The deteriorating optics of central bank independence

The debate over the degree of independence with which the Reserve Bank of India (RBI) operates is neither new nor novel. But a series of public incidents over the last few months have put the spotlight back on the issue.

These incidents have ranged from the comical to the worrisome.

In April, RBI Governor Raghuram Rajan, in an interview to news website MarketWatch, said that India should not get carried away with all the praise being thrown its way for being the world’s fastest-growing economy. He likened the country to being a “one-eyed king in the land of the blind”. Not the best choice of words but hardly enough cause for the uproar that followed from political leaders from the government. The issue spiraled. Four days later, Rajan was forced to defend and explain his remarks although he did not withdraw them.

“We cannot get carried away by our current superiority in growth for as soon as we start distributing future wealth as though we already have it, we stop doing what we are supposed to do to keep growing,” he said. “This movie has played too many times in the past for us not to know how it ends.”

The whole incident was forgotten until former RBI governor D. Subbarao released his memoir Who moved my interest rate this month. In it, Subbarao details the pressures he faced from the government to be a “cheerleader” for the economy. In particular, Subbarao writes about the push from the government to forecast higher rates of growth than the RBI’s own projections indicated. This, even as the government pushed for lower interest rates. The disconnect in asking the RBI to forecast stronger growth while also seeking lower rates apparently escaped the concerned officials.

The demand for lower rates from the government has remained a constant across the tenures of Subbarao, Rajan and presumably other governors as well.

Subbarao speaks openly in his book about government officials asking him to cut rates even though he didn’t feel the conditions were right. Sure, they are entitled to a view but they are not entitled to public rebukes of the RBI and its governor if their advice is not taken. That’s exactly what happened to Subbarao.

While Rajan has not publicly outed any such demands made of him, the series of speeches he has given, since he announced his decision to leave the central bank, suggest that his anti-inflation stance was being questioned.

In a speech titled ‘Policy & Evidence’ on 26 July, Rajan highlighted fallacies in the view that the Reserve Bank has hurt growth and credit growth by keeping interest rates high. Credit growth is low not because of high rates or even the clean-up of bank balance sheets, said Rajan.

His charts highlighted that it is largely the growth in corporate credit that has fallen in the case of public sector banks. The reason for this is excess exposure to certain groups, companies and sectors rather than high rates or lack of capital. Rajan also refuted claims that inflation had slipped because of the fall in global prices and not because of RBI’s interest-rate policy.

“How could the Reserve Bank have brought down inflation without killing demand? By bringing down the public’s expectations of inflation and by not giving in to the clamour to slash interest rates!” said Rajan. He went on to say that governments must look beyond “uninformed and motivated public criticism and protect the independence of their central bank to act” and added, that this is essential for stable sustainable growth.

This was the second time that Rajan came out strongly to defend his stance on inflation. On 20 June, two days after he announced his decision to step down, Rajan argued that the inflation fight must continue even if it means some pain in the short term.

The fact that Rajan felt the need to defend his policies leaves you with the impression that the Rajan-led RBI and the government were at odds on the issue of growth and inflation.

Rajan has also come out to defend his decision to push for a time-bound clean-up of bank balance sheets. Needless to say, the vacuuming of bad loans has meant pain for a number of well-connected industrialists and has put pressure on the government to recapitalise state-owned banks. Many speculate that this was a point of friction and fear that the bad loan clean-up will now slow down. “Rajan’s departure is very bearish if it is a sign that the Modi government is not going to prioritise cleaning up the banking system. For unless the balance sheets of the public sector banks are ‘sorted’ Modi is not going to realise his growth ambitions. Hopefully, this is not the case,” wrote Christopher Wood, managing director and equity strategist at CLSA on 23 June.

Apart from the differences over substantive issues, Raghuram Rajan, the outgoing governor, has also been subjected to personal attacks—something not seen in India in the past.

Each of these instances, individually and collectively, paint a picture of a political establishment that is not averse to subverting the independence of the Reserve Bank of India. If this impression is incorrect, it is up to the government and the politicians to correct it before it damages the standing of the country’s central bank and, in turn, its economy. As reams of research over the years has shown, a more independent central bank is a more effective central bank.

Ira Dugal is deputy managing editor, Mint.