Broke And On The Brink

Rahul Bajoria. The Story Of The Reserve Bank Of India. Rupa Publications India. PP 296. Rs 589.

RBI cautions government on living beyond its means

The government’s ambitions far outstripped its ability to raise resources. The desperation to raise funds at a lower cost started to increase by 1986. During the fiscal year 1986–87, as the budget deficit was running much higher than the government intended, Prime Minister Rajiv Gandhi turned to his new finance secretary S. Venkitaramanan to get more money. Venkitaramanan leaned on the Reserve Bank, asking for a higher dividend and for an increase in SLR, which was a cheap source of funds for the government. Currently, this is a standard practice for the government and the Reserve Bank (in 2017–18, RBI was expected to transfer more than Rs 70,000 crore in profits), but it was a radical suggestion back in the eighties, given the lack of foreign reserves and interest incomes.

The Reserve Bank naturally pushed back, with Governor Malhotra arguing in a letter that such a step would have significant consequences for monetary policy as the profits for the Reserve Bank were largely notional, given it was directly monetizing the deficit through its holding of bills and bonds. As such, any move to transfer more money from the Reserve Bank would be detrimental to money supply growth, which was already rising at a rapid pace. The governor further said that RBI’s transfer had remained constant at Rs 210 crore, since there were other agency fees it was paying to banks on the government’s behalf. The RBI was hard-nosed on the SLR as well, refusing to raise it given already high rates.

Such a sharp rebuke from the Reserve Bank took the Ministry of Finance by surprise, and the matter was escalated to Rajiv Gandhi. The prime minister invited Malhotra for a meeting, but it was cancelled, and instead, Malhotra made a representation to Finance Minister V.P. Singh. The finance minister managed to convince the government to stop demanding a higher surplus transfer from the Reserve Bank. While the pressure eased for a while, the discussion was kept alive by the Ministry of Finance over the next two years, and eventually as the economy entered a full-fledged crisis in 1990–1992, the surplus transfer was increased to Rs 1,500 crore—a sevenfold jump—to tide over the fiscal fences. This decision to give larger surpluses was taken by S. Venkitaramanan, who was by then the governor of the RBI.

Political troubles and poor economic management

The hand-wringing over a larger profit transfer from the Reserve Bank was a harbinger of things to come. Cornered politically despite having a huge majority in the Parliament, Rajiv Gandhi reshuffled his cabinet for the sixth time in two years in November 1986. However, his political problems were just beginning. In an effort to cut his popular finance minister down to size, Rajiv shifted V.P. Singh to the Ministry of Defence on 24 January and assumed the finance portfolio for himself.

Subsequently, the government decided to turn a bit more populist in the budget for fiscal year 1987–88, with Rajiv himself presenting the budget in February 1987. Rajiv Gandhi outlined a budget that seemed conservative on paper but allocated large subsidies to the farm sector. However, given a widespread drought and marginal flooding in some parts of the country, the fiscal position started getting stretched very quickly. Inflation started climbing, but the overall inflationary impact was dented by buffer stocks of foodgrains.

With inflation rising and the balance of payments position deteriorating, the Reserve Bank sounded a note of caution, but given low deficit projections, it was comfortable in raising the SLR by 50 bps to 37.5 per cent in April 1987. However, with the drought looming large over the kharif sowing season, the RBI quickly became cautious about inflation and raised the CRR to tighten liquidity conditions in October 1987. But even with the drought, the economy was doing well, showing growth rates above 4 per cent, supported by the industrial delicensing from 1985.

Rajiv Gandhi was preoccupied with the political storm clouds gathering over his government. V.P. Singh, who had been made the defence minister, was widely recognized as the second most popular man in the government, given his very public confrontation with large business houses over issues of rent-seeking, corruption and tax evasion. V.P. Singh was keen to maintain his anti-corruption image and started looking into defence deals for the purchase of arms and ammunition by ordering a probe, aimed at Rajiv himself, who had held the defence portfolio before Singh. By April 1987, a full-blown controversy broke out over the Bofors gun deal between India and Sweden after The Hindu ran a story led by journalist Chitra Subramaniam on the illegal kickbacks paid to top Indian politicians and key defence officials. Singh had resigned as the defence minister before the story broke.

This was perhaps the last blow, and the momentum to reform the economy was lost once the allegations around the defence scandal started tumbling out of the closet. As Vinay Sitapati notes in his biography of Narasimha Rao, in May 1987, a document prepared by the Planning Commission to allow greater private participation in the industrial sector was circulated, but the government had no appetite for any major economic reforms. From then on, the government started pushing for growth, and the gap between budgeted government borrowing and actual borrowings widened sharply.

The Reserve Bank was apprehensive about the rising pressures on the currency and the widespread fiscal mismanagement, and in October 1987, decided to raise the CRR in its credit policy review. However, the government was not on board with the decision, and on 10 October, the finance secretary asked the Reserve Bank to put the CRR on hold. The Governor in his response sent directly to the finance minister N.D. Tiwari indicated that an understanding had been reached before, and both the SLR and CRR would be raised at an opportune time. In fact, Governor Malhotra reminded the finance minister that he had urged RBI to announce the decision early on, and this impasse between the government and the RBI had forced the Reserve Bank to postpone its decision, thus creating ‘some embarrassment to the Reserve Bank’. Eventually, the RBI was allowed to go ahead with the 50 bps CRR hike on 24 October 1987 to take it to 10 per cent, and the Reserve Bank raised the SLR to 38 per cent by early January 1988.