Tamal Bandyopadhyay: North Block versus Mint Road

"I want the bank to be in the hands of the government, but not too much"

Had Napoleon Bonaparte still been around, one wonders how he would have tailored his statement about the Bank of France in 1806, given what's happening between the Reserve Bank of India and the Government of India represented by the finance ministry.

By hiking the short-term reverse repo rate by 25 basis points, RBI Governor YV Reddy caught the market by surprise "" an element that has been missing in central banks' monetary policies across the globe. However, more surprising was Finance Minister P Chidambaram's observation on the rate hike. Within hours of announcement of the quarterly review of the monetary policy in Mumbai, Chidambramam said he hoped the move would soon be withdrawn.

"The RBI is trying to be ahead of the curve. As soon as the external situation is clearer, this [rate increase] could be reversed," he said to reporters on TV channels. The finance minister also pointed out that the authorities were watching the US Federal Reserve's next rate decisions. The hint was quite clear: if the US Fed indeed heads towards the end of the rate-raising cycles, the RBI may reverse its decision when it announces its monetary policy in April.

This is not the first time that Chidambaram has spoken about interest rates. In November last year, at a meeting with heads of all public sector bankers, the finance minister extracted a promise from them that there would not be any interest rate hike this fiscal for loans raised by firms for productive purposes.

Just ahead of the January policy announcement too, Chidambaram spoke about stable interest rates. The market was surprise at the RBI decision, not because the rate hike was uncalled for, but few expected the RBI not to toe the finance ministry's line. By deciding to hike the short-term rates, Reddy has made it clear the central bank scripts its own policy.

Prima facie, there is nothing new about the conflict between the ministry and the RBI. The sustained battle of wits between former Finance Secretary Vijay Kelkar and then RBI Governor Bimal Jalan, in late 1990s, is testimony to this. Indeed, both sides tried hard to downplay the differences of perception but the tension between the North Block and Mint Road was obvious. Former Finance Minister Yashwant Sinha was also fond to talking about interest rates though he always qualified his statements saying the RBI was the best judge about the timing of any move (to cut interest rates). Jalan, for his part, perfected the art of hearing but not listening. His successor Reddy is treading the same path.

Chidambaram wants to give further fillip to growth and push the rate above 8 per cent, and so wants an accommodative monetary policy. However, Reddy is concerned about the risk of inflation when asset prices across the spectrum are rising and the year-on-year non-food credit of the banking sector has grown more than 30 per cent, its highest in last three and a half decades.

The legislation to set up the RBI was introduced in January 1927, but enacted after seven years in March 1934. At the initial stage, the RBI was a private entity and, in fact, threats were regularly issued to supersede the RBI's board should it recommend monetary and exchange rate policies incompatible with the government's scheme of things. It was nationalised in 1948 but differences between the RBI and the government over economic policies continued. In the early 1960s, Governor HVR Iyengar (March 1, 1957 to February 28, 1962) identified four areas of potential conflict between the RBI and the Central government "" interest rate policy was one of them.

The finance minister's periodic "interference" in a market-sensitive issue like interest rates, of course, highlights the fact that the overall macroeconomic policy continues to be dominated by the fisc both in terms of numbers as well as the decision-making process. By hiking the interest rate a month ahead of the Budget, Reddy has challenged this notion.

Caught in the crossfire between the ministry and the RBI are public sector banks who constitute a third of the banking industry. They have no choice but to hike their deposit rates to be in sync with the market and at the same time, they are not in a position to hike their lending rates as that would displease the ministry. So, their net interest rate margin is under pressure and profitability is being hit.