By Viral V Acharya
Title: Quest for Restoring Financial Stability in India
Author: Viral V Acharya
Publisher: Penguin Random House India
Pp 416 Pages; Rs 599
While the RBI has always derived several important powers from the RBI Act, 1935 and the Banking Regulation Act, 1949, what matters is the effective independence with which these powers can be exercised in practice. Over time, great strides have been undertaken by successive governments at the behest of the central bank, several economists and umpteen committee reports, to restore the operational independence of the RBI. I will touch upon three such areas of healthy progress.Monetary policy: The RBI, like many central banks of the time, got quickly trapped into the socialist planning policies of post-independence government, setting not just the rate of interest on money but practically all rates of credit at different maturities, as well as doing sectoral credit allocation to the real economy.
Post the deregulation of interest rates in the 1990s, monetary policy achieved a more modern dimension. To start with, there was a ‘multiple indicators’ approach to setting interest rates. Having too many objectives for monetary policy violates the Tinbergen principle of ‘one objective, one instrument’; it also renders it difficult to understand or communicate what the interest-rate setting is attempting to achieve at any point of time. Importantly, this approach entertained much regulatory discretion, often at the level of an individual, namely the RBI Governor. This made independence of monetary policy individual-specific; in other words, it allowed for government pressure to creep in easily for keeping rates low at times of fiscal expansion under one guise or the other. This is exactly a setting where rules would be better than discretion.
Following several episodic bouts of double-digit inflation, a war on inflation and inflationary expectations, was finally launched in September 2013 by the then Governor Raghuram G Rajan; the Urjit Patel Committee Report to revise and strengthen the Monetary Policy Framework was released in 2014; and, finally, the RBI Act was modified in August 2016 to constitute the MPC.While the jury will remain out for some time on the economic impact of the flexible inflation-targeting framework, it is incontrovertible that the MPC has given monetary policy an independent institutional foundationDebt management: For several decades post-independence, the RBI participated in short-term Treasury Bill issuances of the Government of India (bearing extraordinarily low interest rates) to fund its fiscal deficits. The RBI also publicly acknowledged that its open market operations (OMOs) were primarily geared to manage the government bond yields.
This implied that the central bank balance-sheet was always available as a resource—just like tax receipts—ready to monetise excessive government spending. Unsurprisingly, high inflation in India was engineered to please both Milton Friedman and Thomas Sargent, that is, it was always both a monetary and a fiscal phenomenon, as these two Nobel laureates in economics had respectively argued (Friedman 1970; Sargent 1982).Eventually, recognising the fiscal imprudence and inflationary risks engendered by such automatic monetization of government deficits, joint efforts between the RBI and the government during 1994–1997 limited deficit financing from the RBI to the capped Ways and Means Advances (WMA). The Fiscal Responsibility and Budget Management (FRBM) Act of 2003 explicitly prohibited the RBI from participating in primary issuances of the government securities.Open market operations came to be designed to sterilize the impact on domestic money supply of foreign exchange interventions and/or to meet durable liquidity needs of the economy, rather than to fund deficits. While there have been relapses to old habits, overall these changes have left the task of government debt management with the RBI as primarily being one of auctioning government debt and helping it switch between securities or conduct buybacks, rather than of intricate involvement in fiscal planning, and more importantly, in its funding.
Exchange rate management: In the Five Year Plans post independence, prices including the exchange rate were assumed to be constant; however, since the true value of the Indian rupee fluctuated with market prices and macroeconomic conditions, the Sterling holdings had no choice but to take an undue hit. The underlying true value of the rupee was also affected heavily—but not reflected in reality—by monetary policy and debt management operations that were implicitly supporting the ballooning of government deficits.
The result of the fixed exchange rate regime in the midst of ‘fiscal dominance’ was that the RBI was essentially a silent spectator in the build-up to the inevitable exchange rate disequilibrium(though arguably this was true of much of the world at that time).Since 1976, when the level of the rupee moved to being a ‘managed float’ against a basket of currencies, and especially since 1993, the exchange rate has gradually evolved from being entirely a fixed rate to being market-determined for all practical purposes. The RBI deploys reserves management and macroprudential controls on foreign capital flows to manage excessively large movements. With a flexible inflation-targeting mandate for interest-rate policy and funding of fiscal deficit no longer the objective of monetary operations, the desired exchange rate management rests with the RBI.Ongoing challenges in the RBIFew important pockets of persistent weakness, however, remain in maintaining independence of the RBI. Some of these areas were also identified in the 2017 Financial Sector Assessment Programme (FSAP) of India by the IMF and the World Bank (WB) as ways to strengthen the independence of the RBI, an area in which the FSAP rates India as ‘materially non-compliant’.
Regulation of PSBs: One important limitation is that the RBI is statutorily limited in undertaking the full scope of actions against PSBs—such as asset divestiture, replacement of management and board, license revocation and resolution actions such as mergers or sales—all of which it can and does deploy effectively in case of private banks. The significant implications of this limitation were highlighted in detail in Governor Urjit Patel’s speech (Patel 2018).The RBI’s balance sheet strength: Having adequate reserves to bear any losses that arise from central bank operations and having appropriate rules to allocate profits (including rules that govern the accumulation of the capital and reserves) is considered an important part of central bank’s independence from the government (see, for example, Moser-Boehm 2006). A thorny ongoing issue on this front has been that of the rules for surplus transfer from the RBI to the government. It has been covered deftly by Rakesh Mohan (2018) in the last of his three-part series of recent articles on the RBI, titled Protect the RBI’s Balance-Sheet; therein, he elucidates why a central bank needs a strong balance sheet to perform its full range of critical functions for the economy.I quote his main points below:
First, … The longer-term fiscal consequences would be the same if the government issued new securities to fund the expenditure.{R}aiding the RBI’s capital creates no new government revenue on a net basis over time, and only provides an illusion of free money in the short term.Second, …The use of such a transfer would erode whatever confidence that exists in the government’s intention to practice fiscal prudence. Third, … In theory, a central bank can implement monetary policy appropriately with a wide range of capital levels, including levels below zero. In practice, the danger is that it may lose credibility with the financial markets and public at large and may then be unable to attain its objective if it has substantial losses and is seen as having insufficient capital.Are fears with regard to 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.It is also argued by some that the government can always recapitalise a central bank when necessary. This is certainly true in principle but is practically difficult when the government itself suffers from fiscal pressures and maintains a relatively high debt-GDP ratio, as is the case in India. What is also important is the erosion of central bank independence both in reality and perhaps, even more importantly, in optics. …Once again, better sense has prevailed, and the government has not raided the RBI’s balance sheet.
Regulatory scope: A final issue is one of regulatory scope, the most recent case in point being the recommendation to bypass the central bank’s powers over payment and settlement systems by appointing a separate payments regulator. The RBI has published its dissent note7 against this recommendation on 19 October 2018.
Excerpted with permission of Penguin Random House India