From growing freedom to increasing control

The Balance of Payments crisis in 1991 prompted economic reforms in India.  The reforms included fiscal stabilisation, according a degree of autonomy in conduct of monetary policy, and deregulation of financial sector. They also included marketisation of government borrowing programme, adoption of global standards of banking regulation and establishment of separate capital market, insurance and pension regulatory bodies. 

The overall thinking in Government about reforms changed from the moment Raghuram Rajan Committee gave its recommendations in 2008 and Justice Srikrishna Committee gave its report in 2010.  The influence of RBI on the general thinking on reforms changed and a new framework took its place. 

There are several features of the reform process that are noteworthy from the point of view of interface of fiscal, monetary and financial sector policies.

First, the Government shed its authority in regard to financial and external sector to the RBI regulators, and markets.  RBI gained operational autonomy, aligned the policies with Government and worked closely with Government on structural changes.  Often as in the case of end to automatic monetisation and exchange controls, practice preceded legal mandate.

Second, the Reserve Bank of India played an active role as advisor to Government in all aspects of reform of financial sector.

Third, as the reform progressed, the coordination function at an operational level was assigned by the Government to a Committee on Capital Markets headed by the Governor, with regulators as members and the Joint Secretary, Ministry of Finance, as Convenor.  RBI's balance sheet was strengthened through negotiations with fiscal authorities, thus enhancing the effectiveness of policy reform.

In regard to regulation, however, the Narasimham Committee's major recommendation that there should be no dual control over banks has not been implemented.  Government continues to be a privileged owner of enterprises in the financial sector – thus constraining the regulator's effectiveness. 

The overall thinking in Government about reforms changed from the moment Raghuram Rajan Committee gave its recommendations in 2008 and Justice Srikrishna Committee gave its report in 2010.  The influence of RBI on the general thinking on reforms changed and a new framework took its place. 

New Framework: Coordination

 With the establishment of Financial Stability and Development Council (FSDC) in 2010, all coordination functions are directly with the Ministry.  The Union Finance Minister is the Chairperson of the Council.  The members include the Governor, four Secretaries to Government, a Chief Economic Adviser and four Heads of Regulatory bodies.  The Council has been made responsible for financial development, financial stability, financial literacy, financial inclusion, and most important, inter regulatory coordination.

The government by virtue of its role as a coordinator and at the same time as the owner of the regulated entities puts / makes the central bank and the regulators somewhat ineffective unless they are on the same wave length as the government.  The financial intermediaries in banking, insurance and even non banking mutual funds, etc. continue to be dominated by the presence of public sector.  Hence, the regulators' standard tools are ineffective. 

New Framework: Monetary Policy

The legislative mandate for a new monetary policy framework in India has been provided by amendments to Reserve Bank of India Act.  This came into force in June 2016.  The primary objective of the monetary policy now is to maintain price stability while keeping in mind the objective of growth.  The monetary policy framework in India has to be operated by the Reserve Bank of India.  The central government under the new framework determines the inflation target in terms of consumer price index once in five years.  The regime is described as flexible inflation targetting because the target is 4 per cent, but with upper tolerance level of 6 per cent and the lower tolerance of 2 per cent.  The Monetary Policy Committee consists of three members including the Governor from the RBI, and three outsiders nominated by the government through a procedure prescribed under the law.    In sum, the new monetary policy framework represents the global practice of monetary policy, namely, independence to pursue the objective of price stability.

New Reality

FSDC makes the Government responsible for financial sector development and stability.  In emerging market economies, the instability in the financial sector co-incides with political instability.  Hence, the government will find it difficult to handle the issues of financial instability when the source of instability is the instability of the government itself.  Further, as in the most emerging market economies, adequate technical expertise is concentrated in the central banks relative to government or research bodies. 

The government by virtue of its role as a coordinator and at the same time as the owner of the regulated entities puts / makes the central bank and the regulators somewhat ineffective unless they are on the same wave length as the government.  The financial intermediaries in banking, insurance and even non banking mutual funds, etc. continue to be dominated by the presence of public sector.  Hence, the regulators' standard tools are ineffective. 

The government has the tradition of utilising financial sector in particular bank deposits, as an extended arm of the budget without the Parliamentary oversight.  The fiscal stress has the potential to influence the relationship between the regulator and the government owned regulated, the later having fiscal implications. 

The regulatory framework of banks is not neutral to ownership in the sense that governance of public sector banks continues to be determined by the government.  The fiscal authorities use the banking system to implement some of the government developmental programs and RBI as a regulator does facilitate the use of public deposits with the banks for pursuing governmental programs. 

 In the past, the Reserve Bank of India pursued multiple objectives and the Deputy Governor was closely associated with the formulation of the monetary policy.  Under the new regime, the financial stability considerations are not explicitly taken into account.  In regard to external sector also, the stability considerations are not explicitly built into the monetary policy objectives.  Is there a danger that the advantages of in-built coordination available in full service central bank been foregone?  Is there an identity crisis because of the justa-position of the MPC in a full service central bank? 

The transmission of the monetary policy still depends on the banking system which is dominated by public sector banks.  The standard tools of the monetary policy assume that the system responds on the basis of material and market oriented incentives and disincentives.  However, Public Sector bank responds to monetary policy signals keeping broader public interest in view.  The Finance Minister invariably addresses the public sector bankers after the monetary policy statement to guide the banks on their course of action.  The effectiveness of "independent" monetary policy is blunted by the criticality of government owned banks for transmission of monetary policy.   

The banking regulation has been coordinated closely with monetary policy in the past.  Under the new regime, it is not necessary that they should be coordinated.  However, in reality, the regulatory prescriptions take into account the need for ensuring smooth borrowing program of central and state governments. 

The regulatory framework of banks is not neutral to ownership in the sense that governance of public sector banks continues to be determined by the government.  The fiscal authorities use the banking system to implement some of the government developmental programs and RBI as a regulator does facilitate the use of public deposits with the banks for pursuing governmental programs. 

Finally, with fiscal stress, the sharing of sceneiorage itself has become a bone of contention between RBI and Government.  As per law, the dividend pay out to the government is to be made by a decision of the Board every year out of the surplus of income over expenditure after providing for the transfers of surpluses to the reserves, as required.  In the recent past, however, it is manifest that fiscal considerations are driving the transfers of surpluses from RBI and, in fact, even the timings of the transfers wherein interim dividend was paid to the government, is unprecedented.

(Excerpted from the remarks of Dr. Y V Reddy, former Governor, RBI, at the International Conference on Public Finance: Theory, Practice and Challenges at Patna, on Dec. 7 and 8. The speech was titled: Fiscal, Monetary And Financial Sector Policies: Practitioner's Perspectives on Interface. Dr. Y V Reddy was the Governor of the Reserve Bank of India from 2003 to 2008)