The Viral warning to govt

The Viral warning to govt

Viral Acharya

The government vs RBI war became public and full-blown after the central bank’s Deputy Governor Viral Acharya sounded out a warning to the government in the form of a memorial lecture “On the Importance of Independent Regulatory Institutions – The case of the Central Bank” on October 26, pointedly enumerating the very ways in which the Narendra Modi government was seeking to undermine the RBI’s independence. Excerpts from his speech:

…A central bank performs several important functions for the economy

It controls the money supply; sets the rate of interest on borrowing and lending money; manages the external sector including the exchange rate; supervises and regulates the financial sector, notably banks; it often regulates credit and foreign exchange markets; and, seeks to ensure financial stability, domestic as well as on the external front.

The world over, the central bank is set up as an institution separate from the government; put another way, it is not a department of the executive function of the government; its powers are enshrined as being separate through relevant legislation…

…A government’s horizon of decision-making is rendered short, like the duration of a T20 match by several considerations. There are always upcoming elections of some sort – national, state, mid-term, etc. As elections approach, delivering on proclaimed manifestos of the past acquires urgency; where manifestos cannot be delivered upon, populist alternatives need to be arranged with immediacy…

In contrast, 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. In particular, the central bank is not directly subject to political time pressures and the induced neglect of the future…

“Kiss of Death”

…When such a measured perspective of an independent central bank as a key element of durable economic prosperity is missing and/or government myopia so rife as to lead to regular inroads into central banking apparatus and decisions, unfortunate accidents can arise. Macroeconomic management can become a tug of war between securing stability and inflicting misdirection; daily operational decisions lead to power struggles; and, as the central bank is forced to bend over backwards to retain credibility in the face of imminent pressures that would erode its independence, counter efforts to reduce its independence escalate.

As this dynamic plays out, markets watch keenly, and if uncertainty grows and confidence in central bank independence and credibility erode, then markets rap bond yields and exchange rate on the knuckles!

Barry Eichengreen, Professor of Economics and Political Science at the University of California, Berkeley, covers superbly, in his recent piece (2018), this critical feedback role of the market:

“There are good reasons why countries … delegate monetary policy decisions to technocrats appointed for their expertise. They can take the long view. They can resist the temptation to manipulate monetary conditions for short-term gain…And it is on this performance that elected leaders, rightly or wrongly, are judged.

Thoughtful politicians understand this. Hence their support for central bank independence and their respect for the convention that they should refrain from seeking to influence central bank decisions. Unfortunately, not all politicians are thoughtful. Not all have the patience to wait for long-term gains. Not all are pleased when appointees refuse to bow to their wishes. And not all are respectful of inherited institutions and conventions, be they central bank independence or, more broadly, the division of powers.”

…While the Reserve Bank has always derived several important powers from the Reserve Bank Act, 1935 and the Banking Regulation Act, 1949, what matters is the effective independence with which these powers can be exercised in practice. Over time, great strides have been undertaken by successive governments at the behest of the central bank, several economists, and umpteen committee reports, to restore the operational independence of the Reserve Bank.

…Challenges in Maintaining RBI’s Independence

…(2) The Reserve Bank’s Balance-sheet Strength: Having adequate reserves to bear any losses that arise from central bank operations and having appropriate rules to allocate profits (including rules that govern the accumulation of capital and reserves) is considered an important part of central bank’s independence from the government. A thorny ongoing issue on this front has been that of the rules for surplus transfer from the Reserve Bank to the government (Cogencis, 2018, “Govt pegs RBI excess capital at 3.6 trln rupees, seeks it as surplus”)…

(3) Regulatory Scope: A final issue is one of regulatory scope, the most recent case in point being the recommendation to bypass the central bank’s powers over payment and settlement systems by appointing a separate payments regulator. The Reserve Bank has published its dissent note against this recommendation on October 19, 2018.

…independent central bankers will remain undeterred. Governments that do not respect central bank independence will sooner or later incur the wrath of financial markets, ignite economic fire, and come to rue the day they undermined an important regulatory institution; their wiser counterparts who invest in central bank independence will enjoy lower costs of borrowing, the love of international investors, and longer life spans.

Endnote: I am grateful to Governor Dr. Urjit R Patel, Reserve Bank of India (RBI) for his suggestion to explore this theme for a speech...