Reserve Bank of India (RBI) governor D. Subbarao begins his third year in office this week. His first year was spent managing fallout of the global financial crisis and second managing the recovery in Asia’s third largest economy. Subbarao’s third year in office, in many ways, will be more critical than the first two. Apart from high inflation and economic growth, he needs to manage the simmering tension between the finance ministry and the central bank.

RBI has already lost the battle for autonomy to the ministry of finance with Parliament passing the regulatory dispute resolution Bill with a few cosmetic changes to the ordinance it replaced. But the governor seems to be not ready yet to give up the bank’s role in maintaining financial stability, which, too, the ministry is keen to take away.

Also Read Tamal Bandyopadhyay’s earlier columns

When Subbarao took over in September 2008, the wholesale price-based inflation was more than 12% and his immediate predecessor Y.V. Reddy had been following a tight money policy, raising the policy rate as well as banks’ cash reserve ratio (CRR), or the portion of deposits that commercial banks are required to keep with the central bank, to 9% each. About a week later, the US investment bank Lehman Brothers Holdings Inc. collapsed, plunging the world financial system into an unprecedented credit crunch. So Subbarao had to dramatically reverse the stance, cut the policy rate from 9% to 3.25%; CRR to 5%; and the floor for banks’ investment in government bonds from 25% to 24%.

Euphemistically, the policy measures—which generated at least Rs5.6 trillion of liquidity to fight the credit crunch and lift a sagging economy—were taken in close coordination with the finance ministry, but no one will deny the fact that at the time of crisis the real boss was the fiscal authority. Fresh in his assignment, Subbarao didn’t mind playing second fiddle to the government as he needed time to understand the nuances of central banking and an ultra-loose monetary policy was the order of the day globally.

As the signs of economic recovery strengthened and inflation started rising again, the governor signalled withdrawal of monetary accommodation and began raising rates. India’s policy rate is now 5.75% and CRR 6%. Analysts are predicting more rate hikes till the end of the fiscal year.

In a recent speech, Subbarao strongly ruled out inflation targeting, saying this is “neither desirable, nor practical in India". This is because RBI is into multi-tasking (growth, price stability and financial stability) and the drivers of inflation emanate from the supply side on which monetary policy has no control. His arguments may have merit but one should blame his speech writer as he ended up giving an impression that RBI wants to absolve itself of the responsibility of managing price stability. Blaming food prices, and praying for a good monsoon and drop in global commodity prices to tame inflation will not strengthen RBI’s credibility. The Indian central bank may choose not to be an inflation targeter, but it cannot shy away from its role in fighting inflation.

This is one of the many challenges that Subbarao will face in his third year. To his credit, he has taken some baby steps towards financial sector reforms by expanding the scope of currency futures, introducing interest rate futures and repurchase or repo corporate bonds, and allowing banks to offer vanilla cross-currency options. The central bank is also in the process of introducing plain vanilla credit default swaps for corporate bonds. But there are more critical issues. For instance, RBI has freed all loan rates and now the banking regulator is expected to dismantle the last bastion of administered rates—the interest paid on savings accounts. This is easier said than done as it will dramatically change the cost structure of deposits for banks and put pressure on their net interest margins and profitability. Similarly, Subbarao is widely expected to lay down a fresh road map for foreign banks in India. Six years ago, RBI had said it would review the norms for foreign banks’ play in 2009. But the Lehman crisis changed the scenario and the review is still pending. Meanwhile, finance minister Pranab Mukherjee sprang a surprise in his February budget speech announcing that the central bank will consider giving licences to new private players to set up banks. An initially reluctant RBI has already released a discussion paper and we may see quite a few new banks next year.

External experts can help Subbarao identify the “fit and proper" candidates to set up new banks, but the governor has to fight his own battle with the finance ministry for autonomy which is at stake. The relationship between the ministry and RBI was severely strained during Reddy’s regime, and one of the reasons for choosing Subbarao over Reddy’s deputy Rakesh Mohan as governor was possibly to regain the ministry’s grip over RBI. But Subbarao, the seventh finance secretary to become governor in the central bank’s 75-year history, is refusing to play the proverbial Trojan Horse. The differences between RBI and the ministry are not only in regard to their perceptions about growth and inflation, but on key issues such as who will resolve regulatory tussles and who’s responsible for financial stability. This will intensify further as the ministry seems to be determined to be the super-regulator. The governor wants to fight it out. If he does so, he runs the risk of losing confidence of the ministry and may not get another term after his current tenure expires in September 2011. On the other hand, if he gives in, his office’s integrity will be compromised.

Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai. Please email comments to

My Reads Logout