Restoring RBI Independence: A seminal work on the Indian economy and how to maintain financial stability

By Viral V Acharya

Title: Quest to restore financial stability in India
Author: Viral V Acharya
Publisher: Penguin Random House India
p. 416 pages; 599 rupees

While the RBI has always derived several important powers from the RBI Act, 1935 and the Banking Regulation Act, 1949, what matters is the actual independence with which these powers can be exercised in practice. Over time, successive governments, at the behest of the central bank, several economists and countless committee reports, have made great strides to restore the RBI’s operational independence. I will address three such areas of healthy progress. Monetary policy: The RBI, like many central banks of the time, quickly fell into the socialist planning policies of the post-independence government and fixed not only the interest rate on money, but virtually all loan interest rates with different maturities as well as a sectoral allocation of credit to the real economy.

After the deregulation of interest rates in the 1990s, monetary policy acquired a more modern dimension. Initially, there was a multi-indicator approach to setting interest rates. Having too many targets for monetary policy violates the Tinbergen principle of “one target, one instrument”; It also makes it difficult to understand or communicate what the rate setting is intended to achieve at any given time. Importantly, this approach had a lot of regulatory discretion, often at the level of an individual, namely the RBI governor. This made the independence of monetary policy individual; In other words, this could easily create pressure on the government to keep interest rates low under one guise or another during times of fiscal expansion. This is exactly a situation in which rules would be better than discretion.

After several episodic bouts of double-digit inflation, in September 2013, the then Governor Raghuram G. Rajan finally launched a war on inflation and inflation expectations. the report of the Urjit Patel Committee on Revising and Strengthening the Monetary Policy Framework was published in 2014; and finally, the RBI Act was amended in August 2016 to establish the MPC. Although the decision on the economic impact of the flexible inflation targeting framework will remain open for some time, it is undeniable that the MPC has given monetary policy an independent role institutional basisDebt management: After independence, the RBI participated in Indian short-term treasury bill issuances for several decades government (using extraordinarily low interest rates) to finance its budget deficits. The RBI also publicly admitted that its open market operations (OMOs) were primarily aimed at managing government bond yields.

This implied that the central bank balance sheet – like tax revenues – was always available as a resource to monetize excessive government spending. Not surprisingly, high inflation in India appealed to both Milton Friedman and Thomas Sargent, that is, it was always both a monetary and a fiscal phenomenon, as these two Nobel Prize-winning economists had respectively argued (Friedman 1970; Sargent 1982). . Ultimately, recognizing the fiscal imprudence and inflationary risks that such automatic monetization of government deficits entails, the joint efforts of the RBI and the government during 1994–1997 limited deficit financing by the RBI to the limited Ways and Means Advances (WMA) . The Fiscal Responsibility and Budget Management (FRBM) Act of 2003 specifically prohibited the RBI from participating in primary issues of government securities. Open market operations were designed to neutralize and/or offset the impact of foreign exchange interventions on the domestic money supply to meet the economy’s ongoing liquidity needs, rather than to finance deficits. Although there have been relapses into old habits, overall these changes have meant that the role of government debt management at the RBI is primarily to auction government debt and assist it in exchanging securities or carrying out repurchases, rather than in a complicated involvement in financial planning. and more importantly, in its financing.

Exchange rate management: In the five-year plans after independence, prices were assumed to be constant, including the exchange rate; However, as the true value of the Indian rupee fluctuated depending on market prices and macroeconomic conditions, sterling holdings had no choice but to suffer an unreasonable hit. The underlying true value of the rupee was also heavily influenced by monetary policy and debt management measures that implicitly supported the expansion of government deficits – but were not reflected in reality.

The result of the fixed exchange rate system amidst “fiscal dominance” was that the RBI was essentially a silent spectator to the build-up of the inevitable exchange rate imbalance (although this was arguably true of much of the world at the time). Since 1976, when the rate of the rupee became a “managed float” against a basket of currencies, and especially since 1993, the exchange rate has gradually evolved from a purely fixed rate to a market-determined rate for all practical purposes. The RBI employs reserve management and macroprudential controls on foreign capital flows to manage excessively large movements. Since a flexible inflation-oriented mandate for interest rate policy and fiscal deficit financing is no longer the objective of monetary policy operations, the desired exchange rate control lies with the RBI. Ongoing challenges in RBI. However, few key areas of continued weakness remain in maintaining the RBI’s independence. Some of these areas were also identified in India’s 2017 Financial Sector Assessment Program (FSAP) by the IMF and the World Bank (WB) as opportunities to strengthen the RBI’s independence, an area in which the FSAP classifies India as ‘significantly non-compliant’.

Regulation of public broadcasters: An important limitation is that the RBI is legally restricted from taking any action against public broadcasters – such as divestment of assets, replacement of management and board, license revocation and resolution measures such as mergers or sales – all measures it can take can and are used effectively in private banks. The significant impact of this restriction was highlighted in detail in Governor Urjit Patel’s speech (Patel 2018). Boehm 2006). A thorny ongoing issue on this front is the rules governing transfer of surplus from the RBI to the government. This was stated by Rakesh Mohan (2018) in the last of his three-part series of topical articles on the RBI titled Protect the RBI’s Balance-Sheet; In it, he explains why a central bank needs a strong balance sheet to perform its full range of critical functions for the economy. Below I quote his main points:

First… The longer-term fiscal consequences would be the same if the government issued new securities to finance spending. {R}The support of RBI capital does not create new government revenue on a net basis over time and only provides the illusion of free money in the short term. Secondly… the use of such a transfer would undermine any confidence that exists in the government’s intention to exercise fiscal prudence. Third… In theory, a central bank can adequately implement monetary policy with a wide range of capital levels, including sub-zero levels. In practice, if it suffers significant losses and is considered under-capitalized, it risks losing credibility with financial markets and the public and may not be able to achieve its objective. Are fears about possible central bank losses illusory?According to the BIS, 43 out of 108 central banks reported losses for at least one year between 1984 and 2005. Some also argue that the government can always recapitalize a central bank if necessary. While this is true in principle, it is difficult in practice when the government itself is under fiscal pressure and maintains a relatively high debt-to-GDP ratio, as is the case in India. Also important is the erosion of central bank independence, both in reality and, perhaps more importantly, in optics. …Once again, better sense prevailed and the government did not plunder the RBI’s balance sheet.

Scope of regulation: A final issue is the scope of regulation. The most recent example of this is the recommendation to circumvent the central bank’s powers over payment and settlement systems by appointing a separate payments regulator. The RBI published its differing statement7 on this recommendation on October 19, 2018.

Excerpted with permission from Penguin Random House India