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Government intervention undermines RBI's functional autonomy: Viral Acharya

India's Reserve Bank (RBI) Friday strengthened the importance of central bank independence and warned that the administration's focus on short-term goals could be detrimental to the economy, linking the achievement of long-term financial stability to the regulator's conservative approach. It seemed to be in line with the latest developments that have seen the regulator appear to challenge the government's mindset. Undermining the independence of the regulator may be "catastrophic", said RBI Vice Governor Viral Acharya, referring to the former Argentine Governor's example, which ended in a dispute over the transfer of reserves and the recent criticism of the actions of the central banks of the US and Turkish Presidents. He used a cricketing analogue to illustrate his score. "A government's decision horizon is made short, like the time of a T20 match, with several considerations. There are always future choices of some kind &#821 1; national, state, medium term, etc." said Acharya an audience at the AD Shroff Memorial lecture in Mumbai. "A central bank, on the other hand, plays a test match, trying to win every session but more importantly also surviving it to have the chance to win the next session and so on." Acharya's speech follows the central bank's unforeseen task of publicly publishing its opposition to a proposal to amend the Payment and Settlement Act that would eliminate the regulation of payments from it. The sudden tightness of the financial market for non-bank finance companies (NBFC) and the strict implementation of the defaulter rule, even if…

India’s Reserve Bank (RBI) Friday strengthened the importance of central bank independence and warned that the administration’s focus on short-term goals could be detrimental to the economy, linking the achievement of long-term financial stability to the regulator’s conservative approach.

It seemed to be in line with the latest developments that have seen the regulator appear to challenge the government’s mindset.

Undermining the independence of the regulator may be “catastrophic”, said RBI Vice Governor Viral Acharya, referring to the former Argentine Governor’s example, which ended in a dispute over the transfer of reserves and the recent criticism of the actions of the central banks of the US and Turkish Presidents.

He used a cricketing analogue to illustrate his score.

“A government’s decision horizon is made short, like the time of a T20 match, with several considerations. There are always future choices of some kind &#821

1; national, state, medium term, etc.” said Acharya an audience at the AD Shroff Memorial lecture in Mumbai. “A central bank, on the other hand, plays a test match, trying to win every session but more importantly also surviving it to have the chance to win the next session and so on.”

Acharya’s speech follows the central bank’s unforeseen task of publicly publishing its opposition to a proposal to amend the Payment and Settlement Act that would eliminate the regulation of payments from it. The sudden tightness of the financial market for non-bank finance companies (NBFC) and the strict implementation of the defaulter rule, even if a company has no one-day payments, has put the governor and government on a potential collision course.

“Establishing parallel regulatory bodies with weaker statutory powers and / or encouraging the development of unregulated (or easily regulated) entities that perform financial intermediation functions outside the central bank” undermines its independence, “said Acharya. Acharya defended central bank restrictions on banks whose capital has endured and is covered by the RBI’s so-called rapid correction measure (PCA), which the government wants to relieve for better financing of the economy.

“Lowering banks’ credit losses under the backpack by compromising surveillance and regulatory standards can create a facade of financial stability in the short term, but inevitably cause the fragile card to fall in a pouring sometime in the future, probably with a larger taxpayer and loss of potential production, says Acharya.

Recently the NBFC lobby and funds for a liberal liquidity window to ease the pressure on prices came in for special criticism.

“When the government sees often striving to dilute central bank policy and effectively force the central bank to such dilutions, banks and the private sector spend more time lobbying for policies that suit them individually, at the expense of collective good, rather than investing in value creation and growth , he says.

Although the government and the RBI have differed from issues ranging from PCA to transfer of excess reserves, the central bank seems to appreciate the independence of the monetary policy committee.

“The government deserves great credit for its vision to legislate the necessary changes to strengthen this aspect of central bank independence and to remove itself in the process of monetary decision-making (other than by appointing external MPC members), says the former professor in New York University.

With the markets as the key to national economies, governments who do not honor central bank independence face tough times, he said.

“Governments that do not respect central bank independence sooner or later will suffer from the wrath of the financial markets, ignite economic fire and come to the day they undermine an important regulatory institution,” said Acharya. “Their wiser counterparties investing in central bank independence will enjoy lower borrowing costs, international investors’ love and longer service life.”

Here is the full text of Acharia’s speech:

No analogy is perfect; Nonetheless, analogies help to convey things better. Sometimes a straw man must be established to make brief practical or even an academic point. Sometimes, however, copies from real life will be beautiful to make the communicator’s work easier. Let me start with an antecedent from 2010, because it’s especially suitable for my topic:

“My time at the central bank is up and that’s why I’ve decided to leave my service definitely with Satisfaction of my duty was fulfilled, “Martin Redrado, Argentina’s Governor of Central Bank, told a news conference late on Friday, January 29, 2010.

” We have come to this situation because of the state’s permanent stomping of institutions, “he said. “Basically, I defend two main concepts: Central Bank independence in our decision-making process and that reserves should be used for monetary and financial stability.”

The roots of this dramatic exit lie in an emergency decree passed by the Argentine government led by Cristina Fernandéz on December 14, 2010, which would establish a half-year stability and debt reduction to finance government debt due that year. This meant the transfer of central bank reserves to $ 6.6 billion to the treasury bill. The claim was that the central bank had 18 billion dollars in “surplus reserve”. [In fact, Mr. Redrado had refused to transfer the funds; so the government attempted to fire him, by another emergency decree on January 7, 2010 for misconduct and dereliction of duty; this attempt, however, failed, as it was unconstitutional.]

In addition to rubbing one of the worst constitutional crises in Argentina since its economic meltdown in 2001, the chain of events led to a major reassessment of its sovereign risk.

Within one month of Redrado’s resignation, Argentinean government bond yields and annual premiums to buy insurance against default on Argentinian government bonds (measured as the sovereign credit default swap spread) amounted to 2.5% or 250 points, with more than one quarter of its previous levels.

Alberto Ramos, analyst in Argentina at Goldman Sachs, noted on February 7, 2010: “Using the central bank’s reserves to pay public liabilities is not a positive development and the concept of excess reserves is really open to debate. It weakens the central bank’s balance sheet and gives government incorrect incentive because it weakens the incentive to control the rapid expansion of spending and to promote a consolidation of financial accounts in 2010. “

Even more harmful, the risk Governor Redrado had warned for emerged. At the beginning of January 2010, Thomas Griesa, a judge in New York, had frozen the Argentine central bank’s account held at the Federal Reserve Bank of New York, following objections from investors that the central bank was no longer a self-governing agency but under the thumb

This summary is based partly on the departures of Argentina’s Governor, Jude Webber, the Financial Times, January 30, 2010 and Argentina: The Bank’s Independence on Games like Redrado Deleted, Jason Mitchell, Euromoney, February 7, 2010)

This complex interaction between the government’s exercise of its powers , the withdrawal of the central bank and the market revolt will be at the heart of my comments today about why it is important for a well-functioning economy to have an independent central bank, that is, a central bank independent of the government’s executive branch. I will also try to explain why the risks of undermining the independence of the central bank are potentially catastrophic, a “self-esteem” of various kinds, as it can trigger a crisis of capital in capital markets lost by governments (and others in the economy) to drive their finances.

Why nations succeed (or fail)
Before I enter this complex interaction, I want to place the independence of the central bank in a broader context.

Academic discourse of political economists acknowledges the key roles in the rule of law and governments responsibility for the countries to flourish. Francis Fukuyama (Origins of Political Order, 2011) believes that these two parts, together with sufficient state and institution building, are important for “coming to Denmark” or, in other words, creating stable, peaceful and prosperous, including and genuine societies.

Daron Acemoglu and James Robinson (Why Nations Fail, 2012) summarize their work at the priority of the institutions’ quality to explain the political and economic success or failure of the state. With examples of “twin” national studies (like S. Korea and N. Korea), the book elaborates the following important difference:

– Including economic and political institutions involve diversity in decision making that helps to ensure the rule of law and foster talent and creativity; In the presence of such institutions, economics and politics are not hostage to a set of commander who can be hurt by change.

– In contrast, the mining institutions restrict access to a country’s economic and financial resources to the ruling elites, hinder change and innovation, and over time lead to stagnation and atrophy of the country’s potential.

In conversation with former colleagues at the New York University Business School (NYU Stern), there was the routine of categorizing economies as encouraging and supporting either value creation, whereby entrepreneurs believed that their mantra of success lay in challenging orthodoxy or the letting of renting, where companies primarily valued to coincide with regressive state policy measures and push out others who had no such access.

Regardless of the preferred theory and terminology of the significance of the institutions, it is well accepted that they include, among other things, property rights and their enf domaric and the electoral office in a democracy not only established the right ones but functioned independently and effectively de facto.

Somewhat less celebrated is the institution of an independent central bank, perhaps not only because the central bank is a relatively new child in the neighborhood (in most cases less than a century old), but also because it interacts less directly with the public , even though its real influence is far-reaching.

Government and central bank – A number of two horizons
A central bank carries out several important functions for the economy: it controls the money, lays interest rates on loan and lending money; handles the external sector including the exchange rate monitors and regulates the financial sector, especially banks It often regulates the credit and currency markets. and aims to ensure financial stability, both domestically and on the outside.

All over the world, the central bank is set up as an institution separate from the government. Put in another way, it is not a department for the government’s executive function. Its powers are anchored as separate through relevant legislation. Its tasks are somewhat complex and technical, central banks are ideally led and staffed by technicians or field experts – usually economists, academics, commercial banks and sometimes the private sector representatives, appointed by the government but not elected to the office. This architecture reflects the approval of the dissertation that central banks can exercise their powers independently.

Why is the central bank separate from the government? I will offer what I think is a particularly intuitive explanation:

(1) The first part of the explanation relates to the government’s decision-making against central bank
A government’s decision horizon is brief as well as the time for a T20 match (to use a cricketing analogue), with several considerations. There are always future choices of some kind – national, state, medium term, etc. As election thinking acquires the haste of preached manifestations of the past; Where manifesto can not be delivered, populist alternatives must be arranged with immediateity. Less important in the current scenario, but until recently, why war should be brought, funded and won at all costs. This myopy or short-sightedness of governments is best summarized in the history of Louis XV when he proclaimed “Apres moi, le deluge!” (After me flood!). 2

However, a central bank plays a test match, trying to win every session but more importantly also surviving it to have the chance to win the next session, and so forth. In particular, the central bank is not directly exposed to political pressures and induced neglect of the future. By being nominated rather than elected, central banks have horizons of decision-making that tend to be beyond the tensions of governments, which span valcicles or wartime. While they clearly need to factor in the immediate consequences of their political decisions, central banks can afford to take a break, reflect and ask the question of what the long-term consequences of their, as well as government policy would be. In fact, by its mandate, the central banks are committed to stabilizing the economy over business and finance cycles, and therefore need to be in the medium and long term. It is not surprising that central banks strive to build credibility through a series of difficult choices that reflect sacrifice of short-term gains for long-term results, such as price or financial stability.

(2) The second part of the explanation for why the central bank is separate from the government relates to the observation that much of what the central bank is managing or influencing – money creation, credit creation, external sector management and financial stability – brings potential benefits to the economy, but with the possibility of escorts “Swan risk” in the form of reimbursed costs from economic surpluses or instability. For example,

(i) Greater money supply may facilitate the simplification of financial transactions, including government deficit financing, but this may cause the economy to overheat over time and trigger (hyper) inflationary pressures or even a full-blown crisis that ultimately requires sharper monetary clashes,

ii) Excessive interest rate cuts and / or relaxation in bank capital and liquidity requirements can lead to increased credit targeting, asset price inflation and strong economic growth in the short term, but excessive credit growth is usually followed by lending the quality curve that triggers wrong investments, asset pricing and long-term financial crises,

(iii) Allowing foreign capital flows flood to the economy can temporarily facilitate the financial pressures for a widening state balance and the narrow private sector, but a “sudden halt” or relocation of these flows from moods can trigger a collapse of the exchange rate with negative overall economic surpluses and,

(iv) To lower the banks’ credit losses under the backpack by compromising monitoring and regulatory standards can create a facade of financial stability in the short term, but inevitably get the fragile card to fall into a pile at some point in the future, probably with a larger taxpayer and loss of potential production

While not always the case, the necessary efforts for stable growth are often structural reforms by the government with deferred tax expenditures. However, these can endanger populist expenses or require dissatisfaction with existing ones. As a result, it may seem appropriate for the government to ask / mandate / mandate / target the central bank to run strategies that generate short-term profits but effectively create response risks to the economy. To protect the economy from such short-term, the central bank is intended to be at a safe distance from the government’s executive branch.

Undermine Central Bank Independence
Now, although the central bank is formally organized to be separate from the government, its effective decision-making can be reduced for government’s short gains, if desired, through a variety of mechanisms, including

affiliated) officials rather than technocrats to central central banks, such as governors and more senior executives

To work for permanent resignation and erosion of the central bank’s statutory powers through legislative changes for subscriptions that directly or indirectly earmark for the separation of the central bank from the government, [19659002] Blocking or contradicting rule-based central bank policy and instead promoting discretionary or joint decision-making with direct-law intervention interventions; and

Establish parallel regulatory bodies with weaker statutory powers and / or encourage the development of unregulated (or easily regulated) entities that perform financial intermediary functions outside the central bank’s scope., 3 4

If such efforts are successful, the political myopies in the economy will replace macroeconomic stability with punctual arrival of financial crises.

Therefore, there are several reasons why the maintenance and maintenance of central bank independence ceases to be a comprehensive reform for the economy. and vice versa undermine such independence a regressive, extraordinary one:

When the government is often seen to aim at diluting central bank policy and effectively forcing the central bank to such dilutions, banks and the private sector spend more time lobbying for policies that suit them individually at the expense of collective good, instead of investing in value creation and growth.

When the governance of the central bank is undermined, it is unlikely to attract or retain the brightest minds that enjoy the ability to discuss freely, think independently and affect change. The abolition of central bank powers leads to worn out humanity and its effectiveness and competency deteriorates over time.

When important parts of financial intermediation are held outside the central banking system, systemic risks can be built into “shadow bank” With private gains in good times to a small set of players but on material costs for future generations in the form of uncontrolled financial vulnerability.

As such, the difference in decision-making between government and central bank, as I have emphasized, does not lead to any operational incompatibility as long as it is well understood and well accepted by both parties that it is precisely given this difference that the central bank is formally separated from the executive office and intended to perform their tasks in an independent manner. The central bank can of course make mistakes and be held responsible by parliamentary scrutiny and transparency. In this way, the institutional arrangement of independence, openness and accountability for the public balances not only balance but also strengthens central bank independence. Direct intervention and involvement of the government in operational mandates from the central bank denies its functional autonomy.

“Death Death” – Intrinsic Market Wrath
Foresighted Heads of Government can be able to reap the benefits of convincing voters about the importance of investing in macroeconomic stability, for example by requiring credit for the long-term character of the financial sector’s earnings achieved by letting the central bank independently deciding and delivering its core functions. When such an encouraged perspective of an independent central bank as a key element of lasting economic prosperity is lacking and / or the government’s myopia is so extensive that it leads to regular burglary breakdowns and decision-making, accidents can occur. Macroeconomic management can be a war of war between securing stability and misalignment. Daily operational decisions lead to power struggles. and because the central bank is forced to bend backwards to maintain credibility for an imminent pressure that would cause concern for its independence, increasing conflicting efforts to reduce its independence.

As this dynamic is playing out, markets are paying attention and uncertainty grows and confidence in the central bank’s independence and credibility erodes, rap bond yields and exchange rates are being marketed!

Let me elaborate.

Modern economies are basically not autarchies; They rely on capital markets to fund their investments. This is especially true of governments reflected in the relatively large size of government bonds (and quasi-sovereign) debt markets, denominated in domestic currency and foreign currency. As long-term risks as inflation or financial instability, the markets increase the government debt of the Republic and may potentially reduce funding altogether. This could lead to immediate game translations to other markets such as for foreign currency and foreign investment, which potentially also risks the stability of the economy’s external sector.

Therefore, the presence of this third player market – back and forth between a government and the central bank (more general regulations) is an important feedback mechanism. The market can discipline the government not to worry about the independence of the central bank, and it may also cause the government to pay for its violations. Interestingly, the market also forces the central banks to remain responsible and independent when under pressure.

In addition to the market revolts and strings during Argentina’s episode 2010, as I recounted in my introductory remarks, it should be noted that both the government’s government bonds and currency meltdowns have been catalyzed by an idea of ​​the government’s influence on the central bank’s monetary policy, inter alia through sporadic communication by the government with the public about its desire to control central bank decision making. In one case, a reduction in the tax rate in the wake of rising inflation and increased financial deficits caused the damage. and in the second, there was a public statement from the Prime Minister of State about the “accidents” of interest rate hikes even when inflation was in double-digit terrain.

The market censorship does not really need to be limited to emerging markets. The public expression of the government’s confusion and disappointment on monetary tightening in the world’s largest safe economy, once again at a time of rising inflation and budget deficits, has taken into account investors’ scenarios under which foreign exchange reserves can no longer be taken for granted (A debate about Central Bank independence is Delayed, The Economist, October 20, 2018).

Barry Eichengreen, Professor of Economics and Political Science at the University of California, Berkeley, covers excellent, in his latest paragraph (2018), this critical feedback role in the market:

“There are good reasons why countries … delegates monetary policy decisions to technicians appointed for their skills. They may take a long time, they can resist the temptation to manipulate monetary conditions for short-term earnings. Privileging long-term stability, as the story has shown, is positive for economic development. And it is on this achievement that judge, right or wrong, judged.

Thoughtful politicians understand this. Therefore, their support for the independence of the central bank and their respect for the convention that they should refrain from attempting to influence central bank decisions. Unfortunately, not all politicians are thoughtful. Not everyone is patient with waiting on long-term profits. Not everyone is happy when employees refuse to bend for their island And not everyone is respectful of inherited institutions and conventions, whether they are central bank independence or, to a greater extent, the division of powers.

The question is whether they pay attention to the markets. “

What Barry Eichengreen perceives carefully is that if a government would pay attention to the markets, it would realize that the independence of the central bank is actually its strength and the central bank is a kind of true friend, someone who will tell the government unpleasant but brutally honest truths and correct to the extent that it could potentially have negative long-term consequences of government policy.

Let me now turn to how all this relates to India’s reserve bank.

The late deanatatate provides a masterful and scientific assessment in India’s Reserve Bank: A study in the separation of powers and abuse of power (2005). Some of the discussions below draw much of their judgment and are updated for development since then. Other excellent discussions about the independence and independence of the central bank in the Indian context are in lectures from India’s former governors, Dr C. Rangarajan (1993) and Dr. YV Reddy (2001, 2 007). As will be seen below, other governors and deputy governors have also implemented this attentive theme through their missions. For some of them, even when the reserve bank’s independence has been unclear, governments have finally got wisdom to support it. For others, however, Sparebanken’s independence remains an ongoing work, a sustainable challenge that the country has been struggling with continuously.

Progressive Development to Restore Independent of India’s Reserve Bank

While the Reserve Bank has always derived several important powers from the Reserve Bank Act, 1935 and the Banking Ordinance, 1949, what is important is the effective independence that these powers can be exercised in practice. Over time, large governments have been executed by successive governments at the request of central banks, several economists and otvins, to restore the reserve bank’s operational independence. I will touch three such areas with healthy progress.

(1) Monetary policy: The Reserve Bank, like many of the time’s central banks, quickly became part of the government’s socialist planning policy after independence, setting not only interest on money but virtually all credit rates at different maturities, as well as making sectorial credit allocation to the real economy .

After the liberalization of interest rates in the 1990s, monetary policy achieved a more modern dimension. To begin with, there was a “multiple indicator” method for fixing interest rates. Too many goals for monetary policy violate the Tinbergen principle of “a goal, an instrument”. It also makes it difficult to understand or communicate what the interest setting tries to achieve at any time. Importantly, this approach contained much regulatory discretion, often at individual level, namely. Governor. This made the independence of monetary policy individual, in other words, allowed the government press to easily crawl in order to keep prices low at the time of tax expansion under one or the other.

This is exactly an attitude where rules would be better than discretion, especially to avoid problems with time effects, highlighted in the work of Nobel Prize Finn Kydland and Edward Prescott in the 1970s and early 1980s. Kydland and Prescott (1977) consider the consequences that people, including investors, could look at the future and anticipate the behavior of self-governmental governments so that discretionary monetary policy could end up in compromise of government pressure, leaving inflation expectations unrelated, while monetary policy connected with a rule would be more difficult to bend and hold influence expectations.6

After several episodic events of double-digit inflation, a war on inflation and inflation expectations, finally launched in September 2013 by then Governor Raghuram G Rajan; Urjit Patel Committee’s report on revising and strengthening the monetary policy framework was released in 2014. Finally, India’s law was amended in August 2016 to form the Monetary Policy Committee (MPC).

MPC consists of three RBI members, including the governor who reserve a reconciliation vote and three external members appointed by the government. The MPC has been granted a flexible inflation target to achieve inflation in the medium-term 4% consumer price index (CPI) while at the same time recognizing growth with operational independence to achieve it and with responsibility for transparency regarding the MPC resolution, summarizing protocols each individual committee’s decision, semi-annual monetary policy reports and a written report to the government about a +/- 2% band on target inflation are broken against three quarters in a row. [19659002] MPC, which, two years ago, has consistently sought through its decision-making decision to build the credibility of the inflation target, a process that is generally believed and empirically documented to help lower long-term bond yields and stabilize the exchange rate. While the jury will remain a certain amount of time for the economic impact of the flexible inflation targeting framework, it is unbelievable that the MPC has given monetary policy an independent institutional basis. Regeringen förtjänar stor kredit för sin vision att lagstifta de nödvändiga förändringarna för att stärka denna aspekt av centralbankens oberoende och avlägsna sig i processen från monetärt beslutsfattande (annat än genom utnämning av externa ledamöter i MPC). [19659002] 2) Skuldhantering: I flera årtionden efter oberoende deltog resebanken i kortfristiga statsskuldutdelningar från indiens regering (med utomordentligt låga räntor) för att finansiera sina underskott i de offentliga finanserna. The Reserve Bank also publicly acknowledged that its open market operations (OMOs) were primarily geared to manage the government bond yields. This implied that the central bank balance-sheet was always available as a resource – just like tax receipts – ready to monetise excessive government spending. Unsurprisingly, high inflation in India was engineered to please both Milton Friedman and Thomas Sargent, i.e., it was always both a monetary and a fiscal phenomenon, as these two Nobel laureates in economics had respectively argued (Friedman, 1970 and Sargent, 1982).

Eventually, recognizing the fiscal imprudence and inflationary risks engendered by such automatic monetization of government deficits, joint efforts between the Reserve Bank and the government during 1994-1997 limited deficit financing from the Reserve Bank to the capped Ways and Means Advances (WMA). The Fiscal Responsibility and Budget Management (FRBM) Act of 2003 explicitly prohibited the Reserve Bank from participating in primary issuances of the government securities. Open market operations came to be designed to sterilise the impact on domestic money supply of foreign exchange interventions and/or to meet durable liquidity needs of the economy, rather than to fund deficits. While there have been relapses to old habits, overall these changes have left the task of government debt management with the Reserve Bank as primarily being one of auctioning government debt and helping it switch between securities or conduct buybacks, rather than of intricate involvement in fiscal planning, and more importantly, in its funding.

Furthermore, the repressive levels of Statutory Liquid Ratio (SLR) and Cash Reserve Ratio (CRR), which ensured substantial portions of bank deposits were channeled to the government or were readily available to debase in value through monetary expansion, have now been rationalised to be more or less in line with international prudential standards. For instance, in case of SLR, the level has been steadily reduced and the plan is to harmonise it with the Basel III Liquidity Coverage Ratio (LCR).

(3) Exchange Rate Management: In the Five Year Plans post-independence, prices including the exchange rate were assumed to be constant; however, since the true value of the Rupee fluctuated with market prices and macroeconomic conditions, the Sterling holdings had no choice but to take an undue hit. The underlying true value of the Rupee was also affected heavily –– but not reflected in reality ­­–– by monetary policy and debt management operations that were implicitly supporting the ballooning of government deficits. The result of the fixed exchange rate regime in the midst of “fiscal dominance” was that the Reserve Bank was essentially a silent spectator in the build-up to the inevitable exchange rate disequilibrium (though arguably this was true of much of the world at that time).

Since 1976, when the level of the Rupee moved to being a “managed float” against a basket of currencies, and especially since 1993, the exchange rate has gradually evolved from being entirely a fixed rate to being market-determined for all practical purposes. The Reserve Bank deploys reserves management and macro-prudential controls on foreign capital flows to manage excessively large movements. With a flexible inflation-targeting mandate for interest-rate policy and funding of fiscal deficit no longer the objective of monetary operations, the desired exchange rate management rests with the Reserve Bank.

Ongoing Challenges in Maintaining Independence of the Reserve Bank of India

Few important pockets of persistent weakness, however, remain in maintaining independence of the Reserve Bank. Some of these areas were also identified in the 2017 Financial Sector Assessment Programme (FSAP) of India by the International Monetary Fund (IMF) and the World Bank (WB) as ways to strengthen the independence of the Reserve Bank, an area in which the FSAP rates India as “materially non-compliant”.

(1) Regulation of Public Sector Banks: One important limitation is that the Reserve Bank is statutorily limited in undertaking the full scope of actions against public sector banks (PSBs) – such as asset divestiture, replacement of management and Board, license revocation, and resolution actions such as mergers or sales –– all of which it can and does deploy effectively in case of private banks. The significant implications of this limitation were highlighted in detail in Governor Patel’s speech in March 2018, Banking Regulatory Powers should be Ownership Neutral. To reiterate from the FSAP (Para 39 in Summing up Responsibilities, Objectives, Powers, Independence, and Accountabilities, the Basel Core Principles Detailed Assessment Report):

“Legislation should be amended to enable the RBI to extend all the powers currently exercised over private sector banks to PSBs; in particular, regarding Board member dismissals, mergers and license revocation. … It should also remove the option of an appeal to the government when the RBI revokes a license. If statutory changes are difficult, the RBI and the government should consider adopting a framework agreement whereby the government would acknowledge the RBI’s full operational authority and independence in supervision and regulation, as they did recently for monetary policy.”

(2) The Reserve Bank’s Balance-sheet Strength: Having adequate reserves to bear any losses that arise from central bank operations and having appropriate rules to allocate profits (including rules that govern the accumulation of capital and reserves) is considered an important part of central bank’s independence from the government (see, for example, Moser-Boehm, 2006). A thorny ongoing issue on this front has been that of the rules for surplus transfer from the Reserve Bank to the government (Cogencis, 2018, “Govt pegs RBI excess capital at 3.6 trln rupees, seeks it as surplus”), an issue that relates closely to the leading Argentine example in my introductory remarks. It has been covered deftly by Rakesh Mohan (2018) in the last of his three-part series of recent articles on the Reserve Bank, titled Protect the RBI’s balance-sheet; therein, he elucidates why a central bank needs a strong balance-sheet to perform its full range of critical functions for the economy. I quote his main points below:

“First, … The longer-term fiscal consequences would be the same if the government issued new securities today to fund the expenditure. [R]aiding the RBI’s capital creates no new government revenue on a net basis over time, and only provides an illusion of free money in the short term.”

“Second, … The use of such a transfer would erode whatever confidence that exists in the government’s intention to practice fiscal prudence.”

“Third, … In theory, a central bank can implement monetary policy appropriately with a wide range of capital levels, including levels below zero. In practice, the danger is that it may lose credibility with the financial markets and public at large, and may then be unable to attain its objective if it has substantial losses and is seen as having insufficient capital.

Are fears with regard to possible central bank losses illusory? According to the Bank for International Settlements (BIS), 43 out of 108 central banks reported losses for at least one year between 1984 and 2005.

It is also argued by some that the government can always recapitalise a central bank when necessary. This is certainly true in principle but is practically difficult when the government itself suffers from fiscal pressures and maintains a relatively high debt-GDP ratio, as is the case in India. What is also important is the erosion of central bank independence both in reality and perhaps, even more importantly, in optics. …

Once again, better sense has prevailed and the government has not raided the RBI’s balance sheet.”

(3) Regulatory Scope: A final issue is one of regulatory scope, the most recent case in point being the recommendation to bypass the central bank’s powers over payment and settlement systems by appointing a separate payments regulator (also covered by Rakesh Mohan in his series, ibid). The Reserve Bank has published its dissent note against this recommendation on October 19, 2018.

Let me conclude with some notes of gratitude and dedication as well as some for further reflection.

Mr. Malegam has been a long-time adviser, friend and well-wisher of the Reserve Bank of India, as well as its former Board Member. He is someone I personally admire for his intellect, clarity of thinking and sagacity. I thank you, Mr. Malegam, for inviting me to deliver the A D Shroff Memorial Lecture for this year.

The Late Ardashir Darabshaw Shroff served as India’s non-official delegate in 1944 at the United Nations “Bretton Woods Conference” on post-war financial and monetary arrangements. One of his primary concerns was to seek a permanent seat on the executive board of the International Monetary Fund and the World Bank, which unfortunately did not materialise. To me, his most important contribution was the co-founding in 1954 of the Free Forum Enterprise think tank which through open dialogue presented a counterpoint to the socialist tendencies that were taking root in the country in the post-independence era government. Sucheta Dalal’s biography, A. D. Shroff – Titan of Finance and Free Enterprise (2000), notes that George Woods, one of the most popular presidents of the World Bank, said of him:

“Nobody could accuse A. D. Shroff of hiding his opinions and in the later years of his life, very rarely were those opinions fashionable in India. Yet few patriots did more than he [did] to make friends for the Indian nation and to build confidence in that nation among those throughout the world whose business it is to provide capital for sound investment opportunities.”

In all humility, to emulate A. D. Shroff’s freedom to criticize policy “actuated by the single motive of trying to promote the good of my country” (from his letter to Sir Osborne Smith, the first Governor of the Reserve Bank), I chose for today’s occasion the theme of the importance of independent regulatory institutions, and in particular, that of a central bank that is independent from an over-arching reach of the state. This theme is certainly one of great sensitivity but I contend it is of even greater importance to our economic prospects. I earnestly hope that I have done some justice to his immortal legacy to independent economic discourse and policy-making.

In the process, I have attempted to convince you that we have made good progress in earning the Reserve Bank’s independence, most notably in the monetary policy framework (changes wherein, along with the Insolvency and Bankruptcy Code and the Goods and Services Tax, were considered as crucial structural reforms by Moody’s in upgrading India’s sovereign rating eleven months back). To secure greater financial and macroeconomic stability, these efforts need to be extended to effective independence for the Reserve Bank in its regulatory and supervisory powers over public sector banks, its balance-sheet strength, and its regulatory scope. Such endeavor would be a true inclusive reform for the Indian economy’s future. Thankfully, it is only a matter of making the right choices, which I believe as a society we can with adequately thoughtful “what-if” analysis; I have sketched a scenario, which several parts of the world are presently witnessing, of great risk to nations from undermining the independence of their central banks.

In his excellent biography, Volcker: The Triumph of Persistence (2012), my former NYU Stern colleague, Bill Silber, describes in vivid detail how in the 1980s, the then Federal Reserve Governor Paul Volcker adopted a curmudgeonly approach to setting interest rates to target inflation. Besides resisting any and all pressure to keep rates low, which would have effectively allowed cheap funding – in the short term – of President Reagan’s expansionary deficit-based manifesto, Volcker engaged personally with the President to convey the perils of running high fiscal deficits right after double-digit inflation had just been tamed. In the end, Volcker won the day as wise counsel prevailed, deficits were reined in, and inflation tamed even further. I would argue that through Volcker’s tough stance on inflation and candour on risks from government’s fiscal plans, the institution of the Federal Reserve had in fact been President Reagan’s true friend.

As many parts of the world today await 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.

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