Even if they’re wrong, apex banks should have freedom

The government and the Reserve Bank of India (RBI) have been airing their dirty laundry in the public, with statement and counter-statement between officials in the RBI and the finance ministry flying thick and fast.

The differences between the two camps reportedly include addressing liquidity problems faced by the NBFC and MSME sector, the proposal to set up a payment regulatory system independent of the RBI as well as the perennial interest rate issue that devolves into the traditional growth-inflation trade-off debate.

Also, the Prompt and Corrective Action framework under the RBI that restricts lending by sick banks has reduced lending by those banks burdened by huge NPAs, and therefore, according to the government, restricted growth.

Finally, the government has its eyes on RBI cash reserves that it believes it can use to finance its fiscal deficit. The RBI feels that its independence is threatened.

Here is why central bank independence is important.

Central bank independence is a term coined for the ability of a central bank to set its objectives and also operate in an independent fashion from the government of the day. By doing this it must walk the tightrope of the trade-off between price stability – low and stable inflation – and growth, the correct balance between which is a tendentious subject at best in a developing and aspirational country like India.

Independence is necessary for two prime reasons. It is desirable, for one, because a mandate of price-stability is a long-term mandate, to fulfill which it must be able to withstand short-term pressures of increasing credit and fuelling a ‘feel-good’ bubble.

Secondly, and more importantly, the mandate stays the same even as governments change. Therefore, if its policies are to hold any credibility with the markets, for example, just before a change of government, the markets must be assured that the forthcoming (different) government will not have the power of influencing or changing the stated policy once it comes to power.

Credibility is an extremely important factor particularly in central bank decisions because without credibility built up over decades, the efficiency of changes in policy will be eroded and therefore, the ability of the central bank to act in times of crisis will be curtailed.

This concept seems to be what Deputy Governor Viral Acharya is referring to when he says that “Governments that do not respect central bank independence will sooner or later incur the wrath of the financial markets.”

Of course, there are always two sides to every tale. The government may be absolutely correct in its stance that credit is too tight, that rates are too high, that it can use the cash reserves of the RBI, that the payment regulator independent of the RBI may be a good thing, and that growth is a priority for a developing nation.

Central bank autonomy

At the same time, however, central bank independence is all the more important almost precisely because the arguments of the government of the day are correct.

Even if the government is correct, and the central bank wrong, the government should not set a precedent by interfering with the bank’s functioning.

The government must keep in mind that the central bank’s policies must be seen to be, and therefore, must actually be, independent, precisely because while the government’s time horizon is immediate or short-term, “a central bank plays a Test match, trying to win each session, but importantly also survive it so as to have a chance to win the next session, and so on,” to use Dy. Governor Acharya’s cricketing analogy.

Central bankers have “horizons of decision-making that tend to be longer, spanning election cycles,” without which the central bank would not be able to function effectively as a modern central bank.

This is why Raghuram Rajan in a statement strongly supporting officials with “backbone” said that it is essential because ‘these guys’ (officials with the backbone) give you credibility in the market to keep interest rates low.

The government will lose all that if it manages the central bank. “Why then go through the farce of having an independent central bank? Bring it all in (under the finance ministry)! But if you do that, you will become a Zimbabwe,” he warned.

India is not the only country with a current spat between the government and the central bank. In the United States, President Donald Trump has been critical of the Fed for increasing rates too quickly and stifling an economic recovery. There, like here, the central bank is mandated to have a long-term view.

But Trump, love him or hate him, has the mandate of the people, and in a democracy, should not the people’s representative have the ultimate say on whether or not faster growth is a priority over taming inflation?

The point to bear in mind is that there is a difference between disagreeing with central bank policy and actively threatening to undermine its independence. It is the former that is the case in the United States, and, unfortunately, the latter appears to apply to the Indian situation.