Heed warning: RBI sends strong message to govt

The Reserve Bank of India was set up twelve years before India’s independence. In the eight decades of its existence it has distinguished itself with conduct of the highest global standards. It is among a handful of national institutions known for exemplary integrity and incorruptibility. It may, of course, have had its share of bad apples, and it may have committed policy mistakes (known only in hindsight).  But overall its rock-solid reputation has been built over a long period, of testing times that needed tough decisions. This reputation took a bit of a dent during and immediately after demonetisation. Was such a drastic move not fully thought through? Why was there a shortage of the new notes? Why were the ATM’s not ready, and had to be retrofitted due to a size mismatch? The RBI had to issue more than fifty instructions and clarifications, sometimes overturning a prior instruction, in the immediate period after demonetisation. The Governor, Dr. Urjit Patel was unusually silent and absent from public media, and most of the explanation about demonetization came from elsewhere, even though technically this was an RBI decision. And to top it all, the RBI took more than one year to count the returned “demonetised” notes, to finally reveal, that more than 99 percent had come back. So, no “black money” had been caught stranded with crooked hoarders, as had been earlier expected. 

A crucial pre-requisite for the central bank to function effectively in public interest, is its independence from government interference. Of course, it is not one of the three conventional pillars of democracy, like the judiciary, which must be independent of the legislative and executive branches of government. The main reason for keeping the central bank independent is that governments are much more myopic, since political considerations are often short term.

The episode of demonetisation is behind us, and historians with more hindsight may be able to describe RBI’s behaviour with more clarity about the political context. It could be called an aberration in an otherwise stellar record. Be that as it may, since then the RBI seems to have reverted to what it is best known for - a central bank capable of tough decisions, which are proactive and in the best interests of monetary and financial stability. This is especially welcome in the times of rising bad loans, weak bank balance sheets, unstable financial flows, gyrating stock markets and much scope for panic and rumours. 

A crucial pre-requisite for the central bank to function effectively in public interest, is its independence from government interference. Of course, it is not one of the three conventional pillars of democracy, like the judiciary, which must be independent of the legislative and executive branches of government. The main reason for keeping the central bank independent is that governments are much more myopic, since political considerations are often short term. Thus, governments may push up fiscal spending to boost growth in the near term, or may push to keep interest rates low, to keep borrowing costs low, or may prefer to be lenient about loan recovery, so that factory jobs are not endangered. All these actions may be due to electoral compulsions, or simply political short-termism. But the medium or long term costs, in terms of inflation or recession and financial instability may be enormous. Hence it is the central bank which is entrusted with the responsibility of maintaining monetary and financial stability over a longer time horizon. Thus, central banks have to be vigilant and proactive, and be ready to tighten money supply at the slightest hint of build-up of inflationary pressures. A famous central banker once said, the central bank’s job is to take away the punch bowl (with the alcoholic drink), just as the party gets going.

Interest rates should be such that they are appropriate for the supply and demand for overall credit. If they are too low (to suit government’s borrowing), it can lead to runaway credit creation. As for exchange rates, the central bank does not directly control it or fix it. But it can intervene to reduce volatility. The accumulation of stock of forex is to take care of sudden outflows, when investors stampede out. The government may be tempted to raid the balance sheet of the central bank, but that has to be firmly resisted. These are some of the reasons why central bank independence is crucial for the long term interest of the economy.

Dr. Acharya provides relevant international evidence, such as from Argentina, of how interfering with central bank independence led to a financial and ultimately a constitutional crisis. Indeed, he warns that governments that do not respect central bank independence will sooner or later incur the wrath of financial markets, ignite economic fire and rue the day they undermined the institution’s autonomy.

These thoughts were articulated in a masterly fashion by Deputy Governor Dr. Viral Acharya last week at the A. D. Shroff Memorial Lecture in Mumbai. Every speech of the Governor or his deputies is a window into the central bank’s thinking, and provides important clues about its stance and the logic behind it. This speech must be read and studied in its entirety to understand the importance of central bank independence. Lately there are concerns in India that the government may be putting undue pressure on RBI to toe its line, or to deviate from polices with an eye on short term payoffs, but long term grief. Dr. Acharya provides relevant international evidence, such as from Argentina, of how interfering with central bank independence led to a financial and ultimately a constitutional crisis. Indeed, he warns that governments that do not respect central bank independence will sooner or later incur the wrath of financial markets, ignite economic fire and rue the day they undermined the institution’s autonomy.

In the past few years, the RBI Governor too has cautioned the government about fiscal profligacy. In another speech he compared the clean-up of bad loans to the churning of “samudra manthan” and that the RBI was willing to even drink the poison such a churning would throw up, to improve the health of banking. In this context he mentioned the fact that limited authority to control, supervise or discipline public sector banks and their boards, was a serious handicap for the RBI. By contrast the supervision of private banks was more effective. Most significantly, the RBI has been firm about its famous circular of February, which gives clear guidelines for restructuring bad loans in a strict timeline, or else the borrower goes into bankruptcy proceedings. The RBI faced tremendous pressure to dilute this framework, but has stayed firm. It is due to a series of such difficult choices made over many decades, that a formidable reputation is built. It is the cumulative actions of its leadership, as well as unsung actions of the rank and file, which reinforce the sturdiness of this great institution.  For the RBI to remain one of the world’s best and effective central banks, it is crucial to protect and preserve its independence. This was the central message of the lucid and scholarly speech of the Deputy Governor.

(The writer is an economist and Senior Fellow, Takshashila Institution)