1. Here’s why RBI needs to regulate the issue of bank notes and securing monetary stability

Here’s why RBI needs to regulate the issue of bank notes and securing monetary stability

The Reserve Bank of India (RBI) was born under unusual circumstances. A need was felt to ‘regulate the issue of bank notes and the keeping of reserves with a view to securing monetary stability’.

By: | Updated: January 8, 2017 10:56 AM
Under the Act and through numerous amendments, vast powers were conferred on the RBI. (Reuters) Under the Act and through numerous amendments, vast powers were conferred on the RBI. (Reuters)

The Reserve Bank of India (RBI) was born under unusual circumstances. A need was felt to ‘regulate the issue of bank notes and the keeping of reserves with a view to securing monetary stability’. However, in 1929, the world had been hit by an unprecedented economic crisis—the Great Depression. The monetary systems of the world were in disarray. No one was sure what kind of monetary system would be suitable for India. Hence, it was decided to make a ‘temporary provision’ and that temporary provision was the Reserve Bank of India Act, 1934! (the ‘Act’).

The RBI’s main objectives in 1934 and now are the same:

  • to issue bank notes; and
  • to keep the reserves.

An immutable law

Under the Act and through numerous amendments, vast powers were conferred on the RBI. The word ‘autonomous’ does not occur in the Act but, over the years, the principle of Central Bank autonomy has been raised to the level of an immutable law. Under Section 7 of the Act, the central government may give such directions to the RBI as it may consider necessary in the public interest, but the power has never been exercised in the 83 years of the Act.

There have been times when the RBI and the central government did not see eye-to-eye. One governor resigned in protest. One governor was forced to step down. Overall, however, the RBI and the central government respected each other’s jurisdiction and learnt to work with each other. In a closed economy and with little reserves, the RBI was known more as a banking regulator and tight-fisted controller of foreign exchange than as an issuer of bank notes.

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Since November 8, 2016, of course, the role of the RBI as the issuer of bank notes has come into prominence. The RBI has the sole right to issue bank notes (Section 22). The RBI shall recommend the denominational values of the notes as well as the discontinuance of issue of notes (Section 24). Further, it is on the recommendation of the RBI that the central government may declare that any series of bank notes shall cease to be legal tender (Section 26).

In the current exercise of demonetisation, how did the RBI acquit itself?

Role reversal

1. The government has claimed that demonetisation was announced on the recommendation of the RBI. One has to suspend disbelief to accept that statement. The Prime Minister’s speech on November 8 made no reference to the RBI’s recommendation. On the contrary, the government’s and the BJP’s spokespersons boasted that it was entirely Mr Narendra Modi’s brainchild. It was an idea imposed from above and the RBI betrayed its mandate.

2. The decision-making process at the RBI was opaque and dubious. The RBI’s Board of Directors should have 10 directors regarded as independent. Seven vacancies in that category have not been filled by the NDA government. The three independent directors attended the fateful meeting on November 8. The recommendation was sent to Delhi where the Cabinet was waiting! How did the Cabinet know that the RBI Board would recommend demonetisation?

3. Dr Urjit Patel, the governor, justified demonetisation as a policy action to ‘turn around’ the economy. None of the governors before him since 1978 had advocated demonetisation even when the economy faced grave challenges. Dr Patel embraced the idea, barely 65 days after he took office, when the economy was growing, reportedly, at about 7%!

4. The RBI is believed to have told a parliamentary committee that the central government had recommended to the RBI (on November 7) that high denomination notes may be demonetised. Acting in haste, the RBI recommended to the government (on November 8) that high denomination notes may be demonetised! It was an unusual role reversal. The RBI has refused to release the agenda note for the meeting or the minutes. The RBI has refused to answer questions if any director had demanded more information or dissented.

Credibility dented

5. The RBI was totally unprepared to manage the fallout of demonetisation. It did not have sufficient quantities of lower denomination notes. It had printed only R2,000 notes that were not easily exchangeable. Besides, the new note did not fit into ATMs. The RBI started printing R500 and lower denomination notes only much later. A terrible idea caused more pain through terrible implementation.

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6. The RBI has a Monetary Policy Committee (MPC) that was constituted recently after years of deliberation. Money supply is an integral aspect of monetary policy. The MPC was totally excluded from the decision-making process.

7. In his speech on December 31, Mr Modi ventured into territory where no prime minister or finance minister before him had gone. He directed banks to increase the credit limit for small industry from 20% to 25% of turnover and the working capital limit from 20% to 30% of turnover. He directed banks to provide 8% interest on 10-year fixed deposits of senior citizens. On Saturday, the Prime Minister nudged the banks to reduce the lending rates and, on Sunday, State Bank of India led the pack and announced a cut in interest rates! Every announcement by the Prime Minister scuttled the independence and credibility of the RBI.

The RBI has come under severe criticism both within India and abroad. I would like to believe that the RBI has not fallen victim to ‘institutional capture’ by the current regime. I would like to believe that years of nurturing the autonomy of the RBI have not gone to waste.

Website: pchidambaram.in

@Pchidambaram_IN

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  1. Kaddhoo
    Jan 8, 2017 at 4:12 pm
    Those who do not know an iota of economics are guiding the monetary policy. This modi led govt is bent on decreasing interest rates ― without engaging into any reform and going thru the grind.
    Reply
    1. K
      Kumar Gupt
      Jan 8, 2017 at 5:15 am
      Every one seems to be dutifully speaking in "HIS MASTER'S VOICE" at the present moment. Where are we headed for?
      Reply
      1. S
        S.K.Gupta
        Jan 8, 2017 at 5:16 am
        A brilliant piece from PC!
        Reply
        1. V
          Vinayak G
          Jan 8, 2017 at 5:13 am
          This write up raises several key issues that the need an honest answer from both the RBI and Centre. But will it ever happen? No Guesses, please.
          Reply

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