Media reports have portrayed the differences between the government and the Reserve Bank of India (RBI) as a face-off, or worse still, as attempts by the government to undermine the independence of the central bank.
Framing the debate in terms of adversarial engagement is misplaced and ill-informed, and betrays a cynicism that can trigger a chain reaction and generate a critical mass of negative investor perception about the financial markets and the economy. This runs counter to the facts on the ground.
It will be useful to recognise that the fundamentals of the economy are strong, economic growth has been healthy and in excess of seven per cent for the last four quarters, and inflation is well under control. Yes, there are concerns, notably on the current account deficit — largely the result of oil prices — and the pressure it exerts on managing the fiscal deficit. There’s also the liquidity squeeze arising from the Prompt Corrective Action (PCA) Framework enforced by the RBI that can slow domestic investment and output.
The government and the RBI share more than a binary relationship. The economic policy articulated by the government subsumes fiscal policy that is the preserve of the government, and monetary policy that is the mandate of the central bank. Governments pursue a particular economic policy that best addresses their constituencies and hence require a monetary policy that is politically necessary. This is determined by the trade-off between political benefits and economic costs.
The RBI places emphasis on alternative policy objectives that are often different from the political view, and takes a longer-term view of the policy process, than do politicians. From both the strategic and the operational perspectives, in the real world, there will be a conflict of objectives and differences in what actions must be taken and when. The common goal of growth with equity must not be lost sight of.
Differences between the government and the RBI represent a healthy engagement and must be seen as an optimisation process that helps implement a coherent and coordinated strategy that seeks to maximise welfare outcomes. It augurs well for financial regulation.
The government wanting consultations with the RBI must be seen in this light and not with mistrust. Indeed, such consultations can build a coordinated strategy that optimises fiscal policy and monetary policy outcomes, alike. Equally, it would be myopic to see the independent stance and an outspoken central bank as challenging the government. Deputy Governor Viral Acharya’s speech must be seen as an expression of the independence of the RBI.
It has been argued that monetary policy is just another instrument of economic policy, such as fiscal policy, and so should be determined by democratically-elected representatives. But to ensure this is done in a fair and even-handed manner, the accountability of the RBI should be rule-based. Parliament legislates and defines the mandate; thereafter it must be left to the central bank to implement the mandate.
The division of regulatory responsibility is clear. It is within the remit of the RBI to be responsible primarily for price stability, a stable exchange rate for the rupee, and preventing market misconduct to protect small investors. The central bank’s independence is an important institutional mechanism to maintain price stability. The more independent the central bank is, the less the monetary authorities are compelled to finance deficits by creating money.
The most compelling argument for the central bank’s independence is based on the time-inconsistency problem. From a political economy perspective, time-inconsistency arises when there is an incentive for the political government to deviate from a policy commitment made, say on inflation or fiscal deficit targets, and conduct policy by discretion, even when there are no negative shocks.
Typically, this happens when elections are round the corner. Evidence suggests that performance with regard to inflation is better, on average, in countries that have a relatively independent central bank than in countries in which the government more directly controls the central bank. Furthermore, various indicators suggest that this does not come at the cost of lower output growth or higher unemployment.
The crux of the current difference of opinion arises from the concerns in the government, based on representations from its industry constituents, that a liquidity squeeze has resulted from the rather strict enforcement of the PCA norms by the RBI, and that this is affecting investment, growth and hence employment. The government has also sought to draw on the reserves of the RBI to finance its deficit.
These concerns have escalated to the need for consultation, with the RBI remaining unrelenting, despite nudging by the government alluding to section 7 of the Reserve Bank of India Act. From a regulatory perspective we need to remind ourselves that the Vijay Mallya, Nirav Modi and Chanda Kochhar episodes — and the more recent meltdown of Infrastructure Leasing and Financial Services (IL&FS) — are but the symptoms of a deep structural malaise.
The twin balance sheet problem and the mounting NPAs of the public sector banks signify the transfer of public resources to serve private interests, representing serious breach of fiduciary responsibility.
To characterise this political economy process as a systemic failure is to miss the wood for the trees. Governments often encounter the moral hazard in the discharge of fiduciary responsibilities — of ignoring the moral implications of their choices — instead of doing what is right, they do what benefits them the most.
A good central bank is one that can say no to politicians and a good government is one that recognises that good economics trumps bad politics. The recent engagement between the two exemplifies a symbiotic relationship of mutual respect. The government, the market and the citizens must see this in positive light.
(The author is a former Secretary to the Government of India, and is currently Director of Public Affairs Centre, Bengaluru. The views expressed are personal)