Honestly, is the RBI autonomous?

The tussle between the government and the Reserve Bank of India (RBI) is an on and off affair. However, it reached a flash point when it was reported that the government had for the first-time used powers under the RBI Act to give it ‘specific’ directions.

The RBI is the last resort for any bank and is the regulator, which looks at the smooth flow of cash, maintaining financial and monetary stability. The government is blaming the RBI for rising non-performing assets (NPA), higher interest rates and cash crunch.

The government and central bank work together to achieve fiscal, financial and monetary stability in the economy. However, since Independence, the RBI has maintained its autonomy over financial matters. Only in 1937 and 1957, there were major differences when the government questioned the policies of the RBI.

The government’s decision to demonetise high denomination currency in 2016 resulted in a financial downturn. Rising fiscal deficit in recent years due to heavy government expenditure has resulted in easing of monetary policy as it is tied to the fiscal deficit. Resultantly, we have rising interest rates and inflation.

In this context, we need to look at how independent the RBI really is, the need for autonomy, the economic consequences and the need for harmony between the government and the central bank.

By autonomy, we mean self-governance, freedom from external control or influence, and being independent. The communication policy of the RBI states: “Role of communication policy, therefore, lies in articulating the hierarchy of objectives in a given context in a transparent manner, emphasising a consultative approach as well as autonomy in policy operations and harmony with other elements of macroeconomic policies”. This re-emphasises the fact that the government gets involved in consultation to give suggestions rather than to take over the entire policy operations in its hands and rule the economy.

Economists believe that central banks need to be given some degree of independence so that they are able to formulate monetary policy to manage inflation, interest rates and other macroeconomic variables such as economic growth. World over, central banks are owned by government, but protect their independence. For instance, the Bank of England is completely owned by the British government and the specific functions of determining interest and policy rates framework are in line with the government. However, it is free from day-to-day political influence. In Japan, the government cannot sack the governor or board members of the Bank of Japan.

Autonomy can have three aspects — personnel, policy and financial independence. Personnel independence indicates how free a central bank is from government influence in appointments, terms of office of top-tier officials and governing board members. Policy independence refers to the control a central bank has over its instruments to tackle and implement monetary policy. This can mean it can decide what goals to achieve, say, for instance, inflation or the government can set a goal and it can achieve this goal by whatever means it has, on which the government has no control.

Financial independence is the most challenging one. Here, it gets to decide the extent to which government expenditure is either directly or indirectly financed by central bank credits. Financial independence is dependent on the fiscal deficit. This usually leads to monetisation of fiscal deficit through seigniorage (the difference between the value of money and the cost to produce it), which results in rising inflation.

The RBI enjoys great independence, since it is a prerequisite for implementing effective monetary policy. What leads to questions over its autonomy is the relationship between fiscal and monetary matters. The functioning of the RBI is tied to fiscal policy; in most cases, the fiscal deficit. Harmony has to be maintained between monetary and fiscal policies for a stable economy.

Section 7 of RBI Act

The rift between the government and the RBI is based on the implementation of Section 7 of the RBI Act. This section specifies that the central government may from time to time give such directions to the bank as it may, after consultation with the governor of the bank, consider necessary in the public interest. The section had never been invoked since Independence. However, Section 7 is vague on the extent of the government’s right to overrule the RBI.

The power to control money supply, maintain inflation rate, regulate reserves and assets of banks is with the RBI. The finance ministry is not in sync with the RBI’s recent move to follow stringent regulation. In 2008, the RBI initiated purchasing of assets of NBFCs through a special purpose vehicle to curb the liquidity crisis. However, in the current situation, it has refused to act, due to which the finance ministry had to fall back on public sector banks to buy NBFCs’ assets. As the PSU banks are already bogged down by NPAs, the government was pushing RBI to step in.

The recent blame-game kicked off with the Punjab National Bank scam. The RBI blamed the government for not giving it the same powers to supervise public sector banks as it has for supervising private banks. The finance ministry hit back saying that the RBI has enough powers to check asset quality of banks and defaulters. The government’s claims over the amount of black money recovered through demonetisation and the RBI’s figures do not match, either.

Overall, to sustain economic growth by containing inflation and interest rates, the central government and the RBI must work in harmony. Monetary and fiscal policies must complement each other. Better outcomes can be achieved only when “The Reserve Bank cannot just exist, its ability to say ‘NO!’ has to be protected. At the same time, the central bank cannot be free of all constraints, it has to work under a framework set by the government” as stated by former RBI governor Raghuram Rajan.

(The writer is an alumnus of the London School of Economics)