The spat between India’s central bank and the government gets more heated as the finance minister blames it for not doing enough to prevent the country’s bad loan problem

• Arun Jaitley, India’s finance minister, has criticised the RBI for “not doing enough” to prevent the build-up of bad loans at the country’s banks between 2008 and 2014.
  
• Some may say that this is an unfair assertion from Jaitley as the build-up in bad loans stemmed from a lapses in governance at state-owned banks and politically-motivated lending to power and infrastructure projects.
  
• As per the latest Financial Stability Report from the RBI, bad loans constituted 13% of all outstanding loans in India.
  

The ongoing feud between the Reserve Bank of India (RBI) and the Modi administration took a sharp turn yesterday as Arun Jaitley, India’s finance minister, criticised the central bank for “not doing enough” to prevent the build-up of bad loans at the country’s banks between 2008 and 2014.

Some may say that this is an unfair assertion from Jaitley. The RBI has consistently lobbied for more decision-making powers when it comes to regulating the banking sector, as indicated by the deputy-governor Viral Acharya’s speech last week wherein he issued a warning about the problem of government interference.

In Jaitley’s defense, though, the RBI only got wind of the problem in early 2016 following a comprehensive asset quality review of the entire banking sector as a whole. This reportedly followed a written note in February 2015 sent by Raghuram Rajan, the RBI governor at the time, to the Prime Minister’s Office indicating a need to assess several key bad loan accounts.

During the boom years under the UPA regime leading up to the 2008-09 financial crisis, a wave of optimism drove an unprecedented surge in lending as credit grew by as much as 30% compared to a traditional average of 14%. A significant portion of this, was politically motivated as large loans were extended to infrastructure and power projects run by people with strong political connections.

However, as the financial crisis hit, projects became delayed and defaults became regular, banks understated these problems and categorised bad loans as “restructured loans”. This pointed to a failure of governance, especially at state-owned banks, - an issue that the RBI has been vocal about addressing in the last few years provided it is given more supervisory powers.

India’s non-performing loan problem is well documented. As per the latest Financial Stability Report from the RBI, bad loans constituted 13% of all outstanding loans in India.

At the end of the previous financial year, total bad loans on the balance sheets of Indian banks reached ₹10.3 trillion, 85-90% of which are accounted for by state-owned banks. This marks a 25% jump from 2016-17 as banks wrote off a record ₹1.44 trillion worth of unrecoverable loans. There has, however, been a slight improvement in the year so far, with bad loans declining by ₹210 billion in the quarter ended June 2018.

The statements from Jaitley, which are characteristic of a government used to apportioning blame for past problems, signal an acceleration in tensions between the RBI and the central government. This may result in the resignation of Urjit Patel, the RBI’s governor, as per media reports. This would be unfortunate.

The conflict between the RBI and the central government is long overdue. While it may cause some short-term volatility to Indian markets, the RBI’s case for greater independence is bound to resonate across the world.

India faces some significant financial headwinds, be it a depreciating currency, a slowdown in credit growth, a a liquidity crunch or shrinking foreign reserves, and an independent regulator is the need of the hour. The central bank needs to adopt a long-term approach to solving these problems as opposed to short-term fixes generally favoured by governments.