The RBI and the real sector

Last month someone posted a very interesting link on Twitter.  

It is about something that matters in the current Indian context: The politics of central bank lending, namely, can a central bank lend to the real sector instead of just the financial sector.

The author is an economist called Parinitha Sastry who used to work at the New York Fed. The paper is about Section 13 of the Federal Reserve Act that allows the US Fed to lend to the real part of the private sector, that is, the parts that make real things. 

Sastry traces the political considerations that led to this section. It is a fascinating read. 

It turns out that originally the US Congress “demonstrated its steadfast commitment to the ‘real bills’ doctrine in two interrelated ways: 1) By limiting what assets the Fed could purchase, discount, and use as collateral for advances, and 2) By ensuring that any newly created government-sponsored credit enterprises were kept separate from the Federal Reserve System.”

But then along came the Great Depression and the politicians, seeing that the Fed was the only one with money to lend and wasn’t lending to all those who needed money, undid these restrictive but precautionary clauses. 

Sastry writes, “It was in this context that Congress added Section 13(3) to the Federal Reserve Act. The original framers of Section 13(3) meant to sanction direct Federal Reserve lending to the real economy, rather than simply to a weakened financial sector, in emergency circumstances.”  

Indian position

I sent the link to some old friends who had worked at the Reserve bank of India (RBI). One of them, Dr K Kanagasabapathy who had once headed the Monetary Policy Division, pointed out that the RBI Act has a similar provision. It is contained in Section 18 of the RBI Act, 1934.

“...When, in the opinion of the Bank, a special occasion has arisen making it necessary or expedient that action should be taken for the purpose of regulating credit in the interests of Indian trade, commerce, industry and agriculture, the Bank may, notwithstanding any limitation contained in section 17, purchase, sell or discount any bill of exchange or promissory note though such bill or promissory note is not eligible for purchase or discount by the Bank under that section; or make loans or advances to... any other person, repayable on demand or on the expiry of fixed periods, not exceeding ninety days, on such terms and conditions as the Bank may consider to be sufficient.”

Dr Kanagasabapathy said he didn’t think this power had been used on any occasion. We should take his word for it.

And while doing so we should note the first line of the section that says when the RBI thinks “a special occasion has arisen”. The big question that the government and the RBI need to ask is if such a “special occasion” indeed exists now and whether the time has come, in addition to helping out banks, to help out the real sector also.

In other words, since it can by law, should the RBI lend directly to firms in the real sector.

Moral hazard

Whatever may have been the American experience, in India we have to be aware of a much higher degree of what economists, borrowing a term from insurance, call moral hazard. In the context of bank lending, this means businessmen behave more badly than they would otherwise because the risk is borne by the taxpayer.

Given the integrity of our countrymen in business, politics and administration, it is almost certain that these three groups, having made off with shareholders’ and banks’ money will make off with the RBI’s cash also. 

Yet, the need for such lending when “a special occasion has arisen” can’t be ignored. Some thought needs to be given to the seriousness of the problem and a possible solution.  

Given that the RBI doesn’t have the wherewithal to deal directly with entities in the real sector, it might be a good idea for it to appoint an agent. I would nominate the State Bank of India for the job. 

Even if a small portion of what the RBI lends to the government is diverted to the real sector, we will be able to revive businesses that should not be dying.