Managing the RBI-finance ministry rift

It was an open secret that the Union finance ministry did not see eye to eye with the Reserve Bank of India (RBI) on monetary policy. The rift is now out in the open.

The sequence of recent events is as follows. The finance ministry had summoned the members of the monetary policy committee (MPC) to New Delhi to discuss interest rate policy. The MPC members formally refused to attend the meeting. RBI governor Urjit Patel made this public in an interaction with journalists. The MPC also decided—rightly in our opinion—to not cut interest rates in their policy meeting on Wednesday. Chief economic adviser Arvind Subramanian put out a statement on why he disagreed with the decision.

Subramanian argues in his short note that the root of the disagreement is different assessments of the state of the Indian economy. Rising real interest rates are out of place when inflation is low while economic growth is slowing. The MPC press note after the policy decision argues that problems such as stagnant private sector investment, the state of the banking sector and infrastructure bottlenecks cannot be addressed by lowering interest rates (though the actual minutes of the meeting, especially the dissenting vote by MPC member Ravindra Dholakia, will be worth reading when they are published).

Such conflicts between finance ministries and central banks are not uncommon across the world. The question is how well the creative tension is managed. India itself provides starkly different examples.

There was excellent coordination between New Delhi and Mumbai when Manmohan Singh was finance minister and C. Rangarajan was RBI governor, even when the central bank went in for a brutal tightening of policy in response to double-digit inflation. We saw a similar smooth working relationship between Yashwant Sinha and Bimal Jalan.

Matters have been more tense since then. The episodes of friction between the two masters of our financial universe are well known. Some of them were highlighted in the book written by former RBI governor D. Subbarao, Who Moved My Interest Rate?. These years of conflict also saw a concerted campaign from New Delhi to cut the RBI down to size, as when the financial stability and development council was set up in 2010 with the central bank as just one of several regulatory institutions who are its members. The rupee crisis of 2013 did act as a glue, but even here most of the coordination was done by officials rather than the finance minister and the governor.

Institutional coordination is as much an art as a science. The art comes from the ability of people to work together despite conflicting views. The science comes from the institutional rules that set out the specific areas of responsibility. Both need to be nurtured.

The MPC members did well to not attend the meeting in the finance ministry. We had argued in these columns earlier that such a meeting was in conflict with the clear provisions of the RBI Act. However, the finance ministry is also empowered under the revised Act to offer its views on interest policy in writing to the MPC. Subramanian has done precisely that, though in the public sphere.

Disagreement is not in itself a bad thing, as long as the legal provision that the MPC gets freedom to pursue the inflation target formally given to it by the government is respected. What matters more right now is the threat of a breakdown in communication. It is not just about interest rate policy. The biggest risks to economic stability right now come from the banking sector. Several policies have been tried out. Several ideas have been floated. The mountain of bad loans has kept getting bigger.

The finance ministry and the central bank—with the Prime Minister’s office also an important player—need to work together to provide credible solutions to the bad loans problem. Institutional coordination will be important, and the current tension needs to dissipate.

Finance minister Arun Jaitley has been remarkably disciplined when it comes to commenting on monetary policy, unlike some of his predecessors. He now needs to bring in his famed negotiating skills to establish the ground rules, so that bigger problems than an interest rate cut can be credibly sorted out in the coming months.

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