G. Gurucharan | 06 Nov, 2018
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
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
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
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
A good central bank is one that can say no to politicians and a good government
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.