It has been a rough week for Indian Prime Minister Narendra Modi – and a troubling one for investors in South Asia’s emerging economic giant.
Last weekend, voters in three key states turned away from Modi’s ruling Bharatiya Janata Party (BJP), choosing instead the opposition Congress party in local elections: a worrying sign for the prime minister ahead of national elections that must be held by May 2019.
Then last Monday, Urjit Patel, governor of the Reserve Bank of India (RBI), resigned following an extended dispute with Modi’s government, the second boss of India’s central bank to quit his job in a little over two years.
Together, these two events are likely to combine to deliver a near-term boost for India’s economic activity and financial markets in the run-up to next year’s general election.
But in the longer term, they spell bad news for investor confidence and future economic growth.
First, the state elections. It is not altogether surprising that Modi’s party should have suffered a setback. His popularity took a severe knock after he oversaw a disastrous 2016 attempt to withdraw large-denomination banknotes from circulation, a decision which contributed heavily to a deep slump in the economy’s growth rate last year.
But developments such as the unseating last week of Rajasthan’s cow welfare minister suggest the electorate may be turning against Modi’s brand of political Hinduism in favour of Congress’s more secular approach.
This will make Modi all the more eager to engineer an economic pickup ahead of next May’s national vote, by increasing government spending and ramping up state bank lending.
Monday’s resignation of Patel as RBI governor makes both of these more likely. For months now, Modi’s government has been leaning on the supposedly independent central bank to hand over a portion of its capital cushion to the government, and to ease credit conditions in the economy.
Patel resisted the pressure. But the appointment in August of Hindu nationalist ideologue Swaminathan Gurumurthy to the RBI’s board, the subsequent resignation of Patel, and his replacement as RBI governor by Shaktikanta Das, the civil servant who oversaw Modi’s demonetisation initiative, all suggest that the central bank’s independence has been greatly curtailed, and that from now on the RBI will be far more willing to do Modi’s bidding.
The trouble is that the government’s demands for the central bank to hand over a portion of its capital and to loosen its policy on credit are both misguided.
Yes, it true that the RBI is sitting on capital equal to around 30 per cent of its gross assets, a remarkably high proportion for any institution, let alone a central bank. But it does not follow that all that capital is cash the government can dip into at will and spend to pump up the economy.
Instead, much of it consists of nominal valuation gains. They were conjured up when the value of the RBI’s foreign exchange reserves rose in rupee terms as the Indian currency declined in value by 50 per cent against the US dollar between early 2008 and October this year. If the rupee now strengthens again, that paper capital will vanish just as quickly it appeared.
And of course, it is denominated in foreign currencies. Which means if Modi’s ministers were actually to try to spend it, they would first have to sell the foreign exchange for rupees. If they tried to sell it to the market, the rupee would soar in value, wiping out the spending power of their foreign currency.
And if they tried to sell it to the central bank, the net effect would be as if the RBI were printing rupees to fund the government’s budget deficit – a classic trigger for runaway inflation and the collapse of economic confidence.
In other words, demands for the RBI to hand over a portion of its capital to the government display an extraordinary degree of economic illiteracy that bodes ill for India’s future policymaking.
Calls for the RBI to ease credit conditions are equally worrying. Again, it is true that the RBI has kept its benchmark interest rate relatively high at 6.5 per cent as inflation has moderated. But high interest rates are not the only – or even the main – cause of the government’s anger.
In recent years the RBI has been pressing India’s state-owned banks to clean up the trillions of rupees in bad loans sitting on their balance sheets. But the politically connected businessmen who have benefited from the eternal evergreening of the state banks’ bad loans have pushed back fiercely, which helps to explain why currently the RBI has imposed tough lending restrictions on 11 of India’s 21 state-owned banks under its “prompt corrective action policy”.
The result is a painful liquidity squeeze, exacerbated by a meltdown in the country’s shadow financing market following the September default by non-bank lender Infrastructure Leasing & Financial Services.
The government wants the central bank to ease its lending restrictions and allow the state banks to pump liquidity into the economy to juice up activity and produce a feel-good factor ahead of the general election. Following Patel’s resignation, it is a lot more likely to get what it wants.
That might work in the short term; Indian stock and bond prices rose last week in anticipation of easier monetary conditions.
But in the longer term, back-pedalling on bank reform will do India’s economy no favours. With state banks making up 70 per cent of the country’s banking system, a clean-up is badly needed.
Until now, the banks have endlessly rolled over loans to zombie borrowers to avoid having to declare said loans to be non-performing. But as long as they allow these assets to sit unmolested on their balance sheets, the banks will never be able to grant the new long-term loans needed to fund the capital investment projects India requires to unleash future growth.
In other words, the resignation last week of RBI governor Patel strongly suggests Modi prefers to choose short-term gain at the cost of long-term pain. If so, long-term pain is exactly what India’s economy is likely to suffer. ■
Tom Holland is a former SCMP staffer who has been writing about Asian affairs for more than 25 years