document envisages three possible methods to recapitalize lenders:

The RBI directly purchases stakes in the banks The money is transferred to the government, which uses it to buy shares The funds are used to create a “bad bank” to acquire more than 4.7 trillion rupees of soured debt in the system

The central bank funds have been accumulated for a rainy day such as the problems now afflicting the banking sector, according to a Finance Ministry official who asked not to be identified, citing rules for speaking with the media. Transferring the RBI’s capital would reduce both the assets of the central bank and the debt of the government, the official said. D. S. Malik, a Finance Ministry spokesman, declined to comment.

“Most important, any such move would need to be initiated jointly and cooperatively between the government and the RBI,” Subramanian’s team wrote in the February report. “It will also be critical to ensure that any redeployment of capital would preserve the RBI’s independence, integrity, and financial soundness — and be seen to do so.”

Critics of the plan, including Rajan, say it would leave the RBI open to conflicts of interest and economic shocks. It also raises questions about the amount of control Prime Minister Narendra Modi seeks over the central bank, which under Rajan embarked on the most ambitious overhaul in its 81-year history.

Rajan’s focus on inflation and cleaning up bad debt at Indian lenders has met resistance among elements in Modi’s administration, the bureaucracy and the banking industry. In two speeches last week, Rajan defended his policies and critiqued the government’s proposal to use RBI equity to help state-run lenders.

‘NON-TRANSPARENT’

“This seems a non-transparent way of proceeding, getting the banking regulator once again into the business of owning banks, with attendant conflicts of interest,” Rajan said. “Better that the RBI pay the government the maximum dividend that it can” and let the government directly inject capital, he said.

In 2007, the Indian government agreed to buy the RBI’s 59.7% stake in the nation’s largest lender, State Bank of India, to avoid the appearance of impropriety.

Under Rajan’s proposal, the RBI’s existing capital base would stay untouched, giving it more ammunition to deal with a sudden cash squeeze. Like the US Federal Reserve and other central banks, the RBI pays income to the government from what it earns on its assets. A portion of its earnings are set aside for staff salaries and an emergency buffer.

‘MOST URGENT’

In the 12 months through June 2015, the central bank paid the government a record dividend of 659 billion rupees, more than four times the amount in 2011. Under Rajan, the proportion of the central bank’s net income that has gone to the government has also increased, following the recommendations of an RBI-appointed committee.

The government proposal would also require the central bank to sell some assets from a 5.6 trillion rupee “currency and gold revaluation account,” which reflects unrealized gains on the RBI’s bullion and foreign- exchange holdings. The portfolio is subject to swings in market prices that could slash its value during an economic or financial shock.

Even so, some analysts are open to aspects of the government’s plan given the scale of the problem. Indian banks probably need about 2.3 trillion rupees in fresh capital, S&P Global Ratings estimated in February — more than the combined amount of the dividend and the government’s planned 700 billion rupees cash infusion. — Bloomberg