Reviewing RBI’s monetary policy and financial stability framework

RBI Governor D Subbarao gives a nice overview of various functions conducted by RBI. The speech is remarkably clear and I am yet to see a RBI official talking so clearly on relations of RBI with the government. Again, he is excellent bringing many ideas to the table for discussion.

He calls RBI a full service central bank managing many activities along with monetary policy.

RBI has a mandate that is wider than is typical of central banks. The preamble to the RBI Act, 19342 describes its main functions as “…to regulate the issue of Bank Notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage.”This preamble indicates the two core functions of the Reserve Bank: (i) issue of currency; and (ii) monetary authority. The Act also entrusts other functions to the Reserve Bank such as regulation of non-bank financial institutions, management of foreign exchange reserves, management of sovereign debt – by statute in respect of central government and by agreement in respect of state governments – and regulation of forex, money and government securities markets and their derivatives.

3. The legal mandate for our other key functions and responsibilities comes from specific statutes:

  • The Banking Regulation Act, 1949 together with the RBI Act, gives us the power to regulate and supervise commercial banks and cooperative banks.
  • The Foreign Exchange Management Act, 1999 empowers the RBI to regulate the foreign exchange market.
  • The Payment & Settlement Systems Act, 2007 mandates RBI to regulate and supervise the payment and settlement systems.

4. All the statutes put together make the Reserve Bank a full service central bank. We are the issuer of currency and are the monetary authority. We regulate and supervise banks, non-bank financial companies and segments of the financial markets. We are the banker and debt manager to the Government. We are the gate keepers of the external sector. We regulate and supervise the payment and settlement system. Being both the monetary authority and banking sector regulator gives us also the principal responsibility for financial stability.

5. Even as the Reserve Bank’s statutory mandate is wide compared to that of other central banks, what really sets us apart is the key role the Reserve Bank has had in driving India’s development agenda. Several national level programmes such as those for the flow of credit to the agriculture sector and for small and medium industries were initially designed and implemented by the Reserve Bank. The apex national institutions for agriculture credit (NABARD), industrial finance (IDBI) are offshoots of what were once departments within the Reserve Bank. The Reserve Bank has been at the forefront in nurturing institutions and developing financial markets in India – the money market, the foreign exchange market and the government securities market. Efforts in recent years have focussed on enhancing the depth, integrity, transparency and efficiency of these markets.

6. The Reserve Bank pioneered the Lead Bank Scheme in 1969 whereby a designated bank in each district coordinates the flow of credit from all institutions in the district in support of the district credit plan. The Reserve Bank also issues directions and monitors the priority sector lending scheme, whereby all commercial banks are required to set apart a prescribed share of their total advances to priority sector. In recent times, the Reserve Bank has been leading the effort towards financial inclusion and financial literacy with the aim of eventually providing all households in the country meaningful access to the formal financial sector.

He says RBI is not independent as per central bank law but has earned the independence through its high integrity and professional ethics. The advice flows from finance ministry to central bank and vice versa and the central bank is free to conduct its policies without any government interference.

. My second introductory comment is about autonomy and accountability. Neither the RBI Act nor any rules lay down a formal accountability mechanism. In the absence of a specific formulation, the fallback is on the general principle underlying a democracy – which is to render accountability to the parliament through the Finance Minister. The Reserve Bank assists the Finance Minister in answering parliament questions that pertain to its domain. Besides, the Standing Committee on Finance of Parliament summons the Governor for testimony on specific issues including legislations under consideration.

8. As regards autonomy, the Reserve Bank has not been accorded autonomy under the statute. The RBI Act  lays down that the Central Government may give directions to the Bank, from time to time, after consultation with the Governor, where considered necessary in public interest.

9. To an untutored observer, the above arrangements present a picture of a central bank with limited autonomy, and that too enjoyed at the pleasure of the Government, juxtaposed with relatively loose systems of accountability.

10. The reality, however, is quite different. RBI in effect functions with a functionally autonomous mandate and there has been no instance so far of the Government exercising its reserve powers to issue a directive. This is all the more remarkable since the  interaction between the Government and the Reserve Bank is closer and more frequent than is typical in other countries, and this draws from the key role of the Reserve Bank in financial sector reforms and economic development. But this close relationship has not spilled over into the Government encroaching on the Reserve Bank’s autonomy in making monetary policy and regulatory policy.

He then touches on how RBI makes its monetary policy. Again unlike central banks that have a formal MPC/FOMC, RBI does not have any such committees. It has a more informal process with Governor in charge of the decisions:

Monetary policy decisions are made by the Governor. There is no formal committee structure like the FOMC of the Fed or the Monetary Policy Committee (MPC) of the Bank of England. The Governor holds structured consultations with the four Deputy Governors and they constitute an informal MPC although a committee structure is not enjoined under the law or the rules. By its very nature there is no voting in this committee and the final call is that of the Governor.

We do have a Technical Advisory Committee (TAC) on Monetary Policy that acts as a proxy policy committee, but it is advisory in nature. It comprises the Governor as chairman, the Deputy Governor in charge of monetary policy as the vice chairman and other three Deputy Governors as members. Besides, the committee has five external members, two of whom are experts from the Central Board of the Bank while the other three are drawn from a wider pool. The external members are nominated by the Governor. They give specific recommendations on policy options and these are minuted. We have recently started putting the minutes of the meeting in the public domain, including specific recommendations, without directly identifying members with their advice.

….close to the policy decision, an established practice for the Governor is to meet the Prime Minister and the Finance Minister informally, give them an assessment of the macroeconomic situation and indicate to them his proposed policy stance. This is only a matter of courtesy, and the process has not impinged on the autonomy of the Reserve Bank in monetary policy making. The consultation with the Finance Minister, in particular, should be seen as an avenue for fiscal-monetary coordination, since on a reciprocal basis, the Finance Minister too takes the Governor into confidence on the fiscal stance ahead of presenting the budget to the Parliament.

He says RBI should over a period move on to the MPC model. But for that it needs to fit in following conditions:

  • legally-backed formal autonomy
  • inflation is still dependent on supply side issues which RBI cannot do much. So, we need to sort these supply issues
  • markets need to deepen further and monetray transmission to improve

I would agree on the first point. We need to have legal system to appoint members of MPC. Not sure about the next two as MPCs worldwide face these issues. They can guide on improving the system and it is going to be like the RBI monetary policy setting system as of now.

He again says RBI cannot become an inflation targeting central bank. Reasons are:

  • It has a mandate with many objectives
  • supply side inflation pressures
  • many measures of inflation; India still does not have an accepted CPI measure other countries target
  • monetary transmission is not proper as many kinds of administered interest rates like postal savings etc.

He says unlike other economies which might not look at inflation, in India both central bank and politicians want lower inflation:

Importantly, there is a political economy argument too against the Reserve Bank becoming an inflation targetter. The intellectual basis for central bank independence draws from Rogoff’s conservative central bank construct. The construct is based on the assumption that governments tend to favour growth and employment while central banks, left to themselves, would seek to lower inflation. Precise inflation targeting formalizes this arrangement and dilutes the scope for interference in each other’s domain. Such independent policy pursuits by the Government and the central bank, it is contended, serve the best interests of the national economy.

This assumption does not hold in the case of India because societal tolerance in India for inflation is low. Given the compulsions of democracy and the large population of poor, any government in India has always to be, and indeed has been, sensitive to price stability even if it means sacrificing output in the short-term. So, the argument of divergence of natural preferences as between the government and the central bank that underpins the inflation targeting framework does not hold in the case of India. Indeed both the Government and the Reserve Bank have to factor in the short-term growth-inflation trade off in their policy calculations.

I mean who would believe this. Wanting is different from intent. Average Inflation since Jan-10 has been around 9.3% and whether there is good or bad monsoon, food inflation remains exceptionally high. Since Apr-05 food inflation has averaged 10.3%, a completely unacceptable number.

He then touches on macroprudential policy and says RBI has been doing it for many years as part of its mandate.  Other economies are struggling to balance mon pol with fin stability, but RBI finds no such issue:

Possibly because of this judgement dimension, among central banks that are new to macroprudential regulation and supervision, there is an apprehension that performing this task will make them vulnerable to political interference. There is also an unstated fear that once a culture of political interference into central bank business gets a foothold, it will rapidly ‘spillover’ into all areas of central bank business, including monetary policy, and thus erode the much prized autonomy of the central bank.

34. The Indian experience does not bear out this apprehension. Macroprudential regulation and supervision have historically been a part of the Reserve Bank’s mandate. Yet there have been no instances of political influence on the macro prudential policies of the Reserve Bank acting in its capacity as the regulator. In fact, the Reserve Bank enjoys as much autonomy over its regulatory decisions as it does on its monetary policy decisions, and the political system has not tried to influence the Reserve Bank’s stance.

This is quite true and ironical. RBI has a much better track record in handling financial stability rather than price stability atleast in recent years. Which is different from other central banks which have a better record managing inflation and an abysmal record in managing financial stability. As central banks are expanding on their financial stability objective, they would soon be judged on both price and financial stability.

Then there is another aspect of Public Debt management. Guv disagrees that a sepearte office would be better. Indian conditions are diffrenet and RBI is best suited for the job:

There is need to reconsider the content and pace of this process in view of the revised circumstances post-crisis. The case for shifting debt management function out of the central bank is made on several arguments such as resolving conflict of interest, reducing the cost of debt, facilitating debt consolidation and increasing transparency. These advantages are overstated.

40. The most potent of these arguments is the one relating to conflict of interest. The other arguments pertain to mechanics of debt management which can be said to be model neutral. Let me, therefore focus on the conflict of interest issue.

41. The primary conflict which is generally associated with a central bank managing sovereign debt pertains to the one between its inherent responsibility as the monetary authority, and its obligations as a debt manager. In particular, it is argued that the central bank will be biased towards a low interest regime in order to reduce the costs of sovereign debt even if it compromises its anti-inflation stance. A similar conflict may also distort the open market operations of the central bank.

42. The above arguments, though valid in some countries, fail to recognize that in countries such as India, given the large size of the government borrowing program, sovereign debt management is much more than merely an exercise in resource raising. The size and dynamics of government borrowing program has a much wider influence on interest rate movements, systemic liquidity and even credit growth through the crowding out of private sector credit demand.  Management of public debt, therefore, has necessarily to be seen as part of broader macroeconomic management framework involving various tradeoffs. Once this is recognised, the centrality of central banks in this regard becomes quite evident. Only central banks have the requisite market pulse and instruments to aid in making contextual judgements which an independent debt agency, driven by narrow objectives, will not be able to do.

43. Also, it is not that these conflicts would disappear merely by shifting debt management out of the central bank. In fact resolving those conflicts could become much more complicated leading to inferior outcomes. This is because even after the separation, the central bank would continue to be expected to manage the market volatility and market expectations arising out of government borrowing.

In the Indian context, there is the added complexity of managing the debt of the states. The sensitivity of the states to entrust debt management to an agency of the Central Government also needs to be kept in view given the political-economy dimensions of our federal structure. This is all the more important since market borrowings have emerged as the dominant source of deficit financing at the sub-national level. Taken together, the borrowing by states has attained a critical mass vis-a-vis the absorptive capacity of the market. That makes it imperative to harmonise the market borrowing programmes of the Centre and the States. Separation of the Centre’s debt management from the central bank will make such harmonisation difficult.

46. Thus, on balance, as long as there are institutionalized mechanisms to negotiate various tradeoffs in a given context within the overarching objective of achieving monetary and financial stability, separation of debt management from central bank seems to be a sub-optimal choice. Even internationally, the emerging post-crisis wisdom recognizes the interdependence between the functions of monetary policy, financial stability and sovereign debt management and the need for close association of the central bank with sovereign debt management.

Amazing clarity once again.

Very good speech. A good primer on RBI’s various objectives and how it manages/balances them.

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4 Responses to “Reviewing RBI’s monetary policy and financial stability framework”

  1. littleG Says:

    India is fortunate that we had excellent RBI governors for sometime now. Current governor is in my opinion the boldest. Even under tremendous pressure from politicians (backed by real estate mafia), he chose to do the right thing by increasing interest rates. Unfortunately, this hurts the poor and middle class who borrow the most. It doesn’t affect the rich who speculate the most and don’t borrow at all (since they are flushed with tons of black money).

  2. Many thanks Says:

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  4. Yogesh Says:

    Any one pls let me understand how on earth does high interest rate reduce inflation, in my context i explain it that rising interest rates will increase inflation….
    no one taking loan will pay the interest from his or her pocket, any businessmen will add the cost of fund to cost of product that inturn will increase interest. hence RBI increasing interest rates is increasing inflation…..

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