S. Sivadas 
S. Sivadas 

Central bank in the centre of the storm



The stand-off between the Finance Ministry and the Reserve Bank of India that has been simmering for long seems to have cooled down for the time being but the basic issues that triggered the crisis remain, that of autonomy and exercise of control.

Considering the country’s archaic laws and learning from the financial crisis across the globe, the Financial Sector Legislative Reforms Commission (FSLRC) had highlighted the need for reform, in its report submitted in 2013. It had recommended changes in financial sector laws to provide the rapidly growing Indian economy a new regulatory architecture.

These were based on a number of RBI and government committee reports that had suggested changes, but it was the first to propose legal changes in the form of the Indian Financial Code that sought to modernize governance and make regulators more independent and accountable. But these attempts, over the last five years have, strangely, been opposed by the RBI itself, the exception being the FSLRC’s proposal for making RBI an inflation targeting central bank.

It has been reported that the RBI opposed the larger number of external members proposed by FSLRC, as this would undermine its independence. Even with three external and three internal members in the committee, the new law gave the RBI governor a casting vote and thus tilted the balance in RBI’s favour.

The RBI has consistently opposed all sorts of reforms. As a former Governor, Raghuram Rajan, argued famously, ‘If it ain’t broke, don’t fix it’.

As the economy grew rapidly, it would seem the RBI’s capacity to evolve and reform did not keep pace and it failed to recognize that if we wait to fix things when they get broken, then the short term solutions that need to be provided were rarely optimal. Long term reform can only be undertaken when there is no crisis.

The speech of an RBI Deputy Governor, Mr. Viral Acharya that discussed these issues was the trigger that brought the rift between the two into public domain more visibly. One reason for the fissures seems to be that at the RBI board meeting there was a debate on some items listed on the agenda and there were reported to be differences between the independent directors and the RBI management.

The present rift seems to be a turning point. If the government uses this opportunity to improve governance, initiate changes in laws and regulations that strengthen India’s financial regulatory architecture, it would be a move in the right direction. If it merely asserts its powers by giving directions or imposing its will by other means, it could well turn into a catastrophe as predicted by Mr. Acharya.

Dr. John Williamson of the US Institutional International Economics coined the phrase ‘Washington Consensus’  to represent a set of  ‘good’ economic policies which commanded general agreement among various powerful institutions situated in Washington like the US Government, the World Bank,  the IMF and many other think tanks. By common usage this came to represent stabilisation and structural reforms policies recommended by these institutions to developing countries as a part and parcel of their loan conditionalities.

These institutions favour immediate marketization, wholesale privatisation, and sharp reduction in government’s fiscal deficit. The assumption is if these defects are reduced and markets liberalised there will be adequate supply response irrespective of financial and structural characteristics of the economy.

They favour uninhibited trade with low or zero tariffs, and flexible market-set exchange rates and current account convertibility. Despite minor variations these are ‘good’ policies and a country that commits to the pursuit of these get their stamp of approval. The actual experience of the implementation of the IMF-backed stabilisation policies has been rather mixed; there have been more failures than successes.

There is no such thing as ‘free aid’ and if we do not keep our economic house in order and there are no options except to beg and borrow to survive then we have to do what the lenders ask us to do.

Come to think of it India’s autonomy was no greater in 1958 when it had to approach the World Bank to organize the Aid India Consortium or in 1966 when the country was living from ‘ship to mouth’. This has happened again in 1973, 1979, 1981 and 1991 to meet the periodic balance of payments crises.

Economic policy, after all, is the art of the possible and economists may propose theories conceptually as well as ideal policies but those have to be  legislated by politicians and carried out by administrators and enforced by the judiciary. The success of any policy would depend upon the response of each segment of these as well as of workers, trade unions, business lobbies, consumers and savers and distributors. Some policies like fiscal prudence might be clearly right while others like bias against agriculture might be clearly wrong. Whether these are proved to be right or not are likely to be determined by the actions and responses of a large number of actors with conflicting interests.

It is in this context that the RBI’s actions have to be seen. While  major central banks the world over have stopped trying to manage government debt after being given an inflation target, the RBI protected its turf and forced the government to withdraw the bill that proposed to reform the bond market. This created a financial system in which large firms with better ratings and collateral accessed the banking sector at the cost of small firms.

Also even though the RBI was free to give out commercial bank licences, it only gave out two such licences in more than a decade. This failed to create a competitive environment where banks compete to give loans to small firms and no one has over the last 15 years addressed the issue of the lack of competition in the banking sector.

Significantly Mr. Acharya’s speech, that triggered the crisis, is peppered with the usual fear mongering and the favourite RBI buzz words whenever the word  reform is mentioned, ‘hyper-inflation’, ‘full-blown crisis’, ‘asset-price crashes’, ‘financial crisis’, ‘sudden-stops’, ‘collapse’, ‘unchecked financial fragility.’

Many countries has undertaken central bank reforms without leading to a crisis, but here  fear mongering has often resulted in governments backing off on the question of reform. As a consequence the RBI is one of the unreformed central banks, according to one economist.

The present stand-off could be turning point if the government uses this opportunity to improve governance, initiate changes in laws and regulations that strengthen India’s financial regulatory architecture. But if it merely asserts its powers by giving directions or imposing its will, this could be the catastrophe Mr. Acharya has predicted.

Until now the government has not paid any heed to the functioning of the RBI board. A healthy functioning board with discussions and debates on important issues and a more accountable RBI should have been the norm and debates at board meetings need not have kicked off storms and brought to the public domain.

When new guidelines for regulation making processes by regulatory boards were brought in 2015 and accepted by all members of the Financial Stability and Development Council, these were not followed by some regulators. But there was no serious follow up. Now after publicly airing differences if the government uses Section 7 of the RBI Act, 1934, to give directions to the RBI on regulations may not be a step towards improving the central bank’s functioning. It would be a step backward in the reform process.

The reserves with RBI have been created by the RBI board and these were not created with the prior permission of the Central Government. The RBI board has not made rules about how much should go into each reserve and in its 2015 Annual Report said that it would come up with a framework for equity capital, but has not done that. The present RBI Act requires only one Reserve Fund of Rs.5 crore.

A central bank is not a normal bank, it is not a commercial bank and so it bears negligible credit risk. Therefore  there is no clear framework, as there is for commercial banks, on the reserves or equity capital and it is not correct to use the Basel framework to compute the equity capital required in a central bank. As a former IMF chief economist, Prof Olivier Blanchard, said, it’s perfectly feasible for a central bank to run on negative equity capital. A central bank could have negative values of rupee equity capital and this does not induce any stress.

Mr. Acharya began his speech thus; ‘No analogy is perfect; yet, analogies help convey things better. At times, a straw man has to be set up to make succinctly a practical or even an academic point.  Let me start with an antecedent from 2010:

‘My time at the central bank is up and that is why I have decided to leave my post definitively, with the satisfaction of my duty fulfilled,’ Mr Martin Redrado, Argentina's central bank chief, told a news conference on January 29, 2010.‘We have arrived at this situation because of the national government's permanent trampling of institutions.’

The roots of this dramatic exit lay was an emergency decree by the Argentine government that would set up a Bicentennial Stability and Reduced Indebtedness Fund to finance public debt maturing that year.

Besides sparking off one of the worst constitutional crises in Argentina since its economic meltdown in 2001, the chain of events led to a grave reassessment of its sovereign risk.

‘This complex interplay of the sovereign's exercise of its powers, the central banker's exit, and the market's revolt, will be at the centre of my remarks today on why it is important for a well functioning economy to have an independent central bank. I will also try to lay out why the risks of undermining the central bank's independence are potentially catastrophic, a ‘self-goal’ of sorts.

‘Before I delve into this complex interplay, I wish to place the independence of the central bank in a more general context. Francis Fukuyama considers two elements, along with adequate state- and institution-building, as all being critical for ‘getting to Denmark,’ or in other words, creating stable, peaceful, prosperous, inclusive and honest societies.’

Switching to cricket from football Mr. Acharya said; ‘A government's horizon of decision-making is rendered short, like the duration of a T20 match by several considerations. There are always upcoming elections of some sort. As elections approach, delivering on proclaimed manifestos of the past acquires urgency; where manifestos cannot be delivered upon, populist alternatives need to be arranged with immediacy.’

In contrast, he says testily, ‘a central bank plays a Test match, trying to win each session but importantly also survive it so as to have a chance to win the next session, and so on. The central bank is not directly subject to political time pressures and the induced neglect of the future; by virtue of being nominated rather than elected, central bankers have horizons of decision-making that tend to be longer than that of governments, spanning election cycles or war periods.

‘Barry Eichengreen, Professor of Economics and Political Science at the University of California, Berkeley, describes the critical feedback role of the market: ‘There are good reasons why countries... delegate monetary policy decisions to technocrats appointed for their expertise. They can take the long view. They can resist the temptation to manipulate monetary conditions for short-term gain. Privileging long-term stability, as history has shown, is positive for economic performance. And it is on this performance that elected leaders, rightly or wrongly, are judged.

‘Thoughtful politicians understand this,’ he continued. ‘Unfortunately, not all politicians are thoughtful.  Not all are pleased when appointees refuse to bow to their wishes. And not all are respectful of inherited institutions and conventions.’

In conclusion he said ominously, ‘As many parts of the world today wait for greater government respect for central bank independence, independent central bankers will remain undeterred. Governments that do not respect central bank independence will sooner or later incur the wrath of financial markets, ignite economic fire, and come to rue the day they undermined an important regulatory institution; their wiser counterparts who invest in central bank independence will enjoy lower costs of borrowing, the love of international investors, and longer life spans.’

- S. Sivadas, Senior Journalist.

(The ideas expressed in the above article are those of the author)