Bullying India’s Central Bank Won’t Help Its Economy
After a brief lull, the strain in the fractious relationship between India’s Finance Ministry and its central bank, the Reserve Bank of India, is back. India’s annual budget ritual last month, in which Finance Minister Palaniappan Chidambaram presented the country’s economic and fiscal policy, provided a brief respite.
With the RBI scheduled to announce a monetary-policy review on March 19, however, pressure on the central bank to cut interest rates to spur growth is once again building. There are no prizes for guessing who’s piling it on -- the finance minister himself. And he chose a rather awkward moment to rekindle his campaign, conveying his desire for lower rates through the media soon after attending a meeting of the central bank’s board.
Chidambaram’s duel with the RBI is of a piece with global developments. Although countries caught up in the global slump of the last five years initially coordinated their monetary and fiscal survival strategies, the lingering crisis is testing that comity. Indeed, many governments are reconsidering the so-called independence of central banks. Whether this process will eventually lead to a complete rescinding of central bank independence is uncertain, but one thing is definite: The uneasy relationship between fiscal and monetary authorities will certainly get renegotiated.
Some pointers to its evolution might emerge from India. The struggle between RBI Governor Duvvuri Subbarao and the Finance Ministry, first led by Pranab Mukherjee (who has since been named India’s president) and now by Chidambaram, has raged for the past three years, ever since the RBI began increasing interest rates to squeeze out inflation. As growth slowed dramatically, the Indian corporate sector and government were quick to blame the RBI.
Subbarao has reasons for keeping rates high. Inflation has failed to moderate; headline inflation (measured through its wholesale price index) averaged about 7.5 percent from April through December 2012, way above the RBI’s comfort zone of 4 percent to 4.5 percent. Consumer inflation has been above 10 percent for a while now. Subbarao’s communiques have consistently asked the government to help cool prices by getting its finances under control.
He has a point.
Rocked by the jet wash of the global financial crisis, the Indian government and RBI jointly started a stimulus program that involved duty cuts, easy liquidity, rock-bottom interest rates, higher outlays for social entitlement programs, salary increases for government employees and increased grain prices for farmers. All these were designed to boost consumption. Economic growth bounced back -- from 6.7 percent in 2008-09 to 8.6 percent in 2009-10. However, this spurt in consumption and demand, combined with monsoons failing in 2009, sparked an inflationary spiral, forcing the RBI to pull back its easy-money policy.
Unfortunately, the government hasn’t been as swift in ending its stimulus program. The government’s boost to consumption, especially at a time when demand has exceeded the system’s capacity to supply, fueled inflationary fires. One reason the ruling party has persisted with more funding for numerous welfare plans and burgeoning subsidies could be its misplaced perception that higher outlays for entitlement programs helped it win additional votes in 2009.
The central bank, on the other hand, thinks the government hasn’t invested enough in supply-side infrastructure -- such as roads -- that could efficiently deliver goods and services without creating inflationary friction. The RBI contends that, given the inadequate level of infrastructure, India’s potential growth rate, or the gross domestic product growth rate at which inflation stabilizes at a desired level, shouldn’t be higher than 6 percent. And the only way to slow down growth is to increase interest rates.
Starting in 2010, allegations of government favoritism in allocating natural resources to preferred industrialists added to the economy’s woes. Spooked by court cases and investigations, investors pulled back. As a result, GDP also started floating down.
The government, however, held to its contention that India’s potential growth rate was higher, at 7 percent to 7.5 percent. Because of this difference, the two economy managers also, unfortunately, adopted divergent prescriptions.
It isn’t that the RBI has been unreasonable or obdurate. On Jan. 29 this year, the RBI cut benchmark rates and a crucial reserve requirement (which mandates banks to deposit a certain percentage of their deposits with the central bank without earning any interest on it) by 25 basis points. This was the second rate cut in nine months. In April 2012, too, the RBI slashed benchmark interest rates by 50 bps. Notwithstanding industry’s specious arguments that only rate cuts can spur economic growth, the interest-rate reduction has failed to translate into improved economic activity. Instead, for the quarter ending in December, the Indian economy posted its lowest quarterly GDP growth in 10 years.
The RBI worries that an already stretched government has little room for more fiscal stimulus if another global crisis emerges. Europe came close to delivering on that threat in 2012.
In addition to the unseemly battle of wits over interest rates, the RBI has also been fighting an escalating series of skirmishes with the Finance Ministry on other fronts. In 2010, for example, then-Finance-Minister Mukherjee announced the creation of the Financial Stability and Development Council, a monitoring body that took over some functions that the RBI used to oversee, much to the bank’s public discomfiture.
In the same speech that he used to introduce the FSDC, Mukherjee announced the issuance of new banking licenses. That step irked the RBI not just because of its bad experiences with private banks in the days before they were nationalized in 1969 and 1980, but also because after private banks were allowed again in 1991, several of them had to be subsequently absorbed by bigger banks or shut because of bad lending and poor- governance issues.
As a precondition to issuing new licenses, the RBI forwarded a list of demands, including powers to inspect any holding company’s books (even if it was a manufacturing company) and a request for the authority to overhaul the board of any bank. The RBI also drew a line in the sand forbidding securities firms or real-estate companies from getting bank licenses. Needless to say, the Finance Ministry pressed the RBI to hasten the release of guidelines and not to disqualify anybody. When the RBI issued the final guidelines on Feb. 22, it did so without any exclusions, though it reserved the right to reject any applicant.
Last year, the RBI was also irritated by instructions on the handling of bulk deposits that the ministry issued directly to 26 public sector banks in which the government had more than a 51 percent stake. That marked the first time the ministry issued prudential regulations without involving the regulator. And in November, the RBI and the finance minister got into a quiet tussle over extending the terms of two of the bank’s deputy governors. The government’s handling of the matter created an impression that it was, in effect, trading extensions and appointments in exchange for obedience.
Combined with the Jan. 29 rate cut, such scuffles (and in particular the one over bank licensing guidelines) have provoked disquiet: Is the RBI capitulating to unremitting Finance Ministry pressure? If that’s so, it could have severe implications for India’s future economic management, because an independent central bank has been the centerpiece of the country’s growth story. Apologists for fiscal supremacy point to global developments and claim that India can’t remain isolated from how the relationship between monetary authorities and governments is changing worldwide.
In Japan, for instance, newly elected Prime Minister Shinzo Abe started his term in office by asking the Bank of Japan to print more money and moving to install his like-minded candidates at the bank. Hungarian Prime Minister Viktor Orban used his party’s majority in parliament to push through legislation that curtails central bank powers. Serbia’s new president, Tomislav Nikolic, legislated rules that make it incumbent on the National Bank of Serbia to buy public-sector debt. Bank of Israel Governor Stanley Fischer plans to step down in June after more than eight years at the job and ahead of his retirement, sparking rumors of discord (which Fischer denies) with Israel Prime Minister Benjamin Netanyahu.
Nobel Prize-winning economist Joseph Stiglitz recently waded into these muddy waters. Speaking in Mumbai in early January at the invitation of the RBI, the economics professor from Columbia University derided the notion of central-bank independence. “In the crisis, countries with less independent central banks -- China, India, and Brazil -- did far, far better than countries with more independent central banks, Europe and the United States.”
It fell upon a central banker to defend the fortress of monetary policy. While welcoming Stiglitz, Subbarao pitched hard for central-bank independence: “The issue of monetary policy independence has acquired greater potency following the expansion of the mandates of central banks and their more explicit pursuit of real sector targets such as growth and unemployment.”
So, with the Indian economy sagging and the bank’s prerogatives under assault, which way will the RBI turn on March 19? While Chidambaram asks for a rate cut, fresh price increases blow new life into inflationary embers. Consumer price inflation for February came in at 10.9 percent, including food inflation at an unconscionable 13.4 percent. Moreover, given a budget that promises only a modicum of cuts over the next year, worries remain on the expenditure side of the balance sheet -- especially given the continued resorting to handouts and subsidies, items that spur consumption and hence inflation. Chidambaram also might have other compulsions: another round of elections in 2014.
In the absence of a move to kick-start stalled investments, the government seems overly reliant on the RBI to deliver economic growth through rate cuts. This is undermining the bank’s institutional autonomy.
The root of the problem lies within the legislation governing the RBI -- the Reserve Bank of India Act, 1934. It is completely outdated and needs to be rewritten immediately. For one, the preamble of the Act confers on the RBI a “temporary” status that hasn’t changed in the 75-odd years of its existence.
Second, the act also stipulates that the government will appoint the governor and “not more than” four deputy governors. Consequently, a governor entrusted with the responsibility of steering an economy down the narrow path of growth -- while shielding it from inflationary pressures, financial instability and external risks -- can’t select even one member of the team that he would like to work with.
A commission set up by the Finance Ministry to review all laws regulating the financial sector has promised to revisit the RBI Act. As the approach paper of the Financial Sector Legislative Reforms Commission says, “Monetary policy independence is required, in order to avoid election-related cycles in monetary policy. Alongside this independence, an accountability mechanism needs to be set up.”
The central bank’s role as an investment bank for government-issued debt is another source of controversy. While selling government securities, the RBI also must try and wrest the lowest possible interest rate from the market. However, that might be antithetical to its views as a monetary authority, thereby engendering a conflict of interest. The FSLRC promises to draft a new law on this.
The shape of the FSLRC’s draft -- specifically, how it combines independence with accountability -- may hold lessons for the rest of the world. Chidambaram and Prime Minister Manmohan Singh (who has served, at different times, as both RBI governor and finance minister) have an opportunity to create an institution that can become a regulatory role model. That is in their interest, too. India direly needs foreign capital, given its gaping current-account deficit, and investors across the world admire an independent central bank.
Of course, the RBI already has some things going for it, such as a deep organizational culture that has helped it evade “regulatory capture.” But, more importantly, by shielding the Indian financial system from the global financial crisis, the bank rightfully earned some bragging rights.
Its ability to detect incipient systemic risks won it admiration across the world. The combination of two critical attributes -- risk mitigation and independence (tempered duly by accountability) -- in a world fraught with new uncertainties is a killer app. That alone should be a compelling reason for augmenting, not diluting, the RBI’s independence.
(Rajrishi Singhal, the former research head for Dhanlaxmi Bank and executive editor at The Economic Times, is a policy analyst in Mumbai. The opinions expressed are his own.)
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