Aniruddha Chowdhury/Mint
Aniruddha Chowdhury/Mint

Opinion | Why the Reserve Bank of India needs de jure independence

We are now headed to a situation where the central bank will be, in all but name, a branch of the finance ministry

And so it has begun. I first sounded an early warning bell as early as 8 October 2018 in this space (Ill Winds Blow On Mint Road) and most recently wrote about it on 17 December 2018 (Watching A Tragedy Unfold), exactly a week after the resignation of Urjit Patel as governor of the Reserve Bank of India (RBI).

Since then, newly appointed governor Shaktikanta Das, a veteran bureaucrat and loyal lieutenant of the Narendra Modi government, has wasted little time in making clear that it is back to business as usual, as it was in the good old days: cosy consultations with stakeholders such as the chiefs of public sector banks and vague promises of injecting more liquidity into the system, as well as reversing RBI’s tough stance on bad debts in the micro, small and medium enterprises (MSME) sector.

More recently, RBI has paid out a hefty dividend to the government, while assorted committees deliberate on the capital structure of the institution and the governance and management of RBI itself. The message: the spigots are being opened wide, in the hope they may give a fillip to the economy in advance of elections.

If there were any grain of doubt anyone might have had on 11 December, when Das took charge, that should now be erased. The government has taken a wrecking ball to the de facto functional autonomy of the central bank, and by the time his work is done, RBI will be but a shadow of the formidable institution it had become under former governors Raghuram Rajan and Urjit Patel.

Instead, we are now headed toward Latin American and African territory, where the central bank will become, in all but name, a branch of the finance ministry. Or, if you find that analogy too extreme for your comfort level, we will, at a minimum, hark back to the bad old days of the previous bureaucrat-turned-governor Duvvuri Subbarao, who tried to intervene during the “taper tantrum" of 2013 and made a complete hash of it.

What is now self-evident is that de facto central bank independence in a political economy with generally weak institutions is not good enough. RBI needs legal, de jure autonomy, and this will require a thorough revamp of the RBI Act. Let us recall that the Act dates back to 1934, in the depths of the Great Depression and under our former colonial rulers. Independence of the central bank was not a well understood concept at that time, if it was understood at all.

It might be objected that central banks in other Westminster democracies, such as the United Kingdom or Canada, are not as legally autonomous as, say, the US Federal Reserve System, which is governed by an Act of Congress. Even US President Donald J. Trump, who has bent, or has tried to bend, other institutions out of shape, has not been able to act on his wish, or whim, to fire Jerome Powell, the chairperson of the Federal Reserve, and has had to remain content with fuming on Twitter.

As for central banks such as those in the UK and Canada, they operate within a system in which unwritten convention and accepted practice just about carry the weight of law. Thus, in Canada, after the infamous sacking of James Coyne, the central bank chief, by the Conservative government of Prime Minister John Diefenbaker in 1961, it was legally established that the central bank chief served at the pleasure of the government and could be removed by the minister of finance (Donald Fleming in 1961).

However, after it was quickly realized how disastrous this move proved to be, shaking the confidence of markets in the autonomy of the central bank, no such attempt has been made since then, though the statute governing the central bank remains unchanged. This was true even when inflation hawk and arch monetarist John William Crowe drove the interest rate (and, with it, the unemployment rate) into double digits, thereby dooming the re-election chances of the then Conservative government in 1993. However, Prime Minister Brian Mulroney never once attempted to intervene in Crowe’s monetary policy, though he clearly realized the political cost—much as a stoic former US President Jimmy Carter gave Federal Reserve chief Paul Volcker the green light to slay the evil of inflation, knowing fully well it would imperil his re-election chances in 1980.

The notion that RBI needs greater autonomy is not just the view of inflation nutters, but that of the International Monetary Fund (IMF), the arbiter of the global monetary and financial system. In the most recent review under the IMF’s Financial Sector Assessment Program (FSAP) on 21 December 2017, the Financial System Stability Assessment (FSSA) for India observed that there was “scope for further improvement", most notably “strengthening the RBI’s de jure independence as well as its powers over" public sector banks. One shudders to think what the assessors would make of recent developments.

The overarching political economy problem in India, as in most emerging economies, is that no incumbent government has an incentive to strengthen institutions, when there is short term political gain to be reaped by weakening and capturing them. This is a bad equilibrium. Meanwhile, advanced economies have converged on a good equilibrium where everyone sees it in their long-term interests to keep institutions strong.

In the case of India, as far as RBI is concerned, expect us to go from bad to worse.

Vivek Dehejia is resident senior fellow at the IDFC Institute, Mumbai. Read Vivek’s Mint columns at livemint.com/vivekdehejia

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